The Handbook of Financial Instruments

Chapter 22 Exchange-Traded Funds and Their Competitors

Gary L. Gastineau

Managing Director ETF Advisors, LLC

Exchange-traded funds (ETFs) are the most important—and potentially the most versatile—financial instruments introduced since the debut of financial futures 30 years ago. We begin this chapter by explaining the origins of ETFs and some of their important features like intra-day trading on a stock exchange, creation and redemption of fund shares “in-kind,” and tax efficiency. We also compare the recently popular open-end ETFs to competitive products like closed-end funds, conventional mutual funds, HOLDRs, and Folios in terms of costs, applications, and tax efficiency.

THE HISTORY AND STRUCTURE OF ETFS AND SOME COMPETITORS¹

Exchange-traded funds, referred to by friends and foes alike as “ETFs,” are outstanding examples of step-by-step evolution of new financial instruments starting with a series of proto-products that led in a natural progression to the current generation of exchange-traded funds and set the stage for products yet to come.

Portfolio Trading

The basic idea of trading an entire portfolio in a single transaction did not originate with the TIPS or SPDRS, which are the earliest successful examples of the modern portfolio-traded-as-a-share structure. The idea originated with what has come to be known as “portfolio trading” or “program trading.” In the late 1970s and early 1980s, program trading was the then revolutionary ability to trade an entire portfolio, ...