An exchange-traded fund (ETF) is an investment fund traded on stock exchanges, much like stocks.^[1] An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as the S&P 500 or MSCI EAFE. ETFs may be attractive as investments because of their low costs, tax efficiency, and stock-like features.^[2][3] ETFs are the most popular type of exchange-traded product.^{[citation needed]}

Only so-called authorized participants (typically, large institutional investors) actually buy or sell shares of an ETF directly from or to the fund manager, and then only in creation units, which are large blocks of tens of thousands of ETF shares, usually exchanged in-kind with baskets of the underlying securities. Authorized participants may wish to invest in the ETF shares for the long-term, but usually act as market makers on the open market, using their ability to exchange creation units with their underlying securities to provide liquidity of the ETF shares and help ensure that their intraday market price approximates to the net asset value of the underlying assets.^[4] Other investors, such as individuals using a retail broker, trade ETF shares on this secondary market.

An ETF combines the valuation feature of a mutual fund or unit investment trust, which can be bought or sold at the end of each trading day for its net asset value, with the tradability feature of a closed-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 been index funds, but in 2008 the U.S. Securities and Exchange Commission began to authorize the creation of actively managed ETFs.^[4]

Structure[link]

ETFs offer public investors an undivided interest in a pool of securities and other assets and thus are similar in many ways to traditional mutual funds, except that shares in an ETF can be bought and sold throughout the day like stocks on a securities exchange through a broker-dealer. Unlike traditional mutual funds, ETFs do not sell or redeem their individual shares at net asset value, or NAV. Instead, financial institutions purchase and redeem ETF shares directly from the ETF, but only in large blocks, varying in size by ETF from 25,000 to 200,000 shares, called "creation units". Purchases and redemptions of the creation units generally are in kind, with the institutional investor contributing or receiving a basket of securities of 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.^[4]

The ability to purchase and redeem creation units gives ETFs an arbitrage mechanism intended to minimize the potential deviation between the market price and the net asset value of ETF shares. Existing ETFs have transparent portfolios, 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.^[4]

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 the premium over net asset value. A similar process applies when there is weak demand for an ETF and 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 and money 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 in securities lending programs or from using futures and options in achieving their investment objectives.^[5]

Under existing regulations, a new ETF must receive an order from the Securities and Exchange Commission, or SEC, giving it relief from provisions of the Investment Company Act of 1940 that would not otherwise allow the ETF structure. In 2008, however, 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 day's net asset value and closing market price of the fund's shares, and the premium or discount of the closing market price against the net asset value of the fund's shares as a percentage of net asset value; and
• 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.^[4]

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 have been index funds. In 2008, however, the SEC began issuing exemptive orders to fully transparent actively managed ETFs. The first such order was to PowerShares Actively Managed Exchange-Traded Fund Trust,^[6] and 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 the American Stock Exchange under the symbol YYY on 25 March 2008.^[7] The 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 rule's transparency requirements.^[4]

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.^[4]

Publicly traded grantor trusts, such as Merrill Lynch's 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.^[8]

As of 2009, there were approximately 1,500 exchange-traded funds traded on US exchanges.^[9] This count uses the wider definition of ETF, including HOLDRs and closed-end funds.

History[link]

ETFs had their genesis in 1989 with Index Participation Shares, an S&P 500 proxy that traded on the American Stock Exchange and the Philadelphia Stock Exchange. This product, however, was short-lived after a lawsuit by the Chicago Mercantile Exchange was successful in stopping sales in the United States.^[10]

A similar product, Toronto Index Participation Shares, started trading on the Toronto Stock Exchange in 1990. The shares, which tracked the TSE 35 and later the TSE 100 stocks, 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.^[10]

Nathan Most and Steven Bloom, executives with the exchange, designed and developed Standard & Poor's Depositary Receipts (NYSE: SPY), which were introduced in January 1993.^[11][12] Known as SPDRs or "Spiders", the fund became the largest ETF in the world. In May 1995 they introduced the MidCap SPDRs (NYSE: MDY).

