What are Exchange Traded Funds (ETF)
Exchange Traded Funds (ETFs) give their owners ownership rights over a portion of a group of separate stock certificates. They represent securities certificates, which call for a number of financial firms of various kinds, so that they are created. ETFs are traded at prices that are similar to the prices of the assets that constitute them. When investors no longer want them they are disbanded.
The fund manager is the person who is in charge of the foundations of ETFs. S/he has to prepare a plan on the characteristics and activities of the ETF, which should be submitted to the SEC for approval. After the SEC confirms the viability of the ETF, it can go into action.
The major responsibilities of the fund manager are the setting of well-defined procedures and the establishment of the structure of the ETF. Clear information about these should be given to the other firms that are part of the ETF. However, these functions are typical only for large institutional money management firms that possess the necessary indexing experience. The loaning of stocks is needed for the creation of ETFs, which is actually done by these large companies through the management of pension funds that include huge baskets of stocks that operate throughout the world. The lining up of customers is used as a tool for creating demand for the new ETF.
The market maker (also known as specialist) is the initiator of the creation of an ETF. S/he has to possess the necessary authorization and operational competence. His/her major responsibility is to create the needed basket of stocks. Next, this basket is sent for safekeeping to a selected custodial bank. Verification by the custodial bank is done of the representation of the basket of the target ETF. When everything is all right the shares of the ETF are proceeded to the participant, who possesses the appropriate authorization. This process doesn't bring capital gains to investors and is known as in-kind trade of essentially equivalent items.
The monitoring of the basket of stocks is done by the fund manager while they are being held in the account of the mutual fund that is in the custodial bank. Additionally, derivatives can be used by some fund managers for the purposes of tracking a particular index.
The Depository Trust Clearing Corp represents the government agency that is responsible for the supervision of individual stock sales and the recording of the executed transactions. The flow of ETF certificates passes through this US government agency as well. The agency also provides a degree of protection against potential deceit.
The ETF goes to the open market when an authorized participant buys it from the custodial market and then sells. Additionally, the process of redemption of the ETF follows the same path. The authorized participant buys the ETF on the open market and then sells it back to the custodial bank. S/he in return gets an equivalent basket of individual stocks, which s/he is free to sell on the open market.
In return to the creation and monitoring of the ETF, the fund manager receives a percentage of the annual assets. Additionally, the investors that have loaned the stocks for the creation of the ETF receive an interest fee. The custodial bank also gets a reward for its services which is in the form of a portion of assets and usually comes from the management fees of the fund manager. As for the authorized participant, they are motivated to participate in the process by the potential profits they can get.
As it can be seen the process surrounding the creation and trading of ETFs is well-defined and possesses the necessary transparency for executing transactions. Even though it is regarded by some as cumbersome, ETFs provide for a degree of security in case their prices diverge from those of the underlying stocks, since if the prices deviate, a participant can quickly fix this.
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