Regardless of the organizational structure of an ETF, all existing ETFs operate in essentially the same manner. Unlike typical open-end funds or UITs, ETFs issue shares only in large aggregations or blocks (such as 50,000 ETF shares) called "Creation Units." An investor, usually a brokerage house or large institutional investor, may purchase a Creation Unit with a "Portfolio Deposit" equal in value to the aggregate NAV of the ETF Shares in the Creation Unit. The investment adviser or sponsor of the ETF announces the contents of the Portfolio Deposit at the beginning of each business day. The Portfolio Deposit generally consists of a basket of securities that mirrors the composition of the ETF's portfolio. Because the purchase price of the Creation Unit must equal the NAV of the underlying ETF shares, the required Portfolio Deposit generally also includes a small amount of cash to account for the difference between the value of the basket of securities and the NAV of the ETF shares. The value of a Creation Unit typically exceeds several million dollars. After purchasing a Creation Unit, the investor may hold the ETF shares, or sell some or all of the ETF shares to investors in the secondary market.
1. Secondary Market Trading
Like operating companies or closed-end funds, ETFs register offers and sales of shares under the Securities Act and list their ETF shares for trading on a national securities exchange under the Securities Exchange Act of 1934 ("Exchange Act"). As with any listed security, investors also may trade ETF shares in off-exchange transactions. In either case, ETF shares trade at negotiated prices. The development of the secondary market in ETF shares depends upon the activities of the exchange specialist assigned to make a market in the ETF shares and upon the willingness of Creation Unit purchasers to sell ETF shares in the secondary market.
ETF shares purchased in the secondary market are not redeemable from the ETF except in Creation Unit aggregations. If an investor presents a Creation Unit to the ETF for redemption, the redeeming investor receives a "Redemption Basket," the contents of which are identified by the ETF investment adviser or sponsor at the beginning of the day. The Redemption Basket (usually the same as the Portfolio Deposit) consists of securities and a small amount of cash. As with purchases from the ETF, redemptions from the ETF are priced at NAV (i.e., the value of the Redemption Basket is equal to the NAV of the ETF shares in the Creation Unit). An investor holding fewer ETF shares than the amount needed to constitute a Creation Unit may dispose of those ETF shares only by selling them in the secondary market. The investor receives market price for the ETF shares, which may be higher or lower than the NAV of the ETF shares. The investor also pays customary brokerage commissions on the sale.
2. Arbitrage Opportunities
Because of arbitrage opportunities inherent in the ETF structure, ETF shares generally have not traded in the secondary market at a significant premium or discount in relation to NAV. If ETF shares begin to trade at a discount (i.e., a price less than NAV), arbitrageurs may purchase ETF shares in the secondary market and, after accumulating enough shares to equal a Creation Unit, redeem them from the ETF at NAV, and thereby acquire the more-valuable securities in the Redemption Basket. In purchasing the ETF shares, arbitrageurs create greater market demand for the shares, which may raise the market price to a level closer to NAV. If ETF shares trade at a premium (i.e., a price greater than NAV), arbitrageurs may purchase the securities in the Portfolio Deposit, use them to obtain the more-valuable Creation Units from the ETF and then sell the individual ETF shares in the secondary market to realize their profit. As the supply of individual ETF shares available in the secondary market increases, the price of the ETF shares may fall to levels closer to NAV. An exchange specialist designated to maintain a market in the ETF shares also works to provide appropriate amounts of shares in the secondary market in response to supply and demand.
In addition, because the ETF investment adviser or sponsor announces the identities of the securities in the Portfolio Deposit and Redemption Basket each day, arbitrageurs also may decide to engage in arbitrage transactions based on their need for particular securities (for example, to replace borrowed securities that the arbitrageur previously sold "short") or on their own assessment of the relative value of the Portfolio Deposit or Redemption Basket in comparison to the price of the ETF shares. As an apparent result of this arbitrage discipline, ETF sponsors and market participants report that the average deviation between the daily closing price and the daily NAV of ETFs that track domestic indices is generally less than 2%.17 With respect to ETFs that track certain foreign indices, the deviations may be more significant.18
| 17 | See, e.g., Second Amended and Restated Application of Barclays Global Fund Advisors, File No. 812-11600, filed May 11, 2001 ("Barclays Application") at 57-58 (stating that average deviations between the daily closing price and the daily NAV of ETF shares of ETFs tracking domestic indices range from a premium of .05% to a discount of .02%). Persons may obtain copies of applications cited in this concept release for a fee from the Commission's Public Reference Branch, 450 5th Street, N.W., Washington, D.C. 20549-0102 (telephone 202/942-8090). See also John Spence, Salomon Releases ETF Premium/Discount Study, indexfunds.com, Oct. 23, 2000 (reporting that a Salomon Smith Barney study of the trading of ETF shares found that shares of ETFs tracking domestic indices had an average bid price that was a .17% discount to the ETFs' respective estimated intra-day NAVs, as recorded at random points during the trading days in September 2000), at http://www.indexfunds.com/Pfarticles/20001023_SSMBstudy_iss_etf_JS.htm. |
| 18 | See, e.g., Barclays Application at 36 (stating that the Malaysia (Free) WEBs Index Fund traded at wider spreads to NAV following the imposition of capital controls by the Malaysian government in 1998). See also Memorandum in Support of Hearing Request filed by Fund Democracy, LLC, and the Consumer Federation of America with respect to the Barclays Application (arguing that arbitrage opportunities do not ensure that the difference between the market price and NAV of ETF shares will remain narrow, and citing in particular the experience of ETFs tracking various foreign indices), available at http://www.funddemocracy.com/hearing_request_docs.htm. |
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