Barclays Global Investors, a subsidiary of Barclays plc, entered the fray in 1996 with World Equity Benchmark Shares, or WEBS, subsequently renamed iShares MSCI Index Fund Shares. WEBS tracked MSCI country 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 as unit investment trusts, WEBS were set up as a mutual fund, the first of their kind.^[13][14]

In 1998, State Street Global Advisors introduced the "Sector Spiders", which follow the nine sectors of the S&P 500.^[15] Also in 1998, the "Dow Diamonds" (NYSE: DIA) were introduced, tracking the famous Dow Jones Industrial Average. In 1999, the influential "cubes" (NASDAQ: QQQQ) were launched attempting to replicate the movement of the NASDAQ-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. The iShares line was launched in early 2000. Within 5 years iShares had surpassed the assets of any other ETF competitor in the U.S. and Europe. Barclays Global Investors was sold to BlackRock in 2009. The Vanguard Group entered the market in 2001.

Since then ETFs have proliferated, tailored to an increasingly specific array of regions, sectors, commodities, bonds, futures, and other asset classes. As of September 2010, there were 916 ETFs in the U.S., with $882 billion in assets, an increase of $189 billion over the previous twelve months.^[16]

Investment uses[link]

ETFs generally provide the easy diversification, low expense ratios, and tax efficiency of index funds, while still maintaining all the features of ordinary stock, such as limit orders, short selling, and options. 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 implement market timing investment strategies.^[5] Among the advantages of ETFs are the following:^[8][17]

• 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 have 12b-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 of hedging strategies, 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.

Types of ETFs[link]

Index ETFs[link]

Most ETFs are index funds that hold securities and attempt to replicate the performance of a stock market index. 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.^[5] Some index ETFs, known as leveraged ETFs or inverse ETFs, use investments in derivatives to seek a return that corresponds to a multiple of, or the inverse (opposite) of, the daily performance of the index.^[18] As of February 2008, index ETFs in the United States included 415 domestic equity ETFs, with assets of $350 billion; 160 global/international equity ETFs, with assets of $169 billion; and 53 bond ETFs, with assets of $40 billion.^[19] As of November 2010 an index ETF, namely Standard & Poor's Depositary Receipts (SPDR S&P 500), was the largest ETF by market capitalization.^[20]

Some index ETFs invest 100% of their assets proportionately in the securities underlying an index, a manner of investing called "replication". Other index ETFs use "representative 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 fund's adviser believes will help the ETF to achieve its investment objective. For 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.^[21][22]

Commodity ETFs or ETCs[link]

Commodity ETFs (ETCs or CETFs) invest in commodities, such as precious metals and futures. Among the first commodity ETFs were gold exchange-traded funds, which have been offered in a number of countries. The idea of a Gold ETF was first officially conceptualised by Benchmark Asset Management Company Private Ltd in India when they filed a proposal with the SEBI in May 2002.^[23] The first gold exchange-traded fund was Gold Bullion Securities launched on the ASX in 2003, and the first silver exchange-traded fund was iShares Silver Trust launched on the NYSE in 2006. As of November 2010 a commodity ETF, namely SPDR Gold Shares, was the second-largest ETF by market capitalization.^[20]

However, generally commodity ETFs are index funds tracking non-security indices. Because they do not invest in securities, commodity ETFs are not regulated as investment companies under the Investment Company Act of 1940 in the United States, although their public offering is subject to SEC review and they need an SEC no-action letter under the Securities Exchange Act of 1934. They may, however, be subject to regulation by the Commodity Futures Trading Commission.^[24][25]

Exchange-traded commodities (ETCs) are investment vehicles (asset backed bonds, fully collateralised) that track the performance of an underlying commodity index including total return indices based on a single commodity. Similar to ETFs and traded and settled exactly like normal shares on their own dedicated segment, ETCs have market maker support with guaranteed liquidity, enabling investors to gain exposure to commodities, on-exchange, during market hours.

