) is aninvestment fundtraded onstock exchanges, much likestocks.An ETF holds assets such as stocks, commodities, or bonds and generally operates with an arbitrage mechanism designed to keep it trading close to itsnet asset value,although deviations can occasionally occur. Most ETFs track anindex, such as astock indexorbond index. ETFs may be attractive as investments because of their low costs,tax efficiency, and stock-like features.

ETF distributors only buy or sell ETFs directly from or toauthorized participants, which are largebroker-dealerswith whom they have entered into agreementsand then, only increation units, which are large blocks of tens of thousands of ETF shares, usually exchangedin-kindwithbasketsof the underlyingsecurities. Authorized participants may wish to invest in the ETF shares for the long-term, but they usually act asmarket makerson the open market, using their ability to exchange creation units with their underlying securities to provideliquidityof the ETF shares and help ensure that their intraday market price approximates the netassetvalue of the underlying assets.3Other investors, such as individuals using a retail broker, trade ETF shares on thissecondary market.

An ETF combines the valuation feature of amutual fundorunit investment trust, which can be bought or sold at the end of each trading day for its netassetvalue, with the tradability feature of aclosed-end fund, which trades throughout the trading day at prices that may be more or less than its net asset value. Closed-end funds are not considered to be ETFs, even though they are funds and are traded on an exchange. ETFs have been available in the US since 1993 and in Europe since 1999. ETFs traditionally have beenindex funds, but in 2008 theU.S. Securities and Exchange Commissionbegan to authorize the creation ofactively managedETFs.3

ETFs offer both tax efficiency as well as lower transaction and management costs. More than US$2 trillion were invested in ETFs in the United States between when they were introduced in 1993 and 2015. By the end of 2015, ETFs offered 1,800 different products, covering almost every conceivable market sector, niche and trading strategy.6

An ETF is a type offund. It owns assets (bonds, stocks, gold bars, etc.) and divides ownership of itself intosharesthat are held by shareholders. The details of the structure (such as a corporation or trust) will vary by country, and even within one country there may be multiple possible structures.7The shareholders indirectly own the assets of the fund, and they will typically get an annual report. Shareholders are entitled to a share of the profits, such as interest or dividends, and they may get a residual value in case the fund is liquidated. Their ownership interest in the fund can easily be bought and sold.

ETFs are similar in many ways to traditional mutual funds, except that shares in an ETF can be bought and sold throughout the day likestockson astock exchangethrough a broker-dealer. Unlike traditional mutual funds, ETFs do not sell or redeem their individual shares at net asset value (NAV). Instead,financial institutionspurchase and redeem ETF shares directly from the ETF, but only in large blocks (such as 50,000 shares), calledcreation units. Purchases and redemptions of the creation units generally arein kind, with the institutional investor contributing or receiving a basket ofsecuritiesof the same type and proportion held by the ETF, although some ETFs may require or permit a purchasing or redeeming shareholder to substitute cash for some or all of the securities in the basket of assets.3

The ability to purchase and redeem creation units gives ETFs anarbitragemechanism intended to minimize the potential deviation between the market price and the net asset value of ETF shares. Existing ETFs have transparentportfolios, so institutional investors will know exactly what portfolio assets they must assemble if they wish to purchase a creation unit, and the exchange disseminates the updated net asset value of the shares throughout the trading day, typically at 15-second intervals.3

If there is strong investor demand for an ETF, its share price will temporarily rise above its net asset value per share, giving arbitrageurs an incentive to purchase additional creation units from the ETF and sell the component ETF shares in the open market. The additional supply of ETF shares reduces the market price per share, generally eliminating thepremiumover net asset value. A similar process applies when there is weak demand for an ETF: its shares trade at a discount from net asset value.

