This magazine doesn’t normally find itself defining things, the assumption being that we have a sophisticated audience which has at least a passing familiarity with most investment concepts. However, exchangetraded funds (ETFs) seem to be so far off the radar of the average chief investment officer, a little explanation can’t hurt (with a nod to Russell consultants Nick Curtin and Raewyn Williams, whose April 2010 paper ‘ETFs: An Australian perspective on a global phenomenon’ is a comprehensive review of the ETF ecosystem).

An ETF is a managed portfolio of assets, often but not always passively tracking a benchmark, which is housed in an open-ended listed trust vehicle. Investors buy units in the trust, which for most major ETFs exactly reflects the underlying portfolio of assets, thanks to hedge funds and other traders who arbitrage away any divergence in the ETF’s net asset value. ETFs are flow-through collective investment vehicles, passing through all income and gains to each investor, and in doing so answering the oft-asked question of how exactly they are different from a listed investment company.

Even if institutional investors are not the most avid endcustomers of ETFs (of which more later), they do play a pivotal role in the so-called ‘primary market’ for the securities. The institutions offer baskets of securities to the fund, in return for which the fund issues new units in the ETF to the investor, equal to the value of the basket of securities contributed. These securities become part of the portfolio of the fund. The transactions are executed by brokers, the ‘market makers’ in the process, who are also the middlemen in the ‘secondary market’ for ETFs. Here, the institutions (by which is meant the ETF providers, such as BlackRock, SSgA, Vanguard, Russell and so on) transact units in the funds with retail investors, but there is no change in the underlying portfolio of assets held by the fund.

As the Russell paper notes: “This is a key difference to unlisted managed or mutual funds, where buyers and sellers transact with the fund, not each other directly. Unlike ETFs, these unlisted funds typically need to trade underlying assets in the fund to invest the funds of new investors or to raise funds to pay redemption proceeds to exiting investors.” The ETFs’ primary market mechanism pays redemptions as in specie transfers of assets out of the ETF. This is not a taxable event in the US, although predictably it is one in Australia. However Australian ETFs have preserved most of their tax efficiency by ensuring that the tax is allocated out to the redeeming investor in the primary market, rather than being left for remaining investors in the secondary market.

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