Exchange-Traded Funds

May 20, 2014

Exchange-traded funds (ETFs) are true hybrid investment vehicles. Their shares trade on a securities exchange like any other stock, but may also be purchased and redeemed in large blocks (typically 50,000–100,000 shares) at net asset value per share on a daily basis. ETFs therefore possess characteristics of both open-end investment companies and unit investment trusts (UIT), which issue redeemable securities and closed-end investment companies which issue shares that are purchased and sold on securities exchanges throughout the trading day.

Unlike traditional open-end investment companies and unit invest­ment trusts, ETFs afford investors the opportunity to capitalize on market movements (upward or downward) during the trading day. In this respect, they are similar to closed-end investment companies. A key distinction between ETFs and closed-end investment companies, however, is the ability to continually purchase and redeem shares of the ETF at net asset value per share (NAV). This feature is intended to create an arbitrage pricing discipline which minimizes the occurrence of discount and/or premium pricing historically experienced by closed-end investment companies. Another distinguishing feature of ETFs is that typically purchases and redemptions are effected by an in-kind tender of a specified basket of securities. The in-kind mechanism is designed to limit portfolio turnover and related transaction expenses by minimizing the need to liquidate portfolio securities to meet redemp­tions and/or to acquire portfolio securities in connection with purchases of ETF shares.

In this chapter, we first look at organizational issues surrounding ETFs and then examine regulatory issues under the Investment Company Act of 1940 (the “Investment Company Act”) and the Securities Exchange Act of 1934 (the “Exchange Act”). Except as otherwise indicated, this chapter relates to ETFs which are investment companies under the Investment Company Act.

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