The majority of exchange traded funds follow an index for example the S&P 500, an index published since 1957 that details the prices of 500 large-cap common shares regularly traded in America. These shares are usually those of the big PLCâ€™s traded on NYSE and NASDAQ. They are often used as part of private wealth management portfolios due to their low costs and share-like tendencies but more than anything, because of the tax benefits.
The fees involved in an exchange traded fund are predominantly annual fees of under 0.5% and have no exit or entry fees. Similar to tracker funds, they may not buy every share in the index tracked (called total replication) but may use some sampling technique that can lead to tracking error ie the performance of the fund does not follow its target completely and this can range from about 0.25% to about 4%, which can outweigh fees and price changes.
Only certain investors referred to as authorised participants, generally bigger institutional investors, trade shares of an exchange traded fund directly with the fund manager and even then, only in big quantities of tens of thousands of that particular funds shares - often exchanged for large amounts of the funds underlying assets. These authorised participants often decide to invest in the exchange traded funds over a longer period but frequently act as market makers on the open market. Other investors such as individuals using a retail broker who often deals with the private wealth management clients, trade exchange traded funds on what is classed as the â€śsecondary marketâ€ť (sometimes referred to as the aftermarket).
Some Index Exchange Traded Funds (funds that aim to follow indexes), invest 100% of their assets in securities within that index so that it reflects the trend of that index, often referred to as â€śreplicationâ€ť investing Some others use representative investing which involves acquiring around 80-95% in assets associated with a certain index in the same way, but the rest in potentially more profitable but more risky investments that the manager believes would help meet the investment targets.
One of the benefits of an exchange traded fund is that it uses both features of a mutual fund and a unit investment trust which can be bought or sold at the end of each trading day for itâ€™s net asset value, with the tradability that comes with a closed-end fund which trades through the day at a value that can often be higher or lower than the value of itâ€™s assets. Closed-end funds arenâ€™t generally thought of as exchange traded funds, despite the fact that they are actually traded on stock exchanges.