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Abstract
Exchange traded funds (ETFs) have seen phenomenal growth in the USA. They work like index-tracking mutual funds but have an added advantage in that they can be traded like an ordinary share. The flexibility and low-cost of ETFs have made them attractive to retail and institutional investors alike. In some circumstances, they are a better alternative than futures. In Europe, fund management firms are rapidly rolling out ETFs in response to a perceived demand for investment tools that facilitate investing by sector as opposed to country.
INTRODUCTION
Exchange traded funds (ETFs) have seen rapid growth in the USA. According to Lehman Brothers, ETF assets grew to over $80bn in April 2001, from less than $10bn as recently as 1997.1 Many financial services providers are beginning to offer them in Europe too.
This paper aims to explain briefly what they are, and then to examine why what was predominantly designed as a retail product is gaining popularity among sophisticated investors, who are using them as an alternative to derivatives.
The paper is not proposed as an academic study of ETFs, but rather as an insight into a rapidly developing investment tool written by someone involved in their construction and distribution.
WHAT ARE ETFs?
ETFs are exchange listed open ended funds backed by a basket of stocks from which they derive their value. Unlike closed end funds, the basket of securities can be expanded or contracted as demand for the product increases or decreases. For the most part, they track designated indices, including country, sector, industry and style indices. Market coverage of ETFs includes indices from Dow Jones, FTSE, MSCI, Russell and S&P.2
ETFs can be traded just like any other share, subject to normal trading commissions and spreads, and incur a management fee. This fee is typically substantially lower than for traditional mutual funds. At the same time they provide the diversification properties of tracking an entire index. Popular ETFs include the S&P 500 SPDR (which tracks the S&P 500 Index) and the Nasdaq-100 Index Tracking Stock (also known as 'the Cube' due to its QQQ ticker symbol). Annual expense ratios for these two products are 0.12 per cent and 0.18 per cent respectively.
WHY USE AN ETF?
There are many uses...