The earliest commodity ETFs (e.g., GLD and SLV) actually owned the physical commodity (e.g., gold and silver bars). Similar to these are NYSE: PALL (palladium) and NYSE: PPLT (platinum). However, most ETCs implement a futures trading strategy, 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, softs and 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 isn't 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 the term structure, such as a high cost to roll.^[26][27]

Bond ETFs[link]

Exchange-traded funds that invest in bonds are known as bond ETFs. They thrive during economic recessions because investors pull their money out of the stock market and into bonds (for example, government treasury bonds or those issues 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.^[28] There 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.^[29]

Currency ETFs or ETCs[link]

In 2005, Rydex Investments launched the first ever currency ETF called the Euro Currency Trust (NYSE: FXE) in New York. Since then Rydex has launched a series of funds tracking all major currencies under their brand CurrencyShares. In 2007 Deutsche Bank's db x-trackers launched EONIA Total Return Index ETF in Frankfurt tracking the euro, and later in 2008 the Sterling Money Market ETF (

1. REDIRECT Template:London Stock Exchange) and US Dollar Money Market ETF (LSE: XUSD) in London. In 2009, ETF Securities launched the world's largest FX platform tracking the MSFX^SM Index covering 18 long or short USD ETC vs. single G10 currencies. The funds are total return products where the investor gets access to the FX spot change, local institutional interest rates and a collateral yield.

Actively managed ETFs[link]

Actively managed ETFs (AMETFs) are quite recent in the United States. The first one was offered in March 2008 but was liquidated in October 2008. The actively managed ETFs approved to date are fully transparent, publishing their current securities portfolios on their web sites daily. However, the SEC has indicated that it is willing to consider allowing actively managed ETFs that are not fully transparent in the future.^[4]

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 to front run its trades^{[citation needed]}. The initial actively traded equity ETFs have addressed this problem by trading only weekly or monthly, however today, actively managed ETFs trade at the discretion of the manager and to date, there have been no instances of front running. Actively traded debt ETFs, which are less susceptible to front-running, trade their holdings more frequently.^[30]

Actively managed ETFs have grown faster in their first 3 years of existence than index ETFs did in their first 3 year of existence. However, as track records develop, many see actively managed ETFs as a significant competitive threat to actively managed mutual funds. ^[31]

Exchange-traded grantor trusts[link]

An exchange-traded grantor trust share represents a direct interest in a static basket of stocks selected from a particular industry. The leading example is Holding Company Depositary Receipts, or HOLDRs, a proprietary Merrill Lynch product. HOLDRs are neither index funds nor actively managed; rather, the investor has a direct interest in specific underlying stocks. While HOLDRs have some qualities in common with ETFs, including low costs, low turnover, and tax efficiency, many observers consider HOLDRs to be a separate product from ETFs.^{[8] [32]}

Leveraged ETFs[link]

Leveraged exchange-traded funds (LETFs), or simply leveraged ETFs, are a special type of ETF that attempt to achieve returns that are more sensitive to market movements than non-leveraged ETFs.^[33] Leveraged index ETFs are often marketed as bull or bear funds. A leveraged bull ETF fund might for example attempt to achieve daily returns that are 2x or 3x more pronounced than the Dow Jones Industrial Average or the S&P 500. A leveraged inverse (bear) ETF fund on the other hand may attempt to achieve returns that are -2x or -3x the daily index return, meaning that it will gain double or triple the loss of the market. Leveraged ETFs require the use of financial engineering techniques, including the use of equity swaps, derivatives and rebalancing to achieve the desired return.^[34] The most common way to construct leveraged ETFs is by trading futures contracts.

The rebalancing of leveraged ETFs may have considerable costs when markets are volatile.^[35][36] The problem 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.^[37]

A 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.^{[citation needed]}

ETFs compared to mutual funds[link]

Costs[link]

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 can be as low as $0 with discount brokers. Due to this commission cost, the amount invested has a great bearing; someone who wishes to invest $100 per month may have a significant percentage of their investment destroyed 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.^[38]

ETFs have a lower expense ratio than comparable mutual funds. 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.^[39] Mutual funds can charge 1% to 3%, or more; index fund expense ratios are generally lower, while ETFs are almost always in the 0.1% to 1% range. Over the long term, these cost differences can compound into a noticeable difference.^[40]

