Introduction

ETF is short for exchange-traded fund. It is an open securities investment fund traded on stock exchanges. The dealing procedures between ETF and stocks are the same. The dealing prices of ETFs are depending on the net asset value of the unit fund. An ETF holds assets such as stocks, commodities, or bonds close to its net asset value over the course of the trading day. ETFs have a lower expense ratio than comparable mutual funds. John M. Baker (2000) thought that not only does an ETF has lower expenses, but because it does not have to invest cash contributions or fund cash redemptions, an ETF does not have to maintain a cash reserve for redemptions and saves on brokerage expenses. Therefore, ETF has acquired great success since it is designed. In the spite of this, there are still some investors that have little knowledge about ETF. Accordingly, in this report we will present the basic knowledge about ETF. And the main contents are as follows. First, introduce the origin of ETF. Second, we will analysis the operation of ETF market, which is divided into three aspects: portfolio adjustment mechanism, trading mechanism and arbitrage mechanism. Third, we summarize the types of ETF products that are available to investors. In this part, four segmentation ways are discussed. And they are different ways in investment, different investment targets, different investment areas, different investment styles respectively. Fourth, we will discuss the risks and opportunities of ETFs. Besides the risks and opportunities, inverse and leveraged ETFs are analyzed in particular. We also comment on the recent short-selling controversy in the ETF market. At last, we will give our own conclusions about ETFs as an investment tool.

Origin of ETF

ETFs’ origin can be traced back to the Index Participation in 1989, which was traded on the American Stock Exchange and Philadelphia Stock Exchange. However, it is short lived after a lawsuit by the Chicago Mercantile Exchange and be forced to stop sales in the United States. After that, Toronto Index Participation Shares (TIPs), similar to the Index Participation, started to be traded on the Toronto Stock Exchange in 1990. It could be tracked to the TSE 35 stocks and TSE 100 stocks, which were proved to be popular. Moreover it is long lived. Accordingly, Gastineau and Gary pointed out that TIPs could be considered to be the first ETFs in the world. The popularity of these two products led the American Stock Exchange to try to develop something that would satisfy the regulation of Security and Exchange Commission in the United States. So in 1993 the executives with the exchange, Nathan Most and Steven Bloom, designed Standard & Poor’s Depositary Receipts, which was known as SPDRs or ‘Spiders’. Since it was designed, it had acquired great success and became the largest ETFs in America (Jennifer Bayot, 2004). After that, ETFs spread through the world rapidly, and uncovered its development prelude actually.

Operation of the ETFs market

The operation of ETFs market involves many aspects. In order to explain it in precise detail, we will divide the whole process into three aspects: portfolio adjustment mechanism, trading mechanism and arbitrage mechanism.

For the portfolio adjustment mechanism, ETF portfolio is not invariable all the time after it is built. And it must be changed with the alteration of the weight in the index constituent. Because the ETF portfolio is composed according to the weight of the index in the component of index’s construction, and the goal is to track specific index completely. Therefore, the ETF portfolio must also be made some adjustment when the index weight changes in the index component.

For the trading mechanism, it is a double trading mechanism that includes two trading methods simultaneously. One is ETF’s buy and redemptive in the primary market. The other one is ETF’s transaction in the secondary market. In the primary market, investors will put fixed percentage of stocks as well as equivalent amount of dividends of per unit fund shares into the management organization according the index weight. After management agencies create new ETF units, the managers will turn the new units into the investors’ escrow account in the security exchange. The whole process is called ETF’s subscription. And its opposite behavior is called ETF’s redemption. In practice, the subscription and redemption usually have minimum investment requirement. And this number is very big in general. So the primary market limits small investors’ participation and is actually institutional investors’ market. Moreover, these two processes are both completed adopting the real way, which is that investors exchange unit fund vouchers with a basket of stocks when they subscribe ETFs and exchange a basket of stocks with unit fund vouchers when they redeem ETFs. In the secondary market, there is no minimum investment requirement. And investors can invest as much or as little money as they wish. Also, Larry Connors (2008) point out investors can sell short, use a limit order, use a stop-loss order and buy on margin in accordance with market price at any time when exchange opens.

For the arbitrage mechanism, ETF’s double trading mechanism determines its arbitrage mechanism. In conventional practice, the primary market and the secondary market can guarantee the trading prices in secondary market close to fund net value. However, if the transaction price in secondary market appears difference with the net value of fund, investors can use this difference between the two markets to make arbitrage trade until the difference disappears. Its specific operation is that: investors will but ETFs or stocks in the primary market and sell them in the secondary market when price in secondary market exceeds its net value; when the price in secondary market is under its net value, investors will carry on the opposite operation until the arbitrage space disappears.

