6.3.1 Exchange-Traded Funds
Like mutual funds, exchange-traded funds, or ETFs, are pooled investments that contain stocks, bonds, or other financial assets. The assets are usually chosen so that they track an index.
ETFs track an index by owning a basket of representative investments from an index. The idea is that a sample from the index will perform like the entire index, so the performance of the sample of investments will be similar to the performance of the index. The securities are held by a custodian who issues a fixed number of shares that can be purchased by shareholders.
ETFs tend to track their indices well, but tracking is inherently imperfect due to such issues as cash held, fees, and the liquidity of the assets within the fund. Thus, ETFs are subject to tracking risk, which is the risk that the fund will not adequately mimic the index.
Unlike mutual funds, ETFs are bought and sold on an exchange through broker-dealers, and, also unlike mutual funds, individual ETF shares are not redeemable. The exception is that large investors or institutions can purchase something called creation units and redeem them for the underlying assets. A creation unit is a big block of ETF shares that a large investor or market maker receives in exchange for providing the securities to fill the ETF fund. A creation unit usually consists of 50,000 shares but may be smaller or larger. The large investor then sells these shares in the secondary market to individual investors.
The market price of the ETF remains close to the per-share NAV of the underlying assets. Most ETFs are structured as open-end investment companies, but some ETFs are structured as unit investment trusts, grantor trusts, exchange traded notes (ETNs) or partnerships.
In many ways, though, ETFs resem