Creating an ETF

An ETF is created when a marketmaker or “authorized participant” essentially lends a portfolio of shares to the fund manager. Those stocks then are placed in a trust and shares of the ETF are created.

Investing in ETFs allows an institution to stay broadly invested in the stock market, while ensuring that the assets are very easy to convert to cash for reinvestment.

Unlike mutual funds, ETFs do not necessarily trade at the net asset values (NAV) of their underlying holdings.

Rather, an ETF’s price is determined by market forces, although the value of the underlying assets certainly has an impact (larger investors have the ability to put together 50,000-share blocks of the ETF and exchange them for an in-kind distribution of the underlying securities).

ETFs versus Mutual Funds: A Comparison

Like mutual funds, there are no capital gains taxes paid by the fund itself on the buying or selling of securities within the funds, as long as the funds distribute nearly all the capital gains and dividends to the shareholders.

However, as a general rule, ETFs generate less in the way of capital gains distributions than comparable mutual funds-a real benefit to retail investors (though this would not be a factor within a qualified plan). That is because of both higher liquidity as a result of how the fund trades, and a “swapping” mechanism that ETFs use where they swap units of participation for redemptions, rather than going to the market for the cash.

Traditionally, ETFs pay dividends to shareholders on a delayed basis, rather than reinvesting them automatically, an option frequently available to mutual funds.

However, iShares, which have been registered with the SEC as open-ended funds, reinvest dividends immediately.

Beginnings

The notion of an exchange-traded fund goes back to the late 1980s. However, it was not until 1990 that portfolio insurance product developer Leland, O’Brien, Rubenstein Associates (LOR) petitioned the SEC to allow the creation of an ETF as the underlying security for a “SuperTrust.”

The security was approved that year-the first one authorized that had characteristics of both an open-ended and exchange-listed security. However, the product terminated in 1996, due to a lack of market interest.

Fortunately, in 1992, the American Stock Exchange LLC, through its subsidiary PDR Services LLC and the Standard & Poor’s Depository Receipt (SPDR) Trust, took advantage of SEC exemption to gain authorization for a stand-alone S&P 500 Index-based ETF as a unit investment trust.

This SPDR, or “spider” as it became known, was the first commercially successful ETF, followed in 1995 by an ETF tracking the S&P MidCap 400.

A year later, Morgan Stanley teamed up with Barclays Global Investors and the American Stock Exchange to create World Equity Benchmark Shares (WEBS).