( ETF ) Creation and Redemption Process

ETFs have a unique so-called creation / redemption mechanism which allows professional market participants to exchange baskets of shares with the same composition at any time for ETFs (and vice versa) with the fund. This ability to continually create or redeem shares helps keep an ETF’s market price in line with its underlying net asset value. A key feature that distinguishes ETFs is that the shares are created by ‘authorised participants’ or creation/redemption brokers in block-size ‘creation units’. The creator deposits into the applicable fund a portfolio of stocks closely approximating the holdings of the index in exchange for an institutional block of ETF shares (usually 50,000). Similarly, they can only be redeemed in redemption units, mainly ‘in-kind’ for a portfolio of stocks held by the fund. The redemption and creation processes are very similar. However, a key benefit is that the in-kind distribution of securities does not create a tax-event, which could occur if the fund sold securities and delivered cash. This is a special advantage of an index-linked ETF versus an open-ended indexed mutual fund, which would have to sell securities to meet cash redemptions.
The issuers and primary traders of index funds operate following the creation – redemption model. In order to track the underlying index, the Designated Sponsors set up a basket of stocks with a composition that mirrors the fund portfolio 1:1. They receive unit shares from the issuers, to the value of the basket, which can subsequently be sold on the market (creation of fund shares). They can also redeem unit shares in the fund, receiving stocks from the issuer in exchange (redemption).

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ETFs – A Leading Financial Innovation

In a relatively short period of time, the market for Exchange Traded Funds (ETFs) has become popular, especially in Europe, and has established itself firmly in the minds of investors. ETFs have been growing faster in Europe than in the US. This is attributed to the fact that many European managers were already familiar with the concept of ETFs before they were made available in Europe. ETFs are now widely used investment vehicles and considered to be an integral component of the overall asset allocation. ETFs might well be considered the leading financial innovation of the past decade.
During the last few years, ETFs have clearly conquered Europe. At the end of October 2004, there were 326 ETFs with assets of US$ 260 billion, managed by 38 managers and listed on 29 exchanges around the world. Year to date, the overall assets under management of ETFs increased by 5% – the US increased by 4.6%, Europe by 15.7%, while Japan declined by 3.9%. During 2004, 45 new ETFs were launched, a further 66 are planned and six ETFs were delisted. The average daily trading volume in US dollars has increased 50.6% to US$ 13.4 billion. This represents a dramatic increase from 1993, when there were just three ETFs with US$ 811 million in assets. January 29, 2003 marked the 10th anniversary of the first ETF listing in the US.1
The attraction of an ETF is that it provides access to a whole index, market or predefined portfolio strategy, but is much less complicated. An ETF behaves like an ordinary share that can be traded on a daily basis, but its underlying assets are an entire index or portfolio, thereby providing diversification.
Their investment objective is to replicate the price and yield performance of an independently published index. This explains why they are often described as index shares. ETFs allow investors to gain broad exposure to specific segments of equity and fixed income markets with relative ease, on a real-time basis, and at a lower cost than many other forms of investing. Essentially, ETFs opened a new, broad range of investment opportunities in large-cap, mid-cap, smallcap, value, growth, domestic, international, country and regional equity indices as well as in corporate and government fixed income indices. Additionally, a trend towards setting up sector ETFs could eventually include style-based offerings and actively managed funds.
Key benefits of return enhancement and the ability to offset custodial and administrative fees help funds squeeze a few extra basis points out of their performance. This can be anywhere between five and thirty basis points on a portfolio, and can often mean the difference between first and second quartile performance.

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introducing ETF ( exchange trade fund )

ETFs are known by a variety of sometimes quirky names — Spiders, Diamonds, OPALs, WEBS (now iShares), Qubes, VIPERs, HOLDRs and streetTracks are just a few. ETFs are a simple, low cost and flexible way to access the potential rewards of market segments. In essence, it brings important advantage in combining index diversification with the flexibility of trading shares. The market growth continued rapidly despite the disappointing investment climate between 2000 and 2003. Therefore ETFs are regarded as the hottest investment product of the new century.
Performance and fees have been the rationale behind index investing for years. In accordance to many investigations only a few actively managed portfolios outperform the broad market over the long run. That’s enough to make investors think twice about paying high fees or pricey sales loads for a fund manager’s supposed expertise. Like conventional index investments, ETFs allow investors to be as active or passive as they wish. Entire portfolios can be built using plain-vanilla
index ETFs that offer broad exposure to stocks and bonds. Further, investors might instead choose to cobble together portfolios based on a dozen or more sector ETFs. Unlike traditional index funds, ETFs can be bought and sold throughout the trading day at intraday prices, rather than based on a fund’s net asset value at a given day and time. ETFs are an evolutionary advance, bringing institutional-quality products to all investors.
In recent years, these unique features and benefits have helped exchange traded funds explode in popularity and emerge as one of the most flexible, multi-purpose investment vehicles available. Ever since the American Stock Exchange pioneered the concept of a tradable basket of stocks with the creation of the Standard & Poor’s Depositary Receipt (SPDR) in 1993, exchange traded funds have evolved into an entirely new investment category. Today, the number of ETFs listed and traded in the US has grown to more than 150 and continues to grow — not only in the number of products and their variety — but also in terms of assets and market value. Currently, there are about 30 ETF managers in more than 25 countries with listings on almost 30 exchanges.
The U.S. Securities and Exchange Commission defines ETFs as “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.
Typically ETFs are issued for institutions in large blocks, known as “Creation Units”. Payments do not use cash but baskets of securities that generally mirror the ETF portfolio. Creation Units are often split up and sold to individual investors, who are willing to buy shares on a secondary market.
Further it is possible to redeem a Creation Unit back to the ETF by giving investors the securities that comprise the portfolio instead of cash.

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What Creates Trends?

• Government policy. When economic policy is to target a growth rate of 3 percent, then the Federal Reserve (the Fed) raises and lowers interest rates to accomplish this. Lowering rates encourages business activity. Raising rates controls inflation by dampening activity.
• International trade. When the United States imports goods, it pays for it in dollars. That is the same as selling the dollar. It weakens the currency. A country that increases its exports strengthens its currency.
• Expectations. If investors think that stock prices will rise, they buy, causing prices to rise. Consumer confidence is a good measure of how the public feels about buying.
  
• Supply and demand. A shortage, or anticipated shortage, of any product will cause its price to rise. Too much of a product results in declining prices. These trends develop as news makes the public aware of the situation.

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