The Creation of an ETF, or Exchange-Traded Fund

Though the exchange traded fund is the granddaughter of the mutual fund, the family resemblance pretty much ends in creation of ETFs; in fact, ETF creation and redemption has been described as diametrically opposed to those of mutual funds.

Simply put, investment in mutual funds is all about cash assets. A fund company collects cash from investors, subsequently purchasing securities with the cash in order to issue fund shares. In redemption, the shares are returned from the investor and the fund company turns them back into cash. Such transactions in exchange traded funds, however, are cash-free.

The fund manager, the major backer of the proposed ETF, sets the table for the creation of the ETF. As a preliminary step, an extensive plan must be submitted to the Securities and Exchange Commission. The plan must detail the composition of the ETF for the numerous firms that could be involved throughout all activities in the ETF’s lifespan from release to arbitrage to dissolution.

The creation of an exchange traded fund is kicked off with a specialist (sometimes known as the “authorized participant” or “market maker”) officially begins with an authorized participant, also referred to as a market maker or specialist. The specialist is heavily investigated and audited by federal interests to establish its integrity and operational competence. The authorized participant assembles a “basket” of stocks and deposits it into a custodial bank.

As in mutual funds and index funds, a proposed ETF must be registered as an investment company with the Securities and Exchange Commission. Next comes the formulation of an agreement between the sponsor of the potential ETF and an authorized party in creation and redemption of fund shares. In the great majority of cases, though, a single company acts as sponsor and authorized party, e.g. Vanguard, Barclays, State Street.

Meanwhile, the fund manager is given the task of monitoring the stock basket as it sits on account. The U.S. Depository Trust Clearing Corporation in turn monitors the flow of stocks and ETF certificates, recording all sales. Though little activity happens with the account at this time, this step is designed to reduce the possibility of fraud.

The next step for the would-be market maker is the formulation of ETF “creation units.” A creation unit is a collection of stock consisting of between 10,000 to 600,000 shares that will serve to underpin the ETF. Because of these creation units, ETF shares can be traded intraday. Representing a small piece of the creation unit, ETFs are issued to the prospective dealer as an in-kind trade involving the swapping of securities, assisting in tax relief. Once the institutional investor gets shares listed on the national exchange, private investors may purchase and trade the new ETFs.

The first ETF was launched on the Toronto Stock Exchange in 1990, and the first in America in 1993. However, a key expansion occurred when seventeen ETFs based on international stock exchanges hit the market in 1996. While at that time, the U.S. dollar was rocketing to record highs against the yen and Euro, such ETFs are a boon ten years later as the dollar bottoms out and the Euro makes a much better investment.

Other dynamic world economies soon took the plunge. In 1998, the Select Sector SPRD funds joined the market as yet another spider option. Stock exchanges worldwide began to respond to the new-fangled idea. In 1999, ETFs were introduced to the Tokyo Stock Exchange; an agreement between TSE and the American Stock Exchange in 2001 allowed cross listing and trading of ETFs between interests in the two nations.

In July 2001, the Australian Stock Exchange introduced an altogether new trading platform designed for listed investment funds created particularly in response to the still-burgeoning ETF market. Canadian, Hong Kong and Japanese stock markets launched different ETFs. Acceptance of the revolutionary investment scheme generally caught on as quickly outside North America as they had in the U.S. and Canada, as the market grew by 43 percent in a single year.

Surprisingly slow to leap into the fray was Europe; some have blamed this seeming hesitance on European Union bureaucracy. ETFs were only introduced on The Continent in 2001. By year’s end, however, an unknowing observer never would have guessed that European investors had been without this option for so long. With the first introduction came two ETF opportunities: SPDR Europe 350 and SPDR Euro, both based in firms across the EU. By year’s end no fewer than sixty-one ETFs existed on the European market, and by the third quarter alone, the assets within European exchange traded funds was more than $3.6 billion, an increase of fifty-eight percent over the previous quarter. ETFs were also rapidly unveiled in each of the EU 15 countries and, with the May 2004 accession of Poland, Hungary and the Czech Republic, ETF markets have been constructed in these nations as well, though the actual launching of any ETFs has yet to occur.

Today in America, indices tied into the economies of Australia, Austria, Belgium, Brazil, Canada, France, Germany, Hong Kong, Italy, Japan, Latin America, Malaysia, Mexico, the Netherlands, Singapore, South Africa, South Korea, Spain, Sweden, Switzerland, Taiwan and the United Kingdom are readily available. The majority of these are Barclays’ iShares, showing this firm’s forward thinking attitude of the 1990s. Most exciting for those looking to grab some of the European pie (or for those just looking for a new interesting investment opportunity), 2006 will see the launch of Rydex Investments’ Euro Currency Trust, the first currency-based ETF of any sort.

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