The cost difference is more evident when compared with mutual funds that charge a front-end or back-end load as 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 can sometimes go unrecognized and offset potential gains over a longer period of time.^[41]

Taxation[link]

ETFs are structured for tax efficiency and can be more attractive than mutual funds. In the U.S., whenever a mutual fund realizes a capital gain that is not balanced by a realized loss, the mutual fund must distribute the capital gains to its shareholders. This can happen whenever the mutual fund sells portfolio securities, whether to reallocate its investments or to fund shareholder redemptions. These gains are taxable to all shareholders, even those who reinvest the gains distributions in more shares of the fund. In contrast, ETFs are not redeemed by holders (instead, holders simply sell their ETF shares on the stock market, as they would a stock, or effect a non-taxable redemption of a creation unit for portfolio securities), so that investors generally only realize capital gains when they sell their own shares or when the ETF trades to reflect changes in the underlying index.^[5]

In most cases, ETFs are more tax-efficient than conventional mutual funds in the same asset classes or categories.^[42] Because Vanguard's ETFs are a share-class of their mutual funds, they don't get all the tax advantages if there are net redemptions on the mutual fund shares.^[43] Although they do not get all the tax advantages, they get an additional advantage from tax loss harvesting any capital losses from net redemptions.^[44][45]

In the U.K., ETFs can be shielded from capital gains tax by placing them in an Individual Savings Account or self-invested personal pension, in the same manner as many other shares. Because UK-resident ETFs would be liable for UK corporation tax on non-UK dividends, most ETFs which hold non-UK companies sold to UK investors are issued in Ireland or Luxembourg.^[46]

Trading[link]

Perhaps the most important benefit of an ETF is the stock-like features offered. A mutual fund is bought or sold at the end of a day's trading, whereas ETFs can be traded whenever the market is open. Since ETFs trade on the market, investors can carry out the same types of trades that they can with a stock. For instance, investors can sell short, use a limit order, use a stop-loss order, buy on margin, and invest as much or as little money as they wish (there is no minimum investment requirement).^[47] Also, many ETFs have the capability for options (puts and calls) to be written against them. Covered call strategies allow investors and traders to potentially increase their returns on their ETF purchases by collecting premiums (the proceeds of a call sale or write) on calls written against them. Mutual funds do not offer those features.^[48]

Risks[link]

Effects on Stability[link]

ETFs that buy and hold commodities or futures of commodities have become popular. For example, SPDR Gold Shares ETF (GLD) has 41 million ounces in trust. ^[49] The silver ETF, SLV, is also very large. The commodity ETFs are in effect consumers of their target commodities, thereby affecting the price in a spurious fashion. ^[50] In the words of the IMF, “Some market participants believe the growing popularity of exchange-traded funds (ETFs) may have contributed to equity price appreciation in some emerging economies, and warn that leverage embedded in ETFs could pose financial stability risks if equity prices were to decline for a protracted period.” ^[51]

Regulatory Risk[link]

Synthetic ETFs are attracting regulatory attention from the FSB, ^[52] the IMF, ^[53] and the BIS. ^[54] Areas of concern include the lack of transparency in products and increasing complexity; conflicts of interest; and lack of regulatory compliance.

Counterparty Risk[link]

A synthetic ETF has counterparty risk, because the counterparty is contractually obligated to match the return on the index. The deal is arranged with collateral posted by the swap counterparty. A potential hazard is that the investment bank offering the ETF might post its own collateral, and that collateral could be of dubious quality. Furthermore, the investment bank could use its own trading desk as counterparty. These types of set-ups are not allowed under the European guidelines, Undertakings for Collective Investment in Transferable Securities (UCITS), so the investor should look for UCITS III-compliant funds. ^[55]

Criticism[link]

John C. Bogle, founder of the Vanguard Group, a leading issuer of index mutual funds (and, since Bogle's retirement, of ETFs), has argued that ETFs represent short-term speculation, that their trading expenses decrease returns to investors, and that most ETFs provide insufficient diversification. He concedes that a broadly diversified ETF that is held over time can be a good investment.^[56]