The above three mechanisms involve nearly the whole operation process of ETFs market. However, investors should also pay attention to the following aspects in their concrete implementation. First, keep the constituent stock tracked by ETFs modest. Too many stocks may affect the tracking precision; too few are unfavorable to the diversification of risks. Second, inspect the index’s valuation levels to judge the index has long-term investment value or not. And only the overall comparison cheap index can improve marginal investment security, which just also has more investment potential value. Third, inspect the index’s historical performance through the statistics. And the better its performance the lower risk it has.

Types of ETF product

There are many types of ETF product available to investors and four common classifications are listed in the following article.

According to the different ways in investment, ETFs can be divided into index funds and active management funds. Most ETFs are index funds both in home and abroad. The current upcoming release of ETFs in China is also index fund, such as the 50ETF of Shanghai stock exchange. The index funds are also called passively managed funds which hold securities and attempt to replicate the performance of a stock market index. For example, the principle of the 50ETF of Shanghai stock exchange are that select and buy 50 listed stocks in a particular proportion from the Shanghai stock exchange and try to replicate the performance of the Shanghai stock market index. Though the commissions of the active management funds are much higher than index funds, the performance of the active management funds may not be much better than the index funds. Here an example. Edgardo Cayon Fallon, Tomas Ricardo Di Santo Rojas, Camilo Roncancio Pena have written a article to show “in Colombia whether active management of private pension funds actually adds value to the investors or, on the contrary, investors will achieve better results if they invested in passively managed products like an ETF (Exchange Traded Fund). After conducting a review of data available from 30 different private pension funds in Colombia and 30 ETFs that has similar investment goals to these portfolios, their funding reveal that, using common performance indicators, a common Colombia investor would have a better ROI (return on investment) by investing in passively managed products (ETFs) than the active management of private pension funds” (Edgardo Cayon Fallon, Tomas Ricardo Di Santo Rojas, Camilo Roncancio Pena, 2010, p 13). From the example it is clear that the index fund is a better choice for investors.

According to the different investment targets, ETFs can be divided into stock funds and bond funds. Stock funds are more popular than bond funds .In a simple word, stock funds are the exchange traded funds which invest in stock and the bond funds are the exchange traded funds which invest in bonds especially in government treasury. If the economic condition is prosperous, there will be more stock funds and fewer bond funds, vice versa. So we can see the economic situations from the kinds of the exchange traded funds in some extent. There are several advantages to bond ETFs such as the reasonable trading commissions and the fixed interests, but this benefit can be negatively written off by fees if bought and sold through a third party. Generally speaking, stock funds are suit to investors who have much time to research the stock markets and the bond funds are fit for the investors who know little about the stock markets.

According to the different investment areas, ETFs can be divided into a single country (or market) funds and regional funds, among which the single state funds are primary. Compared with regional funds, a single country (or market) funds are easier to control to make a profit. But with good knowledge and investing skills, regional funds can be used to make money more quickly. In some areas, like Europe and East Asia, the regional funds will have a great chance to develop. Because the economic systems are similar in these areas and the currencies are free to exchange. The regional funds play an important role in promoting the economic development and keeping the monetary stability in the regional areas. Another significant difference between a single country (or market) funds and regional funds are the transaction costs. Some scholars have done research about it. By examining the opening of Exchange Traded Fund (ETF) markets in a multimarket trading environment, Vanthuan Nguyen and Chanwit Phengpis (2009) find that “the opening trades on the American Stock Exchange (AMEX) are the most costly”.

According to the different investment styles, ETFS can be divided into market benchmark index fund, industry index fund and style index fund (such as growth, value, grantor trust, leveraged exchange-traded funds) etc, of which market benchmark index funds are most prevailing. Industry index fund, as the name suggests, first is a kind of index fund, keep track of an industry index as a target. Secondly, it shows the characteristics of a industry. The implement of passive management is the biggest difference from ordinary industry funds. In the style index funds, the grantor trust and leveraged exchange-traded funds are most typical. The grantor trust fund is a kind of exchange through the contract or the company, in the form of the fund coupons (such as earnings vouchers, fund unit and fund shares, etc.) .Collecting unequal value funds of the most uncertainty social investors together to form the certain scale trust assets. Then the collecting funds are controlled by special investment institutions to diversify investment guided by the Asset Combination Principle. The profits are shared by investors according to the proportion of investment. Leverage fund are also called as hedge fund. Hedge funds are those funds that make profits by using the arbitrage opportunities among different markets. Viewing formally, the hedge fund is a group of investment tools which trade across all markets, including foreign exchange, stocks, bonds, commodities and various derivatives, etc. Traders should be cautious if they plan to trade inverse and leveraged ETFs for short periods of time. Close attention should be paid to transaction costs and daily performance rates as the potential combined compound loss can sometimes go unrecognized and offset potential gains over a longer period of time (Tristan Yates, 2010). So the risk in investing in leveraged ETFs is much higher than other financial products for ordinary investors.

