Who Constructs ETFs and How Are They Made

An Overview of the ETF Construction Process

If you are going to trade ETFs, you should probably understand how they are made. It will give you better insight on which Exchange Traded Fund is best for your investment strategy. Understanding the ETF construction process will aid you with your research and help you decide what to look for in your next ETF. But first...

What Is an ETF Provider?

ETF providers design, develop and in most cases manage the exchange traded fund.

There are times, however, when the ETF provider will utilize the skills of other financial entities and partner with them to manage a new fund. This synergy may help produce a better exchange traded product.

How Are ETFs Made?

The first step in the creation process is for an ETF provider to decide which sector, commodity or market to track and then create a fund with the goal of emulating the underlying asset or representing index.

Once the concept is finalized, the ETF provider has to file with the SEC (Securities Exchange Commission) to have the new fund approved. Factors that can affect the approval process are the use of derivatives (such as futures or options) if there is a leveraged return and the management of the fund.

Once the approval process is complete, the ETF provider constructs the new fund using instruments such as stocks, options, futures, or other assets in such a way to best accomplish the goal.

There are many different types of investments that can go in an ETF.

In some cases, the ETF provider may work with another participant who is responsible for attaining the assets in a fund and holding them in a trust. Or the ETF provider can handle this responsibility in-house.

The type of ETF is another consideration in the design process.

Will the ETF be actively managed? Will it be an inverse ETF? Will the return be leveraged? And of course, criteria like dividends, interest, and volatility are factored in as well.

Finally, if approved, the new ETF will get a symbol (with a name of course) and a target launch date. Also, other decisions will be made like where the new ETF will actually trade. From there it’s just a case of ringing the opening bell and you’re off.

What Do I Look for in an ETF?

I do think it is important to understand any investment in your portfolio and how they work. So looking under the hood of any ETF is a good idea. I tend to always look at the holdings myself. It’s always smart to see what is in your ETF.

However, some ETFs particularly those that heavily utilize derivatives, can be a bit complex to examine. So in those cases, research about the actual ETF (performance, goals, historical return, etc) can be more important than analyzing the construction itself. But before you make any trade, ETF or otherwise, research is the key.

And if you do have any questions or concerns about any fund you may be considering, be sure to consult a financial professional such as your broker or advisor. No investment is without risk, ETF or otherwise.

So be sure you understand any risk associated with any funds. But once you do, then good luck with all of your trades.