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A LETTER FROM ICI'S
CHIEF ECONOMIST

ICI RESEARCH:
STAFF AND PUBLICATIONS

SECTION 1:
OVERVIEW OF
U.S.-REGISTERED INVESTMENT COMPANIES

SECTION 2:
RECENT MUTUAL FUND TRENDS

SECTION 3:
EXCHANGE-TRADED FUNDS

SECTION 4:
CLOSED-END FUNDS

SECTION 5:
MUTUAL FUND FEES AND EXPENSES

SECTION 6:
CHARACTERISTICS OF MUTUAL FUND OWNERS

SECTION 7:
THE ROLE OF MUTUAL FUNDS IN RETIREMENT AND EDUCATION SAVINGS

DATA TABLES

APPENDIX A:
HOW MUTUAL FUNDS AND INVESTMENT COMPANIES OPERATE

APPENDIX B:
ICI STATISTICAL RELEASES AND RESEARCH PUBLICATIONS

APPENDIX C:
SIGNIFICANT EVENTS IN FUND HISTORY

TIMELINE:
SIGNIFICANT EVENTS FOR FUNDS IN THE FINANCIAL CRISIS

GLOSSARY

FACT BOOK ARCHIVE

Over the past decade, demand for ETFs has grown markedly as investors—both institutional and retail—increasingly turn to them as investment options in their portfolios. With the increase in demand, sponsors have offered more ETFs with a greater variety of investment objectives. While ETFs share some basic characteristics with mutual funds, there remain key operational and structural differences between the two types of investment products.

What Is an ETF?

ETFs are a relatively recent innovation to the investment company concept. The first ETF—a broad-based domestic equity fund tracking the S&P 500 index—was introduced in 1993 after a fund sponsor received U.S. Securities and Exchange Commission (SEC) exemptive relief from various provisions of the Investment Company Act of 1940 that would not otherwise allow the ETF structure. Until 2008, SEC exemptive relief was granted only to ETFs that tracked designated indexes. These ETFs, commonly referred to as index-based ETFs, are designed to track the performance of their specified indexes or, in some cases, a multiple of or an inverse (or multiple inverse) of their indexes.

In early 2008, the SEC granted exemptive relief to several fund sponsors to offer fully transparent actively managed ETFs that meet certain requirements. Among other requirements, these actively managed ETFs must disclose each business day on their publicly available websites the identities and weightings of the component securities and other assets held by the ETF. Actively managed ETFs do not seek to track the return of a particular index. Instead, an actively managed ETF’s investment adviser, like that of an actively managed mutual fund, creates a unique mix of investments to meet a particular investment objective and policy.

By the end of 2008, the total number of index-based and actively managed ETFs had grown to 728, and total net assets were $531 billion (Figure 3.1). Of these, 12 were actively managed ETFs with less than $250 million in total net assets.

FIGURE 3.1

Total Net Assets and Number of ETFs*

Billions of dollars, year-end, 1998–2008

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*ETF data prior to 2001 were provided by Strategic Insight Simfund; ETF data include ETFs not registered under the Investment Company Act of 1940; ETF data exclude ETFs that invest primarily in other ETFs.
Sources: Investment Company Institute and Strategic Insight Simfund

The vast majority of assets in ETFs are registered with the SEC under the Investment Company Act of 1940 (Figure 3.2). About 7 percent of ETF assets, which are commodity-based, are not registered with or regulated by the SEC under the Investment Company Act of 1940. Those commodity-based ETFs that invest in commodity futures are regulated by the Commodity Futures Trading Commission (CFTC), while those that invest solely in physical commodities are not regulated by the CFTC.

FIGURE 3.2

Legal StATUS of ETFs¹

Percentage of total net assets, year-end 2008

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¹ETF data exclude ETFs that invest primarily in other ETFs.
²ETFs not registered under the Investment Company Act of 1940.

Creation of an ETF

An ETF originates with a sponsor, who chooses the investment objective of the ETF. In the case of an index-based ETF, the sponsor chooses both an index and a method of tracking its target index. Index-based ETFs track their target index in one of two ways. A replicate index-based ETF holds every security in the target index because it invests 100 percent of its assets proportionately in all the securities in the target index. A sample index-based ETF does not hold every security in the target index; instead the sponsor chooses a representative sample of securities in the target index in which to invest. Representative sampling is a practical solution for an ETF that has a target index with thousands of securities in it.

The sponsor of an actively managed ETF also determines the investment objectives of the fund and may trade securities at its discretion, much like an actively managed mutual fund. In theory, an actively managed ETF could trade its portfolio securities regularly. In practice, however, most existing actively managed ETFs tend to trade only weekly or monthly for a number of reasons, including minimizing the risk of other market participants front-running their trades (submitting trades in advance of the ETF to take advantage of any predictable changes in security prices).