In the United States, most ETFs are structured as open-end management investment companies (the same structure used by mutual funds andmoney market funds), although a few ETFs, including some of the largest ones, are structured as unit investment trusts. ETFs structured as open-end funds have greater flexibility in constructing a portfolio and are not prohibited from participating insecurities lendingprograms or from using futures and options in achieving their investment objectives.8

Under existing regulations, a new ETF must receive an order from the Securities and Exchange Commission (SEC), giving it relief from provisions of theInvestment Company Act of 1940that would not otherwise allow the ETF structure. In 2008, the SEC proposed rules that would allow the creation of ETFs without the need for exemptive orders. Under the SEC proposal, an ETF would be defined as a registered open-end management investment company that:

issues (or redeems) creation units in exchange for the deposit (or delivery) of basket assets the current value of which is disseminated per share by a national securities exchange at regular intervals during the trading day

identifies itself as an ETF in any sales literature

issues shares that are approved for listing and trading on a securities exchange

discloses each business day on its publicly available web site the prior business days net asset value and closing market price of the funds shares, and the premium or discount of the closing market price against the net asset value of the funds shares as a percentage of net asset value

either is an index fund, or discloses each business day on its publicly available web site the identities and weighting of the component securities and other assets held by the fund

The SEC rule proposal would allow ETFs either to be index funds or to be fully transparent actively managed funds. Historically, all ETFs in the United States had been index funds.citation neededIn 2008, however, the SEC began issuing exemptive orders to fully transparent actively managed ETFs. The first such order was toPowerSharesActively Managed Exchange-Traded Fund Trust,9and the first actively managed ETF in the United States was the Bear Stearns Current Yield Fund, a short-term income fund that began trading on theAmerican Stock Exchangeunder the symbol YYY on March 25, 2008.10The SEC rule proposal indicates that the SEC may still consider future applications for exemptive orders for actively managed ETFs that do not satisfy the proposed rules transparency requirements.3

Some ETFs invest primarily in commodities or commodity-based instruments, such as crude oil and precious metals. Although these commodity ETFs are similar in practice to ETFs that invest in securities, they are not investment companies under the Investment Company Act of 1940.3

Publicly traded grantor trusts, such asMerrill Lynchs HOLDRs securities, are sometimes considered to be ETFs, although they lack many of the characteristics of other ETFs. Investors in a grantor trust have a direct interest in the underlying basket of securities, which does not change except to reflect corporate actions such as stock splits and mergers. Funds of this type are not investment companies under the Investment Company Act of 1940.11

As of 2009, there were approximately 1,500 exchange-traded funds traded on US exchanges.12This count uses the wider definition of ETF, including HOLDRs andclosed-end funds.

ETFs had their genesis in 1989 with Index Participation Shares, anS&P 500proxy that traded on theAmerican Stock Exchangeand thePhiladelphia Stock Exchange. This product, however, was short-lived after a lawsuit by theChicago Mercantile Exchangewas successful in stopping sales in the United States.13

A similar product, Toronto Index Participation Shares, started trading on theToronto Stock Exchange(TSE) in 1990. The shares, which tracked the TSE 35 and later the TSE 100 indices, proved to be popular. The popularity of these products led the American Stock Exchange to try to develop something that would satisfy SEC regulation in the United States.13

Nathan Most and Steven Bloom, under the direction of Ivers Riley, designed and developedStandard & Poors Depositary ReceiptsNYSEArca:SPY), which were introduced in January 1993.1415Known as SPDRs or Spiders, the fund became the largest ETF in the world. In May 1995 they introduced the MidCap SPDRs (NYSEArca:MDY).

Barclays Global Investors, a subsidiary ofBarclays PLC, in conjunction with MSCI and as its underwriter, a Boston-based third party distributor, Funds Distributor Inc., entered the market in 1996 with World Equity Benchmark Shares (WEBS), which becameiSharesMSCI Index Fund Shares. WEBS trackedMSCIcountry indices, originally 17, of the funds index provider, Morgan Stanley. WEBS were particularly innovative because they gave casual investors easy access to foreign markets. While SPDRs were organized asunit investment trusts, WEBS were set up as a mutual fund, the first of their kind.1617

In 1998, State Street Global Advisors introduced SectorSpiders, which follow nine sectors of the S&P 500.18Also in 1998, the Dow Diamonds (NYSEArca:DIA) were introduced, tracking the famousDow Jones Industrial Average. In 1999, the influential cubes (NASDAQ:QQQ), were launched attempting to replicate the movement of theNASDAQ-100.

