An Overview of Exchange-Trade Funds
An exchange traded fund (ETF) is a special type of fund that invests in a
portfolio of stocks or bonds and is designed to mimic the performance of a
specified index. Shares are traded in the secondary market like the shares
of a closed-end fund, with the investor having the ability to trade at any time
during market hours, sell short, or margin shares. Although they trade
shares of a closed-end fund, the legal structure of most ETFs in the U.S. is
that of a traditional open-end mutual fund.
A feature unique to ETFs is their use of “in-kind” creation and redemption of
shares. Exchange specialists are established by the fund to ensure an
efficient, orderly market in the shares. Exchange specialists can create
new shares in the ETF by depositing with a trustee a portfolio of stocks that
track the index. The exchange specialist then receives from the trustee
new ETF shares to be sold in the open market. Conversely, the exchange
specialist can redeem shares to the trustee in exchange for the underlying
stocks.
The ‘in-kind” process used by ETFs has two main advantages. First, the
in-kind creation and redemption feature keeps market prices of ETF shares close
to NAV and avoids the premiums and discounts typical for closed-end funds.
It provides a mechanism for arbitrage by exchange participants between the
shares of stock that make up the fund and shares of the fund. Second,
there is a tax advantage to in-kind redemption. If the fund distributes
shares as a redemption method, any capital gains on the shares are realized at
their sale. It is not a capital gain to the fund, so existing fund
shareholders do not incur a tax liability as they would when a traditional
mutual fund redeems fund shares and must sell portfolio securities to meet the
cash demand. While fund shareholders do have the right to cash redemption,
it is discouraged by redemption fees and the fact that NAV for the redemption is
calculated some days after the redemption request.
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