The Soul of an ETF

soulWhat makes an ETF an ETF? What distinguishes an Exchange-Traded Fund from other investment securities?

When the first US-listed ETF, the SPDR S&P 500 (SPY), arrived on the scene in 1993 it had a number of features setting it apart from every other product that come before it. Yet in some ways it was quite familiar as well. The fact that it was a fund consisting of many stocks was nothing new; mutual funds had been around for decades.

The fact that it tracked the S&P 500 index did not make it unique; the Vanguard 500 (VFINX) was launched in 1976. The fact that it was a fund that traded all day on a stock exchange was also nothing new; closed-end funds had also been around for decades. So what made this product so special? What set it apart from everything else? Two features provided the soul of what was to become the ETF industry:

First, SPY had an Intraday Indicative Value (IIV), sometimes just called the Indicative Value, Underlying Trading Value, or Net Asset Value (NAV). Additionally, this IIV was updated every fifteen seconds while the market was open. For this to be possible, the fund’s holdings have to be 100% transparent because the actual value of the underlying portfolio can be updated only if the actual holdings are fully disclosed.

Second, the first ETF had the ability to create new shares and redeem existing shares through an in-kind exchange process. Since the holdings were known, a large institutional investor (called an Authorized Participant) could put together a basket of stocks that exactly duplicated the ETF’s holdings and exchange these stocks for shares of the ETF (and vice versa).

Full Story:  http://seekingalpha.com/article/138439-the-soul-of-an-etf

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