In 2000, Barclays Global Investors put a significant effort behind the ETF marketplace, with a strong emphasis on education and distribution to reach long-term investors. TheiSharesline was launched in early 2000. Within five years iShares had surpassed the assets of any other ETF competitor in the U.S. and Europe. Barclays Global Investors was sold toBlackRockin 2009.

The Vanguard Groupentered the market in 2001. The first fund was Vanguard Total Stock Market ETF (NYSEArca:VTI), which has become quite popular, and they made the Vanguard Extended Market Index ETF (VXF). Some of Vanguards ETFs are a share class of an existing mutual fund.

iShares made the first bond funds in July 2002, based on US Treasury bonds and corporate bonds, such as iShares iBoxx $ Invst Grade Crp Bond (LQD). They also created a TIPS fund. In 2007, they introduced funds based on junk and muni bonds; about the same time SPDR and Vanguard got in gear and created several of their bond funds.

Since then ETFs have proliferated, tailored to an increasingly specific array of regions, sectors, commodities, bonds, futures, and other asset classes. As of January 2014, there were over 1,500 ETFs traded in the U.S., with over $1.7 trillion in assets.19In December 2014, U.S. ETF assets went above $2 trillion.20

ETFs generally provide the easydiversification, lowexpense ratios, and tax efficiency ofindex funds, while still maintaining all the features of ordinary stock, such aslimit ordersshort selling, andoptions. Because ETFs can be economically acquired, held, and disposed of, some investors invest in ETF shares as a long-term investment for asset allocation purposes, while other investors trade ETF shares frequently to implementmarket timinginvestment strategies.8Among the advantages of ETFs are the following:1121

Lower costs: ETFs generally have lower costs than other investment products because most ETFs are not actively managed and because ETFs are insulated from the costs of having to buy and sell securities to accommodate shareholder purchases and redemptions. ETFs typically have lower marketing, distribution and accounting expenses, and most ETFs do not have12b-1 fees.

Buying and selling flexibility: ETFs can be bought and sold at current market prices at any time during the trading day, unlike mutual funds and unit investment trusts, which can only be traded at the end of the trading day. As publicly traded securities, their shares can be purchased on margin and sold short, enabling the use ofhedgingstrategies, and traded using stop orders and limit orders, which allow investors to specify the price points at which they are willing to trade.

Tax efficiency: ETFs generally generate relatively low capital gains, because they typically have low turnover of their portfolio securities. While this is an advantage they share with other index funds, their tax efficiency is further enhanced because they do not have to sell securities to meet investor redemptions.

Market exposure and diversification: ETFs provide an economical way to rebalance portfolio allocations and to equitize cash by investing it quickly. An index ETF inherently provides diversification across an entire index. ETFs offer exposure to a diverse variety of markets, including broad-based indices, broad-based international and country-specific indices, industry sector-specific indices, bond indices, and commodities.

Transparency: ETFs, whether index funds or actively managed, have transparent portfolios and are priced at frequent intervals throughout the trading day.

Some of these advantages derive from the status of most ETFs as index funds.

Most ETFs areindex fundsthat attempt to replicate the performance of a specificindex. Indexes may be based on stocks,bonds, commodities, orcurrencies. An index fund seeks to track the performance of an index by holding in its portfolio either the contents of the index or a representative sample of the securities in the index.8As of June 2012, in the United States, about 1200 index ETFs exist, with about 50actively managedETFs. Index ETF assets are about $1.2 trillion, compared with about $7 billion for actively managed ETFs.22Some index ETFs, known as leveraged ETFs orinverse ETFs, use investments inderivativesto seek a return that corresponds to a multiple of, or the inverse (opposite) of, the daily performance of the index.23

Some index ETFs invest 100% of their assets proportionately in the securities underlying an index, a manner of investing calledreplication. Other index ETFs userepresentative sampling, investing 80% to 95% of their assets in the securities of an underlying index and investing the remaining 5% to 20% of their assets in other holdings, such as futures, option and swap contracts, and securities not in the underlying index, that the funds adviser believes will help the ETF to achieve its investment objective. There are various ways the ETF can be weighted, such as equal weighting or revenue weighting.24For index ETFs that invest in indices with thousands of underlying securities, some index ETFs employ aggressive sampling and invest in only a tiny percentage of the underlying securities.2526

