7955 / What is an exchange-traded fund (ETF)?

In promulgating a proposed rule under the Investment Company Act of 1940, the SEC described exchange-traded funds (ETFs) as “offer[ing] public investors an undivided interest in a pool of securities and other assets.” They “are similar in many ways to traditional mutual funds, except that shares in an ETF can be bought and sold throughout the day like stocks on an exchange through a broker-dealer. ETFs therefore possess characteristics of traditional mutual funds, which issue redeemable shares, and of closed-end investment companies, which generally issue shares that trade at negotiated market prices on a national securities exchange and are not redeemable.”¹

The first ETFs in the early 1990s generally held baskets of securities that mirrored broad-based stock market indexes, such as the S&P 500. That has changed, however. According to the SEC, “Many of the newer ETFs are based on more specialized indexes, including indexes that are designed specifically for a particular ETF, bond indexes, and international indexes. . . . ETFs are held today in increasing amounts by institutional investors (including mutual funds) and other investors as part of sophisticated trading and hedging strategies. Shares of ETFs can be bought and held (sometimes as a core component of a portfolio), or they can be traded frequently as part of an active trading strategy.”²

ETFs are thought to have certain benefits compared to traditional mutual funds, including “lower expense ratios and certain tax efficiencies” and “allow[ing] investors to buy and sell shares at intra-day market prices.” Investors can also “sell ETF shares short, write options on them, and set market, limit, and stop-loss orders on them.”³ ETF shares can be purchased on margin.

ETFs are promoted as being more tax-efficient than mutual funds, in large part because the turnover in portfolio securities is likely to be lower. In addition, as the SEC noted,” [b]ecause an exchange-traded fund typically redeems creation units of exchange-traded shares by delivering securities in the ‘redemption basket,’ an exchange-traded fund generally does not have to sell securities (and thus possibly realize capital gains) in order to pay redemptions in cash.”⁴ As a result, although ETFs may produce fewer, and smaller, capital gain distributions than some mutual funds, that does not mean that such funds never make capital gain distributions, or that the amount of a distribution will always be smaller than a capital gain distribution from a mutual fund.