ETFs are required to publish information about their portfolio holdings daily. Each business day, the ETF publishes a “creation basket,” a specific list of names and quantities of securities and/or other assets designed to track the performance of the portfolio as a whole. In the case of an index-based ETF, the creation basket is either a replicate or a sample of the ETF’s portfolio. Actively managed ETFs and certain types of index-based ETFs are required to publish their complete portfolio holdings in addition to their creation basket.

ETF shares are created when an “authorized participant”—typically an institutional investor—deposits the daily creation basket and/or cash with the ETF (Figure 3.3). The ETF may require or permit an authorized participant to substitute cash for some or all of the securities or assets in the creation basket. For instance, if a security in the creation basket is difficult to obtain or may not be held by certain types of investors (as is the case with certain foreign securities), the ETF may allow the authorized participant to pay that security’s portion of the basket in cash. An authorized participant may also be charged a transaction fee to offset any transaction expenses the fund undertakes. In return for the creation basket and/or cash, the ETF issues to the authorized participant a “creation unit” that consists of a specified number of ETF shares. Creation units are large blocks of shares that generally range in size from 25,000 to 200,000 shares. The authorized participant can either keep the ETF shares that make up the creation unit or sell all or part of them on a stock exchange. ETF shares are listed on a number of stock exchanges where investors can purchase them as they would shares of a publicly traded company.

A creation unit is liquidated when an authorized participant returns the specified number of shares in the creation unit to the ETF. In return, the authorized participant receives the daily “redemption basket,” a set of specific securities and/or other assets contained within the ETF’s portfolio. The composition of the redemption basket typically mirrors that of the creation basket.

FIGURE 3.3

CREATION OF AN EXCHANGE-TRADED FUND

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ETFs and Mutual Funds

An ETF is similar to a mutual fund in that it offers investors a proportionate share in a pool of stocks, bonds, and other assets. It is most commonly structured as an open-end investment company and is governed by the same regulations as mutual funds. Also, like a mutual fund, an ETF is required to post the marked-to-market net asset value (NAV) of its portfolio at the end of each trading day. Despite these similarities, key features differentiate ETFs from mutual funds.

Key Differences

One major difference is that retail investors buy and sell ETF shares on a stock exchange through a broker-dealer, much like they would with any other type of stock. In contrast, mutual fund shares are not listed on stock exchanges. Retail investors buy and sell mutual fund shares through a variety of distribution channels, including through a financial adviser, broker-dealer, or directly from a fund company.

Pricing also differs between mutual funds and ETFs. Mutual funds are “forward priced,” which means that although investors can place orders to buy or sell shares throughout the day, all orders received during the day will receive the same price—the NAV—the next time it is computed. Most mutual funds calculate their NAV as of 4:00 p.m. eastern time because that is the time U.S. stock exchanges typically close. In contrast, the price of an ETF share is continuously determined on a stock exchange. Consequently, the price at which investors buy and sell ETF shares may not necessarily equal the NAV of the portfolio of securities in the ETF. In addition, two investors selling the same ETF shares at different times on the same day may receive different prices for their shares, both of which may differ from the ETF’s NAV.

How ETFs Trade

The price of an ETF share on a stock exchange is influenced by the forces of supply and demand. While imbalances in supply and demand can cause the price of an ETF share to deviate from its NAV, substantial deviations, for many ETFs, tend to be short-lived. Two primary features of an ETF’s structure promote trading of an ETF’s shares at a price that approximates the ETF’s NAV: portfolio transparency and the ability for authorized participants to create or redeem ETF shares at NAV at the end of each trading day.

ETFs contract with third parties (typically market data vendors) to calculate a real-time estimate of an ETF’s current value, often called the Intraday Indicative Value (IIV), using the portfolio information an ETF publishes daily. IIVs are disseminated at regular intervals during the trading day (typically every 15 to 60 seconds). Investors can observe any discrepancies between the ETF’s share price and its IIV during the trading day. When a gap exists between the ETF share price and its IIV, investors may decide to trade in either the ETF share or the underlying securities that the ETF holds in its portfolio in order to attempt to capture a profit. This trading can help to narrow that gap either by moving the price of the ETF share closer to its IIV or moving the prices of the underlying securities so that the IIV moves closer to the price of the ETF share.

The ability of authorized participants to create or redeem ETF shares at NAV at the end of each trading day also helps an ETF trade at market prices that approximate the underlying market value of the portfolio. When a deviation between an ETF’s market price and its NAV occurs, authorized participants may buy or sell creation units at NAV to capture a profit. For example, when an ETF’s share price is above its NAV, authorized participants may find it profitable to deliver the creation basket of securities to the ETF in exchange for ETF shares that they may sell. When an ETF’s share price is below its NAV, authorized participants may find it profitable to return ETF shares to the fund in exchange for the ETF’s redemption basket of securities that they may sell. These actions by authorized participants help keep the market-determined price of an ETF’s shares close to its NAV.