The first and most popular ETFs track stocks. Many funds track national indexes; for example, Vanguard Total Stock Market ETFNYSEArca:VTItracks the CRSP U.S. Total Market Index, and several funds track the S&P 500, both indexes for US stocks. Other funds own stocks from many countries; for example, Vanguard Total International Stock IndexNYSEArca:VXUStracks the MSCI All Country World ex USA Investable Market Index, while the iShares MSCI EAFE IndexNYSEArca:EFAtracks the MSCI EAFE Index, both world ex-US indexes.

Stock ETFs can have different styles, such aslarge-cap, small-cap, growth, value, et cetera. For example, theS&P 500index is large- and mid-cap, so the SPDR S&P 500 ETF will not contain small-cap stocks. Others such as iShares Russell 2000 are mainly for small-cap stocks. There are many style ETFs such asiShares Russell 1000 GrowthandiShares Russell 1000 Value. ETFs focusing ondividendshave been popular in the first few years of the 2010s decade, such as iShares Select Dividend.27

ETFs can also besector funds. These can be broad sectors, like finance and technology, or specific niche areas, like green power. They can also be for one country or global. Critics have said that no oneneedsa sector fund.28This point is not really specific to ETFs; the issues are the same as with mutual funds. The funds are popular since people can put their money into the latest fashionable trend, rather than investing in boring areas with no cachet.

Exchange-traded funds that invest in bonds are known as bond ETFs.29They thrive during economic recessions because investors pull their money out of the stock market and into bonds (for example, government treasury bonds or those issued by companies regarded as financially stable). Because of this cause and effect relationship, the performance of bond ETFs may be indicative of broader economic conditions.30There are several advantages to bond ETFs such as the reasonable trading commissions, but this benefit can be negatively offset by fees if bought and sold through a third party.31

Commodity ETFs (CETFs or ETCs) invest incommodities, such as precious metals, agricultural products, or hydrocarbons. Among the first commodity ETFs weregold exchange-traded funds, which have been offered in a number of countries. The idea of a Gold ETF was first officially conceptualised byBenchmark Asset Management Company Private Ltdin India when they filed a proposal with theSEBIin May 2002.32The first gold exchange-traded fund wasGold Bullion Securitieslaunched on the ASX in 2003, and the firstsilver exchange-traded fundwas iShares Silver Trust launched on the NYSE in 2006. As of November 2010 a commodity ETF, namelySPDR Gold Shares, was the second-largest ETF by market capitalization.33

However, generally commodity ETFs are index funds tracking non-securityindices. Because they do not invest in securities, commodity ETFs are not regulated as investment companies under theInvestment Company Act of 1940in the United States, although their public offering is subject to SEC review and they need an SECno-action letterunder theSecurities Exchange Act of 1934. They may, however, be subject to regulation by theCommodity Futures Trading Commission.3435

The earliest commodity ETFs, such asSPDR Gold SharesNYSEArca:GLD) andiSharesSilver Trust (NYSEArca:SLV), owned the physical commodity (e.g., gold and silver bars). Similar to these are ETFS Physical Palladium (NYSEArca:PALL) and ETFS Physical Platinum (NYSEArca:PPLT). However, most ETCs implement afutures tradingstrategy, which may produce quite different results from owning the commodity.

Commodity ETFs trade just like shares, are simple and efficient and provide exposure to an ever-increasing range of commodities and commodity indices, including energy, metals,softsand agriculture. However, it is important for an investor to realize that there are often other factors that affect the price of a commodity ETF that might not be immediately apparent. For example, buyers of an oil ETF such as USO might think that as long as oil goes up, they will profit roughly linearly. What isnt clear to the novice investor is the method by which these funds gain exposure to their underlying commodities. In the case of many commodity funds, they simply roll so-called front-month futures contracts from month to month. This does give exposure to the commodity, but subjects the investor to risks involved in different prices along theterm structure, such as a high cost to roll.3637

ETCcan also refer toexchange-tradednotes, which are not exchange-traded funds.