ETFs are dependent on the efficacy of the arbitrage mechanism in order for their share price to track net asset value. While the average deviation between the daily closing price and the daily NAV of ETFs that track domestic indices is generally less than 2%, the deviations may be more significant for ETFs that track certain foreign indices.^[5] The Wall Street Journal reported in November 2008, during a period of market turbulence, that some lightly traded ETFs frequently had deviations of 5% or more, exceeding 10% in a handful of cases, although even for these niche ETFs, the average deviation was only a little more than 1%. The trades with the greatest deviations tended to be made immediately after the market opened.^[57]

According to a study on ETF returns in 2009 by Morgan Stanley, ETFs missed in 2009 their targets by an average of 1.25 percentage points, a gap more than twice as wide as the 0.52-percentage-point average they posted in 2008.^[58] Part of this so-called tracking error is attributed to the proliferation of ETFs targeting exotic investments or areas where trading is less frequent, such as emerging-market stocks, future-contracts based commodity indices and junk bonds.^{[citation needed]}

The tax advantages of ETFs are of no relevance for investors using tax-deferred accounts (or indeed, investors who are tax-exempt in the first place).^[59] However, the lower expense ratios are proving difficult for the proponents of traditional mutual funds to overcome.

In a survey of investment professionals, the most frequently cited disadvantage of ETFs was the unknown, untested indices used by many ETFs, followed by the overwhelming number of choices.^[3]

Some critics claim that ETFs can be, and have been, used to manipulate market prices, including having been used for short selling that has been asserted by some observers (including Jim Cramer of theStreet.com) to have contributed to the market collapse of 2008.^[60][61]

Issuers of ETFs[link]

• AdvisorShares issues actively managed ETFs.
• Bips Investment Managers issues Bips (Beta Investment Performance Securities).
• BNP Paribas issues EasyETFs.
• BlackRock issues iShares.
• Charles Schwab offers several commission-free ETFs for its clients.
• Deutsche Bank issues db x-trackers ETFs, as well as managing PowerShares DB commodity- and currency-based ETFs.
• ETF Securities issues ETFs or specialised commodity ETCs.
• Global X Funds issues ETFs.
• Guggenheim Funds issues specialty Guggenheim Funds ETFs.
• Invesco issues PowerShares ETFs, as well as BLDRS based on American Depositary Receipts.
• Lyxor Asset Management issues Lyxor ETFs.
• Merrill Lynch issues HOLDRs.
• Source UK Services, a European joint-venture between Bank of America Merrill Lynch, Goldman Sachs, Morgan Stanley, Nomura and J. P. Morgan issues ETFs and ETCs
• State Street Global Advisors issues SPDRs.
• Van Eck Global issues Market Vectors ETFs.
• Vanguard Group issues Vanguard ETFs, formerly known as VIPERs.

See also[link]

• Collective investment scheme
• Enhanced indexing
• Exchange-traded note
• Investment trust
• Pension fund
• Separately managed account

References[link]

Further reading[link]

• Carrell, Lawrence. ETFs for the Long Run: What They Are, How They Work, and Simple Strategies for Successful Long-Term Investing. JW Wiley, 2008. ISBN 978-0-470-13894-6
• Ferri, Richard A. The ETF Book: All You Need to Know About Exchange-Traded Funds. Wiley, 2009. ISBN 0-470-53746-9
• Humphries, William. Leveraged ETFs: The Trojan Horse Has Passed the Margin-Rule Gates. 34 Seattle U.L. Rev. 299 (2010), available at [1].
• Koesterich, Russ. The ETF Strategist: Balancing Risk and Reward for Superior Returns. Portfolio, 2008. ISBN 978-1-59184-207-1

External links[link]