Risks and opportunities of ETFs

As with all types of investing, ETFs involve some risks and opportunities with no exception. Here we will discuss them in detail.

For its risks, there are mainly about tracking error risk, market risk, credit risk, interest-rate risk and so on. Next, we will analysis them one by one. The first one is the tracking error risk. A tracking error is inherent system risk in all ETF investments. It is the difference between the total net value of the component stocks of the ETFs and the market share price of the ETFs. In practice, it is that ETFs usually hold cash for various periods throughout each quarter, even though the underlying benchmark index (such as the S&P 500) does not include cash. As such, the fund will not be able to precisely track the targeted index. And there is always a difference between the fund and the targeted index. This is especially true with index ETFs that can not reinvest dividends and therefore must hold such dividends temporarily as cash. The second is the market risk. It means that the price of ETFs fluctuates continuously base on many factors, for example: government policy, economic condition, economic cycle, political condition. Any one of these factors will cause dramatic changes of the security and ETF’s price. So the market risk can not be ignored. The third one is the credit risk. The credit risk is also named default risk. It means that counterparty fails to fulfill the obligation prescribed in the contract caused economic losses of risk. It may caused by two reasons. One is the cyclical economic operation. In the period of expand stage, the credit risk is reduced. Because strong profitability makes overall default rate reduce. In the period of depression stage, credit risk increases. Because of the overall deterioration profitability for various reasons, the possibility of borrower can not full fill the responsibility to repayment increases. The other one is special events. The special events have nothing relation with economic operation cycle, but they can affect the company’s management greatly. For example: the litigation about the products’ quality. The fourth one is the interest-rate risk. It means that the affection to prices of bond caused by uncertainty of market interest rate. The prices of bond fluctuate as the interest rates change. When the interest rates rise, the prices of bond will fall. And when the interest rates fall, the prices of bond will rise. In investors’ portfolios, most other funds will hedge the interest-rate risk. However, the risk for ETFs that hold bonds can be still significant.

For its opportunities, there are also many risks as well as its risks. And we will analysis its advantages first. Trading flexibility: ETFs can be bought and sold as mere shares through many channels, for example, stock exchanges, bank, broker or online. These tools offer convenience to various investors. More important is that the trading flexibility can also increase the instrument’s liquidity to meet investors’ different needs. Diversification: for the investment types, ETFs provide a wide choice of investment options, including various sectors, asset classes, geographical location and investment strategies. Moreover, ETFs can be made up of bonds, stocks, or other securities. Accordingly, ETFs can be a quick way to diversify one’s portfolio strategy and reduce the investment risk. And this makes the risk lower than other financial products. For example, if an investor wants to have a diversified portfolio of stocks and bonds, then one could use a stock ETF and a bond ETF rather than researching, buying and managing a number of individual bonds and stocks. High transparency: ETFs report their holdings every day and typically disclose the specific weight of the components of the tracked index. And that means that investors will know when the ETF has modified its position in a particular stock or other security. The transparency inherent in ETFs, coupled with the tracking of a set index, provides greater confidence that the ETF will maintain its original investment strategy. Besides these three aspects, there are also many other aspects. And these advantages make ETFs bring great opportunities for investors. First, ETFs enrich brokers’ product lines effectively, which adapt to the diversified investment demand of investors. ETF is one of the fastest-growing financial products, which shows that ETF is highly publicized by investors in the world. As a kind of the index of product trading on the spot, ETF has significant innovative sense capital market, becoming super stocks that are convenient to invest particular index. In addition to this, due to the influence of the global financial crisis, the stock market is general at historic lows. Therefore ETF becomes one of the best portfolio selections. Second, ETF revitalizes the investors’ assets effectively. The off-line stock subscription is major bright way that ETF subscribes. Business without trading stock conversion became part of the effective ETFs, which activate the customers’ assets. Third, ETF business brings new opportunity to monopoly market for brokers. Participating dealer almost exclusively grasp the ETF products’ opportunity of arbitraging. Through business of agent subscribe and redemption, they can increase brokerage business income relating with component stock trading effectively. Moreover, they can also increase brokerage revenue and market share in the secondary market, including ETFs’ own volume and component stocks’ transactions.