In 2005, Rydex Investments launched the first currency ETF called the Euro Currency Trust (NYSEArca:FXE) in New York. Since then Rydex has launched a series of funds tracking all major currencies under their brand CurrencyShares. In 2007Deutsche Banks db x-trackers launched EONIA Total Return Index ETF in Frankfurt tracking theeuro, and later in 2008 the Sterling Money Market ETF (LSE:XGBP) and US Dollar Money Market ETF (LSE:XUSD) in London. In 2009,ETF Securitieslaunched the worlds largest FX platform tracking the MSFXSMIndex covering 18 long or short USD ETC vs. single G10 currencies. The funds are total return products where the investor gets access to theFX spotchange, local institutional interest rates and a collateral yield.

Most ETFs areindex funds, but some ETFs do have active management. Actively managed ETFs have been offered in the United States only since 2008. The first active ETF wasBear StearnsCurrent Yield ETF (Ticker: YYY).38Currently, actively managed ETFs are fully transparent, publishing their current securities portfolios on their web sites daily. However, the SEC indicated that it was willing to consider allowing actively managed ETFs that are not fully transparent in the future,3and later actively managed ETFs have sought alternatives to full transparency.

The fully transparent nature of existing ETFs means that an actively managed ETF is at risk from arbitrage activities by market participants who might choose tofront runits trades as daily reports of the ETFs holdings reveals its managers trading strategy. The initial actively managed equity ETFs addressed this problem by trading only weekly or monthly. Actively managed debt ETFs, which are less susceptible to front-running, trade their holdings more frequently.39

The actively managed ETF market has largely been seen as more favorable to bond funds, because concerns about disclosing bond holdings are less pronounced, there are fewer product choices, and there is increased appetite for bond products.Pimcos Enhanced Short Duration ETFNYSE:MINTis the largest actively managed ETF, with approximately $3.93 billion in assets as of May 16, 2014.40

Actively managed ETFs grew faster in their first three years of existence than index ETFs did in their first three years of existence. As track records develop, many see actively managed ETFs as a significant competitive threat to actively managed mutual funds.41However, many academic studies have questioned the value of active management.Jack BogleofVanguard Groupwrote an article in theFinancial Analysts Journalwhere he estimated that higher fees as well as hidden costs (such a more trading fees and lower return from holding cash) reduce returns for investors by around 2.66 percentage points a year a huge differential considering that long-term real returns from American equities have been 6.45%.42Even without considering hidden costs, high fees negatively affect long-term performance. In anotherFinancial Analysts Journalarticle, Nobel laureate,Bill Sharpecalculated that someone who saved via a low-cost fund would have a standard of living in retirement 20% higher than someone who saved in a high-cost fund.42

An exchange-traded grantor trust was used to give a direct interest in a static basket of stocks selected from a particular industry. Such products have some properties in common with ETFslow costs, low turnover, and tax efficiency:but are generally regarded as separate from ETFs. The leading example was Holding Company Depositary Receipts, or HOLDRs, a proprietary Merrill Lynch product, but these have now disappeared from the scene.114344SPDR Gold Shares is a grantor trust.

Inverse ETFs are constructed by using various derivatives for the purpose of profiting from a decline in the value of the underlying benchmark. It is a similar type of investment to holding several short positions or using a combination of advanced investment strategies to profit from falling prices. Many inverse ETFs use daily futures as their underlying benchmark.45

Leveraged exchange-traded funds (LETFs or leveraged ETFs) are a type of ETF that attempt to achieve returns that are more sensitive to market movements than non-leveraged ETFs.46Leveraged index ETFs are often marketed as bull or bear funds. A leveraged bull ETF fund might for example attempt to achieve daily returns that are2xor3xmore pronounced than theDow Jones Industrial Averageor theS&P 500. A leveragedinverse (bear) ETFfund on the other hand may attempt to achieve returns that are-2xor-3xthe daily index return, meaning that it will gain double or triple thelossof the market. Leveraged ETFs require the use offinancial engineeringtechniques, including the use ofequity swapsderivativesandrebalancing, and re-indexing to achieve the desired return.47The most common way to construct leveraged ETFs is by trading futures contracts.