• Exchange Traded Funds (ETF) Johannesburg Stock Exchange (JSE)
• Exchange Traded Funds (ETF) London Stock Exchange (LSE)
• Exchange Traded Funds (ETFs) & Index Funds NASDAQ Stock Market
• Exchange Traded Products New York Stock Exchange
• Exchange Traded Funds (ETF) Toronto Stock Exchange (TSX)
• Exchange Traded Funds (ETF) Australian Stock Exchange (ASX)
• Exchange Traded Funds (ETFs) listed on XETRA or on Nasdaq OMX Nordic ETFSverige.se information web site
• Using ETFs in investment portfolios – Exchange Traded Fund Basics, Investor Knowledge Centre (Vanguard Investments Australia)
• Benefits of ETFs Australian ETF Information Network
• Cross-referenced list of funds U.S., Canadian and U.K. ETFs organized by industry, region and investment strategy.
• Global ETF browser Free ETF Screener based on fundamentals.

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v t e

A futures exchange or futures market is a central financial exchange where people can trade standardized futures contracts; that is, a contract to buy specific quantities of a commodity or financial instrument at a specified price with delivery set at a specified time in the future. These types of contracts fall into the category of derivatives. Such instruments are priced according to the movement of the underlying asset (stock, physical commodity, index, etc.). The aforementioned category is named "derivatives" because the value of these instruments is derived from another asset class.

History of futures exchanges[link]

One of the earliest written records of futures trading is in Aristotle's book Politics. He tells the story of Thales, a poor philosopher from Miletus who developed a "financial device, which involves a principle of universal application". Thales used his skill in forecasting and predicted that the olive harvest would be exceptionally good the next autumn. Confident in his prediction, he made agreements with local olive-press owners to deposit his money with them to guarantee him exclusive use of their olive presses when the harvest was ready. Thales successfully negotiated low prices because the harvest was in the future and no one knew whether the harvest would be plentiful or pathetic and because the olive-press owners were willing to hedge against the possibility of a poor yield. When the harvest-time came, and a sharp increase in demand for the use of the olive presses outstripped supply, he sold his future use contracts of the olive presses at a rate of his choosing, and made a large quantity of money.^[1] It should be noted, however, that this is a very loose example of futures trading and, in fact, more closely resembles an Option contract, given that Thales was not obliged to use the olive presses if the yield was poor.

The first modern organized futures exchange began in 1710 at the Dojima Rice Exchange in Osaka, Japan.^[2]

The United States followed in the early 19th century. Chicago has the largest future exchange in the world, the Chicago Mercantile Exchange. Chicago is located at the base of the Great Lakes, close to the farmlands and cattle country of the U.S. Midwest, making it a natural center for transportation, distribution and trading of agricultural produce. Gluts and shortages of these products caused chaotic fluctuations in price, and this led to the development of a market enabling grain merchants, processors, and agriculture companies to trade in "to arrive" or "cash forward" contracts to insulate them from the risk of adverse price change and enable them to hedge. In March 2008, the Chicago Mercantile Exchange announced its acquisition of NYMEX Holdings Inc, the parent company of the New York Mercantile Exchange and Commodity Exchange. CME's acquisition of NYMEX was completed in August 2008.

For most exchanges, forward contracts were standard at the time. However, most forward contracts weren't honored by both the buyer and the seller. For instance, if the buyer of a corn forward contract made an agreement to buy corn, and at the time of delivery the price of corn differed dramatically from the original contract price, either the buyer or the seller would back out. Additionally, the forward contracts market was very illiquid and an exchange was needed that would bring together a market to find potential buyers and sellers of a commodity instead of making people bear the burden of finding a buyer or seller.

In 1848, the Chicago Board of Trade (CBOT–) was formed. Trading was originally in forward contracts; the first contract (on corn) was written on March 13, 1851. In 1865, standardized futures contracts were introduced.

The Chicago Produce Exchange was established in 1874, renamed the Chicago Butter and Egg Board in 1898 and then reorganised into the Chicago Mercantile Exchange (CME) in 1919. Following the end of the postwar international gold standard, in 1972 the CME formed a division called the International Monetary Market (IMM) to offer futures contracts in foreign currencies: British pound, Canadian dollar, German mark, Japanese yen, Mexican peso, and Swiss franc.