In all kinds of ETF products, leveraged and inverse ETFs are very special undoubtedly. Leveraged ETFs are the stocks that seek to deliver multiples of the index or benchmark they track. Inverse ETFs seek the opposite multiples of the index or benchmark that they track. They both focus on long term objectives, emphasizing the long term profits. However, they do not violate ETFs’ transparency principle. They just reset ETFs’ daily principle. Edhec (2009) said they have become a widely used investment products in both the derivative market and the ETF market. The leveraged and inverse ETFs have become standard products in the financial industry. However, studies (Cheng and Madhavan, 2009; Despande et al, 2009; Lu et al, 2009) in recent pointed out that the performance characteristics of these strategies are fairly complex. In particular, the long-term performance of these funds is path-dependent with respect to the underlying, and is strongly influenced by the volatility of the underlying. Consequently, the long-term performance is full of uncertain. Guido Giese (2010) pointed out that leveraged and inverse ETFs have much higher transaction cost than other standard ETFs. In addition to this, Paul Justice (2009) even argued that leveraged and inverse ETFs can kill investors’ portfolios, and many people are sucked bets to these products. In spite of these critics, there are still many people who are full of confident to leveraged and inverse ETFs. And leveraged also get good performance. So many investors have become copycats that snap up with other people. In this report, we think there are risks as well as opportunities for leveraged and inverse ETFs. When investors make their investment plans, they must recognize leveraged funds design and principle, find exact innovation fund that is suitable to oneself, and do not follow suit blindly. In addition, investors should comply with the following principles: first, clear up your investment style. Second, investors need have certain market judgment ability, and have the right opportunity to operate can earn high returns. Third, understand the characteristic of each grade fund product, especially the critical point of occurrence function of the leveraged and inverse ETFs. Fourth, control risk properly, choose good selling point, be calm and do not be greed (Gao Wenjie, 2010). At last, leveraged and inverse ETFs should be used by investors with much experience. For people who are forced to invest, they should fully learn the purpose of leveraged and inverse ETFs as well as the risks associated with them. If people can grasp these points, the leveraged and inverse ETFs may take great profits investors. Otherwise, they will really kill investors’ all portfolios.

In order to lower the ETFs’ risks, more and more investors begin to sell short ETFs. For the meaning of short selling, Adam Esposito (2004) took an example that if one investor holds a portfolio of stocks and fear that ETF market segment may experience some fluctuate. Then the investor might sell short shares of the ETF that tracks small caps. Short selling has been an issue since the financial market appeared. And many people are against the short selling. To find out its cause, opponents said that there were about eight reasons: First, sell out the wealth that do not belong to investors have suspicion of stealing. Second, investors who make earnings surely based on other losers, so this kind of behavior is wrong. Third, it makes stock prices down. Fourth, it affects companies’ performance. Fifth, short sellers can manipulate market price. Sixth, short sellers increase the undulatory property of ETF market. Seventh, short selling encourages the behavior of excessive speculation. Eighth, liquidation mechanism may be damaged when the short sellers can not return the ETFS that they borrow. In fact, most of the blame for short selling is misunderstanding or totally wrong. If we look closely at once, we can find that short selling plays an important role in the ETF market even the whole financial market. At first, short selling is helpful to increase the liquidity in ETF market, such as market-making. In the second place, short selling is helpful for securities derivatives to fully reflect the actual prices of securities. Because of the arbitrage relations, derivatives price is associated with the price of the underlying security. If derivatives price deviates its reasonable price, short sellers will buy undervalued arbitrage and sell the overvalued securities, which help to push the overestimate prices to the correct level. Last one, also the most important, short selling takes more information into ETF market, which helps to reduce the speculative and volatility of the ETF market.

Conclusions

As the development of ETF, it is an increasingly important vehicle. And ETF has become popular all around the world, which shows that it has been recognized by global investors. It does not only because ETF can take great opportunities to investors but also for the reason that it can diversify the investment risk, which is lower than other financial products. Compared with other investment vehicles, ETF is a valuable investment tool. Yet investors should also pay attention to the following problems: How does the ETF achieve its profit? What are the potential risks? How about the ability of the funds manager? How much are various rates respectively? How long is the board of the fund? To solve these questions, investors must learn the prospectus of the ETF (Gabriel Yap, 2004). Because many of the important things, such as investment objectives, principal strategies, rates, managers, and risks are included in the funds’ prospectus. For the prospectus, investors can find them on the website as well as through their own brokers. Moreover investors can also consult investment professional for investment advice. After learning all the basic knowledge, investors must made investment plan according to their own risk tolerance. Only through these steps can ETF really become a useful investment tool for investors.