The Capital Markets

CHAPTER 27Exchange‐Traded Funds (ETFs)An Overview

Reginald M. Browne

An exchange‐traded fund is a financial instrument, similar to a mutual fund, that is comprised of a basket of securities designed to track the performance of an index such as the S&P 500. However, unlike mutual funds that price daily at the market close based upon the fund's closing net asset value (NAV), these open‐ended trusts trade continuously on public exchanges, with their prices fluctuating throughout the day based on supply and demand like common stock.

ETFs may be indexed to track any of the major market indices across asset classes, geographic regions, and market sectors. ETF sponsors employ several strategies designed to produce market returns based on an investor's risk objectives such as leveraged ETFs, which use credit to amplify market movements. A recent ETF strategy is the smart‐beta ETF, which applies a rules‐based strategy structured to reduce risk and enhance index returns by adjusting the weighting of the components in the fund. There are also actively managed ETFs, which seek to replicate returns on actively managed portfolios but do not track an index per se.

CONSTRUCTING AN ETF: MARKET PARTICIPANTS AND THEIR FUNCTIONS

Regardless of strategy type or investment focus, structuring an ETF requires the interaction of a number of different players including: the issuer or asset manager, the authorized participant, the custodian, and the market maker.

Issuers (Asset Managers)

The ETF issuer, ...