In 1881, a regional market was founded in Minneapolis, Minnesota and in 1883 introduced futures for the first time. Trading continuously since then, today the Minneapolis Grain Exchange (MGEX) is the only exchange for hard red spring wheat futures and options.^[3]

The 1970s saw the development of the financial futures contracts, which allowed trading in the future value of interest rates. These (in particular the 90-day Eurodollar contract introduced in 1981) had an enormous impact on the development of the interest rate swap market.

Today, the futures markets have far outgrown their agricultural origins. With the addition of the New York Mercantile Exchange (NYMEX) the trading and hedging of financial products using futures dwarfs the traditional commodity markets, and plays a major role in the global financial system, trading over 1.5 trillion U.S. dollars per day in 2005.^{[citation needed]}

The recent history of these exchanges (Aug 2006) finds the Chicago Mercantile Exchange trading more than 70% of its Futures contracts on its "Globex" trading platform and this trend is rising daily. It counts for over 45.5 Billion dollars of nominal trade (over 1 million contracts) every single day in "electronic trading" as opposed to open outcry trading of Futures, Options and Derivatives.

In June 2001, IntercontinentalExchange (ICE) acquired the International Petroleum Exchange (IPE), now ICE Futures, which operated Europe’s leading open-outcry energy futures exchange. Since 2003, ICE has partnered with the Chicago Climate Exchange (CCX) to host its electronic marketplace. In April 2005, the entire ICE portfolio of energy futures became fully electronic.

In 2006, the New York Stock Exchange teamed up with the Amsterdam-Brussels-Lisbon-Paris Exchanges "Euronext" electronic exchange to form the first transcontinental Futures and Options Exchange. These two developments as well as the sharp growth of internet Futures trading platforms developed by a number of trading companies clearly points to a race to total internet trading of Futures and Options in the coming years.^{[original research?]}

In terms of trading volume, the National Stock Exchange of India in Mumbai is the largest stock futures trading exchange in the world, followed by JSE Limited in Sandton, Gauteng, South Africa.^[4]

Nature of contracts[link]

Exchange-traded contracts are standardized by the exchanges where they trade. The contract details what asset is to be bought or sold, and how, when, where and in what quantity it is to be delivered. The terms also specify the currency in which the contract will trade, minimum tick value, and the last trading day and expiry or delivery month. Standardized commodity futures contracts may also contain provisions for adjusting the contracted price based on deviations from the "standard" commodity, for example, a contract might specify delivery of heavier USDA Number 1 oats at par value but permit delivery of Number 2 oats for a certain seller's penalty per bushel.

Before the market opens on the first day of trading a new futures contract, there is a specification but no actual contracts exist. Futures contracts are not issued like other securities, but are "created" whenever Open interest increases; that is, when one party first buys (goes long) a contract from another party (who goes short). Contracts are also "destroyed" in the opposite manner whenever Open interest decreases because traders resell to reduce their long positions or rebuy to reduce their short positions.

Speculators on futures price fluctuations who do not intend to make or take ultimate delivery must take care to "zero their positions" prior to the contract's expiry. After expiry, each contract will be settled, either by physical delivery (typically for commodity underlyings) or by a cash settlement (typically for financial underlyings). The contracts ultimately are not between the original buyer and the original seller, but between the holders at expiry and the exchange. Because a contract may pass through many hands after it is created by its initial purchase and sale, or even be liquidated, settling parties do not know with whom they have ultimately traded.

Compare this with other securities, in which there is a primary market when an issuer issues the security, and a secondary market where the security is later traded independently of the issuer. Legally, the security represents an obligation of the issuer rather than the buyer and seller; even if the issuer buys back some securities, they still exist. Only if they are legally cancelled they can disappear.

Standardization[link]

The contracts traded on futures exchanges are always standardized. In principle, the parameters to define a contract are endless (see for instance in futures contract). To make sure liquidity is high, there is only a limited number of standardized contracts.