Therebalancingand re-indexing of leveraged ETFs may have considerable costs when markets are volatile.4849Therebalancingproblem is that the fund manager incurs trading losses because he needs to buy when the index goes up and sell when the index goes down in order to maintain a fixed leverage ratio. A 2.5% daily change in the index will for example reduce value of a -2x bear fund by about 0.18% per day, which means that about a third of the fund may be wasted in trading losses within a year (1-(1-0.18%)252=36.5%). Investors may however circumvent this problem by buying or writing futures directly, accepting a varying leverage ratio.citation neededA more reasonable estimate of daily market changes is 0.5%, which leads to a 2.6% yearly loss of principal in a 3x leveraged fund.

The re-indexing problem of leveraged ETFs stems from the arithmetic effect of volatility of the underlying index.50Take, for example, an index that begins at 100 and a 2X fund based on that index that also starts at 100. In a first trading period (for example, a day), the index rises 10% to 110. The 2X fund will then rise 20% to 120. The index then drops back to 100 (a drop of 9.09%), so that it is now even. The drop in the 2X fund will be 18.18% (2*9.09). But 18.18% of 120 is 21.82. This puts the value of the 2X fund at 98.18. Even though the index is unchanged after two trading periods, an investor in the 2X fund would have lost 1.82%. This decline in value can be even greater for inverse funds (leveraged funds with negative multipliers such as -1, -2, or -3). It always occurs when the change in value of the underlying index changes direction. And the decay in value increases with volatility of the underlying index.

The effect of leverage is also reflected in the pricing of options written on leveraged ETFs. In particular, the terminal payoff of a leveraged ETF European/American put or call depends on the realized variance (hence the path) of the underlying index. The impact of leverage ratio can also be observed from the implied volatility surfaces of leveraged ETF options.51For instance, the implied volatility curves of inverse leveraged ETFs (with negative multipliers such as -1, -2, or -3) are commonly observed to be increasing in strike, which is characteristically different from the implied volatility smiles or skews seen for index options or non-leveraged ETF options.

The SEC, in May 2017, granted approval of a pair of 4x leveraged ETF related to S&P 500 Futures, before rescinding the approval a few weeks later. The decision concerns two potential products: ForceShares Daily 4X US Market Futures Long Fund, which would have listed under the ticker UP, and ForceShares Daily 4X US Market Futures Short Fund, with the ticker DOWN.52

ETFs have a reputation for lower costs than traditional mutual funds. This will be evident as a lowerexpense ratio. This is mainly from two factors, the fact that most ETFs are index funds and some advantages of the ETF structure. However, this needs to be compared in each case, since some index mutual funds also have a very low expense ratio, and some ETFs expense ratios are relatively high. An index fund is much simpler to run, since it does not require some security selection, and can be largely done by computer. Not only does an ETF have lower shareholder-related expenses, but because it does not have to invest cash contributions or fund cash redemptions, an ETF does not have to maintain a cash reserve for redemptions and saves on brokerage expenses.53Mutual funds can charge 1% to 3%, or more; index fund expense ratios are generally lower, while ETFs are almost always less than 1%. Over the long term, these cost differences can compound into a noticeable difference.54

Because ETFs trade on an exchange, each transaction is generally subject to a brokerage commission. Commissions depend on the brokerage and which plan is chosen by the customer. For example, a typical flat fee schedule from an online brokerage firm in the United States ranges from $10 to $20, but it can be as low as $0 with discount brokers. Because of this commission cost, the amount invested has a great bearing; someone who wishes to invest $100 per month may lose a significant percentage of their investment immediately, while for someone making a $200,000 investment, the commission cost may be negligible. Generally, mutual funds obtained directly from the fund company itself do not charge a brokerage fee. Thus, when low or no-cost transactions are available, ETFs become very competitive.55

The cost difference is more evident when compared with mutual funds that charge a front-end or back-endloadas ETFs do not have loads at all. The redemption fee and short-term trading fees are examples of other fees associated with mutual funds that do not exist with ETFs. Traders should be cautious if they plan to trade inverse and leveraged ETFs for short periods of time. Close attention should be paid to transaction costs and daily performance rates as the potential combined compound loss ca