Designing ETFs

January 01, 2001

Exchange traded funds (ETFs) are passively managed portfolios designed to closely track the performance of well-established major stock market indexes.

They offer investors the opportunity to trade domestic and foreign index funds continuously throughout the day, just as they would an individual stock, while allowing for a variety of sophisticated strategies and complex asset allocations.

The wide variety of ETFs currently available provides investors with easy access to many domestic U.S. asset classes: large-, mid- and small-cap stocks, value and growth styles, and nine economic sectors.
They also permit investing in 23 countries in five regions outside the U.S. As evidenced in Exhibit 1, they represent a veritable cornucopia of diversified investment opportunities that are available with minimal trading effort and cost.1,2 

Forms of ETFs

An ETF takes one of three structural forms: a unit investment trust (UIT), an openend fund (OEF) or a grantor trust (GT). Both the UIT and OEF structures are set up under the Securities & Exchange Commission's Investment Company Act of 1940 (1940 Act) and require exemptions from several provisions of the act in order to function as ETFs, rather than as mutual funds. The GT form is not an investment company as defined by the 1940 Act, but it has similarities to the other structures that cause it to be considered an ETF.

The original ETF structure was a unit investment trust, used in funds designed to replicate the Dow Jones Industrial Average (Diamonds, DIA), Standard and Poor's 500 (SPDRs, SPY), and the Nasdaq-100 (Nasdaq-100 Trust, QQQ). Consequently, some observers have argued that ETFs using the UIT structure are misnamed and
should be called exchange traded trusts. ETFs using this structure are required to fully replicate a target index in order to minimize their tracking error. However, the degree to which tracking error can be reduced is limited because dividends paid into the trust cannot be used to purchase additional securities, but can only be used to cover expenses or be distributed to the shareholders. In addition, the trusts are not permitted to lend securities to generate additional income, which lessens the possibilities for enhancing their performance.

A more recent innovation is the openend fund structure 3 used in 65 ETFs recently issued by Barclays Global Investors as iShares. This structure has several advantages over the UIT. It is not required to fully replicate an index but may approximate it using mathematical methods such as optimization and stratified sampling. Unlike the UIT structure, it can reinvest dividends and generate income by lending securities.

The grantor trust is not an ETF in the usual sense applied to the other structures. It has recently been introduced by Merrill Lynch, and is popularly known as Holdrs, 4 which are trust-issued receipts that represent beneficial ownership of a basket of stocks representing a particular industry sector or group. This structure offers some of the benefits of exchange traded funds to individual investors, but also provides a measure of personal control by permitting a shareholder to unbundle one or more of the underlying stocks to suit their investment objectives, risk preferences, and tax strategies.

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