ETF Exchange-Traded Funds

By Prof. Dr. George S. Mentz

05 January, 2007

Exchange-Traded Funds (ETFs)

Edited and Prepared by: Prof. Mentz

An exchange-traded fund, or ETF, is a type of investment company whose investment objective is to achieve the same return as a particular market index. An ETF is similar to an index fund in that it will primarily invest in the securities of companies that are included in a selected market index. An ETF will invest in either all of the securities or a representative sample of the securities included in the index. For example, one type of ETF, known as Spiders or SPDRs, invests in all of the stocks contained in the S&P 500 Composite Stock Price Index.

Although ETFs are legally classified as open-end companies or Unit Investment Trusts (UITs), they differ from traditional open-end companies and UITs in the following respects:

ETFs do not sell individual shares directly to investors and only issue their shares in large blocks (blocks of 50,000 shares, for example) that are known as "Creation Units."

Investors generally do not purchase Creation Units with cash. Instead, they buy Creation Units with a basket of securities that generally mirrors the ETF's portfolio. Those who purchase Creation Units are frequently institutions.

After purchasing a Creation Unit, an investor often splits it up and sells the individual shares on a secondary market. This permits other investors to purchase individual shares (instead of Creation Units).

Investors who want to sell their ETF shares have two options: (1) they can sell individual shares to other investors on the secondary market, or (2) they can sell the Creation Units back to the ETF. In addition, ETFs generally redeem Creation Units by giving investors the securities that comprise the portfolio instead of cash. So, for example, an ETF invested in the stocks contained in the Dow Jones Industrial Average (DJIA) would give a redeeming shareholder the actual securities that constitute the DJIA instead of cash. Because of the limited redeemability of ETF shares, ETFs are not considered to be-and may not call themselves-mutual funds.
An ETF, like any other type of investment company, will have a prospectus. All investors that purchase Creation Units receive a prospectus. Some ETFs also deliver a prospectus to secondary market purchasers. ETFs that do not deliver a prospectus are required to give investors a document known as a Product Description, which summarizes key information about the ETF and explains how to obtain a prospectus. All ETFs will deliver a prospectus upon request. ETFs do not use profiles. ETFs that are legally structured as open-end companies (but not those that are structured as UITs) must also have statements of additional information (SAIs). Open-end ETFs (but not UIT ETFs) must provide shareholders with annual and semi-annual reports. Before purchasing ETF shares, you should carefully read all of an ETF's available information, including its prospectus.

The website of the American Stock Exchange provides more information about different types of ETFs and how they work. You can also find detailed information about ETFs on the website of The Nasdaq Stock Market. An ETF will have annual operating expenses and may also impose certain shareholders fees that are disclosed in the prospectus.

About the Authors
George Mentz is a licensed attorney and is trained in Internatinal Law and Business. Mentz has an earned MBA from an AACSB Accredited Business School and holds a Doctorate Degree or Juris Doctorate Degree from an ABA Accredited USA Law School. Prof. Mentz has faculty appointments and credentials in Silicon Valley, Miami, Chicago, Denver, Hong Kong, Singapore, and The Bahamas. . Prof. Mentz is a consultant providing expertise to Fortune 100 companies in several countries. The first person in the United States to achieve "Quad Designation" Status as a JD, MBA, licensed financial planner, and Certified Financial Consultant. Prof. Mentz has authored/published over 15 Books and has been featured or quoted in the Wall Street Journal, The Hindu National, El Norte Latin America, the Finanical Times, The China Daily, & The Arab Times. His research, publications, and speeches have been syndicated into over 100 countries. Prof. Mentz has recently been elected to the advisory board of the GFF Global Finance Forum in Switzerland and the World E-Commerce Forum in London, England. He also is on the Advisory Board of The ERISA Fiduciary Guild. Mentz was Editor and Chief for the Original Tax and Estate Planning Law Review at Loyola University (A Loyola University Chartered Organization). One of the First Lawyers in the USA to be credentialed and compliant to teach law in all 50 states in law school, graduate and undergraduate colleges and universities. Holds professor faculty appointment at Graduate LLM Law Program . Prof. Mentz has established Certification and Executive Training Accreditation Programs in over 50 Countries around the world including : UK, China, Mexico, Africa, Singapore, Taiwan, USA, Bahamas, India, Russia, EU, Philippines, Saudi Arabia, Canada, Vietnam, The Bahamas and more. General Counsel and Attorneyand Board of Standards Chair Prof. Mentz has recently been awarded a National Faculty Award, a Distinguished Faculty Award and a Meritorious Service Medal for Charitable Service. Prof Mentz has taught over 150 college and graduate courses in his faculty career.