The Exchange-Traded Funds Manual, Second Edition

CHAPTER 3

The Regulatory Framework and Mechanics of the Open-End ETF

This chapter describes the basic regulatory and operations framework for investment company open-end ETFs, including the transaction cost allocation functions of the in-kind fund share creation and redemption process, in more detail than the brief summary in Chapter 1. Investors who rely on an advisor may decide to skip all but the first few sections of this chapter. Advisors and investors who do not rely on an advisor should read the entire chapter to be certain that they understand ETF “best practices.” They need to be able to evaluate ETFs (and mutual funds) that might cut a corner or two at their shareholders’ expense. The increasing diversity of ETF portfolios increases the range of opportunities for product developers to implement features that meet minimum regulatory requirements in a way that (1) compromises established ETF shareholder protection from the cost of other investors’ entry to and exit from the fund, (2) does not provide the capital gains tax deferral that is almost inherent in most pre-2005 equity ETFs, or (3) combines an unusual investment process with the ETF structure in a way that creates unexpected results. There is nothing necessarily wrong with an ETF that does one or more of these things. There may be perfectly valid reasons for an ETF to have different features, but anyone using an ETF needs to know what that particular fund can or can’t deliver and what features of a specific product ...