Demand for ETFs

Demand for ETFs has accelerated as institutional investors have found ETFs a convenient vehicle for participating in, or hedging against, broad movements in the stock market. Retail investors and their financial advisers have become increasingly aware of these investment vehicles. An estimated 2 percent of households, or 2.3 million, owned ETFs in 2008. Of households that owned mutual funds, an estimated 4 percent also owned ETFs. Assets in ETFs accounted for 5 percent of total net assets managed by investment companies at year-end 2008. Net issuance of ETF shares continued to rise in 2008, reaching a record $177 billion (Figure 3.4).

Figure 3.4

Net Issuance of ETF Shares1

Millions of dollars, 1999–2008

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¹Data prior to 2001 were provided by Strategic Insight Simfund.
²Data for ETFs that invest primarily in other ETFs are excluded from the total.
³ETFs not registered under the Investment Company Act of 1940.
Note: Components may not add to the total because of rounding.
Sources: Investment Company Institute and Strategic Insight Simfund

Even with the decline in 2008, assets in ETFs have grown rapidly over the past decade with net issuance of ETF shares contributing to much of this increase. From year-end 1998 through 2008, ETFs issued $661 billion in net new shares, and investor demand for broad-based domestic equity ETFs accounted for about half of this total. These equity ETFs issued $336 billion in net new shares during this 10-year period, and their assets were $266 billion at year-end 2008 (Figure 3.5). Within the broad-based domestic equity category, ETFs that track large cap domestic equity indexes, such as the S&P 500, managed $185 billion or 35 percent of all assets invested in ETFs.

FIGURE 3.5

TOTAL NET Assets of ETFs1 Concentrated in Large Cap Domestic Stocks

Billions of dollars, year-end 2008

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¹ETF data exclude ETFs that primarily invest in other ETFs.
²ETFs not registered under the Investment Company Act of 1940.

Investor interest in global and international ETFs remained fairly strong in 2008 with net issuance amounting to $25 billion. In contrast, mutual funds that invested in foreign markets experienced substantial outflows in 2008. Over the period of 2004 to 2008, international and global ETFs issued $142 billion in net new shares; assets of these funds were $114 billion at the end of 2008.

Increased investor demand for ETFs led to a rapid increase in the number of ETFs created by fund sponsors (Figure 3.6). Over the period of 2000 to 2008, there were 758 ETFs created with the majority being offered in the last three years. Until 2008, few ETFs had been liquidated. In 2008, market pressures, however, appeared to start coming into play as ETFs that track virtually identical indexes competed more vigorously against each other to gather assets. Also, some ETFs tied to niche indexes failed to generate enough investor interest. Although 50 ETFs were liquidated during 2008, the number of ETFs increased, on net, by nearly 100 to 728 at year-end 2008.

FIGURE 3.6

Number of ETFs*

2000–2008

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*ETF data exclude ETFs that primarily invest in other ETFs and include ETFs not registered under the Investment Company Act of 1940.

As demand for ETFs has grown, ETF sponsors have offered more funds with a greater variety of investment objectives. In the mid-1990s, ETF sponsors introduced funds that invested in foreign stock markets. More recently, sponsors have introduced ETFs that invest in particular market sectors, industries, or commodities. At year-end 2008, there were 231 sector and commodity ETFs (Figure 3.7) with $94 billion in assets (Figure 3.8). While commodity ETFs made up 19 percent of the number of sector and commodity ETFs, they accounted for 38 percent of total assets. Since their introduction in 2004, these nonregistered ETFs have grown from just over $1 billion to $36 billion by the end of 2008. Approximately three-quarters of commodity ETF assets tracked the price of gold and silver through the spot and futures markets in 2008. Sector ETFs that have proven to be popular with investors, both in terms of the number offered and assets gathered, are those focused on natural resources and financial institutions.

FIGURE 3.7

Number of Commodity and Sector ETFs1

Percentage, year-end 2008

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¹ETF data exclude ETFs that primarily invest in other ETFs.
²ETFs not registered under the Investment Company Act of 1940.

FIGURE 3.8

TOTAL NET ASSETS OF Commodity and Sector ETFs1

Percentage, year-end 2008

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1ETF data exclude ETFs that primarily invest in other ETFs.
2ETFs not registered under the Investment Company Act of 1940.
Note: Components do not add to 100 percent because of rounding.

In 2008, ETF sponsors continued to create new products. As mentioned above, one development was the action by the SEC to grant exemptive orders to several fund complexes to allow them to sponsor actively managed ETFs under specific conditions. Another was the introduction of ETFs that are structured as funds of funds. ETF funds of funds are ETFs that hold and invest primarily in shares of other ETFs. At year-end 2008, there were 15 ETF funds of funds with $97 million in assets.