Clearing and settlement[link]

There is usually a division of responsibility between provision of trading facility, and that of clearing and settlement of those trades. While derivative exchanges like the CBOE and LIFFE take responsibility for providing efficient, transparent and orderly trading environments, settlement of the resulting trades are usually handled by clearing houses that serve as central counterparties to trades done in the respective exchanges. For instance, the Options Clearing Corporation (OCC) and LCH.Clearnet (London Clearing House) respectively are the clearing corporations for CBOE and LIFFE. A well known exception to this is the case of Chicago Mercantile Exchange and ICE, which clear trades themselves.

Central counterparty[link]

Derivative contracts are leveraged positions whose value is volatile. They are usually more volatile than their underlying asset. This can lead to credit risk, in particular counterparty risk, those situations where one party to a trade loses a big sum of money and is unable to honor its settlement obligation. In a safe trading environment, the parties to a trade need to be assured that their counterparty will honor the trade, no matter how the market has moved. This requirement can lead to messy arrangements like credit assessment, setting of trading limits and so on for each counterparty, and take away most of the advantages of a centralised trading facility. To prevent this, a clearing house interposes themselves as counterparties to every trade and extend guarantee that the trade will be settled as originally intended. This action is called Novation. As a result, trading firms take no risk on the actual counterparty to the trade, but on the clearing corporation. The clearing corporation is able to take on this risk by adopting an efficient margining process.

Margin and Mark-to-Market[link]

A margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty, in this case the central counterparty clearing houses. Clearing houses charge two types of margins: the Initial Margin and the Mark-To-Market margin (also referred to as Variation Margin).

The Initial Margin is the sum of money (or collateral) to be deposited by a firm to the clearing corporation to cover possible future loss in the positions (the set of positions held is also called the portfolio) held by a firm.Several popular methods are used to compute initial margins. They include the CME-owned SPAN (a grid simulation method used by the CME and about 70 other exchanges), STANS (a Monte Carlo simulation based methodology used by the OCC), TIMS (earlier used by the OCC, and still being used by a few other exchanges like the Bursa Malaysia).

The Mark-to-Market Margin (MTM margin) on the other hand is the margin collected to offset losses (if any) that have already been incurred on the positions held by a firm. This is computed as the difference between the cost of the position held and the current market value of that position. If the resulting amount is a loss, the amount is collected from the firm; else, the amount may be returned to the firm (the case with most clearing houses) or kept in reserve depending on local practice. In either case, the positions are 'marked-to-market' by setting their new cost to the market value used in computing this difference. The positions held by the clients of the exchange are marked-to-market daily and the MTM difference computation for the next day would use the new cost figure in its calculation.

Clients hold a margin account with the exchange, and every day the swings in the value of their positions is added to or deducted from their margin account. If the margin account gets too low, they have to replenish it. In this way it is highly unlikely that the client will not be able to fulfill his obligations arising from the contracts. As the clearing house is the counterparty to all their trades, they only have to have one margin account. This is in contrast with OTC derivatives, where issues such as margin accounts have to be negotiated with all counterparties.

Regulators[link]

Each exchange is normally regulated by a national governmental (or semi-governmental) regulatory agency:

• In Australia, this role is performed by the Australian Securities and Investments Commission.
• In the Chinese mainland, by the China Securities Regulatory Commission.
• In Hong Kong, by the Securities and Futures Commission.
• In India, by the Securities and Exchange Board of India and Forward Markets Commission (FMC)
• In Japan, by the Financial Services Agency.
• In Pakistan, by the Securities and Exchange Commission of Pakistan.
• In Singapore by the Monetary Authority of Singapore.
• In the UK, futures exchanges are regulated by the Financial Services Authority.
• In the USA, by the Commodity Futures Trading Commission.
• In Malaysia, by the Securities Commission Malaysia.
• In Spain, by the Comisión Nacional del Mercado de Valores (CNMV).
• In Brazil, by the Comissão de Valores Mobiliários (CVM).
• In South Africa, by the Financial Services Board (South Africa).

See also[link]

• Bond market
• Commodity markets
• Currency market
• List of futures exchanges
• List of traded commodities
• Paper trading
• Prediction market
• Stock market
• Trader (finance)

References[link]