What Is an Exchange Trade Fund Investment?

Investment 101: What Is an Exchange Trade Fund?

Investors have poured more than two trillion dollars into ETFs since they were first introduced in the United States in 1993. As ETFs gain increasing popularity among everyday investors, regulators are boosting their oversight. Most notably, the Securities and Exchange Commission (SEC) recently announced that it plans to examine the operations of ETFs in the coming year. The current market volatility, for now on the downside, is enhanced by leverage and in-and-out strategies used by an Exchange Trade Fund.

What Is an Exchange Trade Fund?

Despite their rapidly growing popularity, many investors are unfamiliar with how ETFs work. To start, an Exchange Trade Fund is an “exchange-traded fund.” The investment funds must register with the SEC under the 1940 Act as either an open-end investment company or a unit investment trust.

As described by the SEC, ETFs are similar to mutual funds in that they allow investors to pool into an investment vehicle that purchases stocks, bonds, or other assets. In return, investors receive an interest in the pool of underlying assets. However, unlike a mutual fund, an Exchange Trade Fund trades on a public stock exchange. In addition, the net asset value (NAV) of an Exchange Trade Fund is not calculated at the end of each day.

ETFs are popular because they are generally more transparent, liquid and cost-effective than similar investments, such as mutual funds. As noted above, they can be bought and sold like stocks with transaction costs that are much lower than mutual funds. In addition, because capital gains from sales within the Exchange Trade Fund are not passed on to shareholders, they have certain tax advantages.

Before jumping into the Exchange Trade Fund market, investors should also understand that there are a number of different types of ETFs, which can vary in both complexity and volatility. The most basic ETFs, known as Spiders, invests in all of the stocks included in the S&P 500 Composite Stock Price Index. On the other end of the spectrum, the goal of a leveraged or inverse ETFs is to achieve a daily return that is a multiple or an inverse multiple of the daily return of a securities index.

Increased Regulatory Oversight 

In December, the SEC proposed a new rule designed to further regulate the use of derivatives by ETFs and other investment vehicles. The proposed rule would limit funds’ use of derivatives and mandate the use of certain risk management measures intended to protect investors.

“The current regulatory framework no longer effectively achieves the statutory objectives of the Investment Company Act, which seeks to protect investors from the risks of excessive leverage,” SEC Chair Mary Jo White stated.

Notably, the SEC’s rule proposal limits aggregate exposure to derivatives an Exchange Trade Fund can have to 150 percent of a fund’s net assets. A fund would be permitted to obtain exposure up to 300 percent of the fund’s net assets, provided that the fund satisfies a risk-based test is designed to determine whether the fund’s derivatives transactions, in aggregate, result in a fund portfolio that is subject to less market risk than if the fund did not use derivatives. Critics of the rule argue that it would effectively force some leveraged ETFs out of business.

Increased Regulatory Oversight 

In December, the SEC proposed a new rule designed to further regulate the use of derivatives by ETFs and other investment vehicles. The proposed rule would limit funds’ use of derivatives and mandate the use of certain risk management measures intended to protect investors.

“The current regulatory framework no longer effectively achieves the statutory objectives of the Investment Company Act, which seeks to protect investors from the risks of excessive leverage,” SEC Chair Mary Jo White stated.

Notably, the SEC’s rule proposal limits aggregate exposure to derivatives an Exchange Trade Fund can have to 150 percent of a fund’s net assets. A fund would be permitted to obtain exposure up to 300 percent of the fund’s net assets, provided that the fund satisfies a risk-based test is designed to determine whether the fund’s derivatives transactions, in aggregate, result in a fund portfolio that is subject to less market risk than if the fund did not use derivatives. Critics of the rule argue that it would effectively force some leveraged ETFs out of business.