Who Constructs ETFs and How Are They Made

An overview of the ETF construction process

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If you want to trade exchange-traded funds (ETFs), it helps if you first understand the creation process for the funds. Understanding the securities underlying the ETFs and how they're created can aid you with your research and help you choose an ETF that fits with your investment strategy.

Key Takeaways

  • Exchange-traded funds (ETFs) must be approved by the Securities and Exchange Commission (SEC) prior to formation.
  • There are many types of ETFs with unique strategies to mirror (or outperform) an underlying index, market, commodity, or sector.
  • Managers or sponsors design the ETF and take it through the process to reach market; they may work with providers to procure fund assets.
  • If you are considering investing in an ETF, study the assets it holds to make sure they align with the goals of your portfolio.

Who Creates ETFs?

ETF managers, also known as sponsors, are responsible for designing, developing, and, in most cases, managing the ETF. Once the sponsor knows the type of security they want to create, they file a plan with the Securities and Exchange Commission (SEC) to create the ETF.

At times, the ETF provider will utilize the skills of other financial entities by partnering with them to manage a new fund. This synergy may help produce a better exchange-traded product.

How Are The Funds Assembled?

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

After finalizing the concept, the ETF provider files with the SEC to get the new fund approved. Factors that can affect the approval process include the use of derivatives such as futures or options, whether or not the fund has a leveraged return, and the proposed management of the fund.

Upon completing the approval process, the ETF provider constructs the new fund using a combination of assets that best accomplish the goal of the ETF.

Many different types of investments can go into an ETF, such as stocks, options, futures, and many other assets that can help attain the goals of the fund.

In some cases, the ETF provider may work with another participant who procures the assets in a fund and holds them in a trust. The ETF provider may also choose to handle this responsibility in-house.

Finally, the ETF sponsor will make several decisions that get the new ETF ready to hit the market. The ETF gets a symbol, a name, and a target launch date. The ETF sponsor will also decide which stock market the ETF will trade on. From there, it’s just a case of ringing the opening bell to officially begin trading the fund.

Fund Types

Part of the design process concerns the type of ETF. Management style and goals will vary from product to product. Criteria such as dividends, interest, and volatility should be taken into account, as well.

Index-Based ETFs

When many investors think of an ETF, an index-based ETF will come to mind. These ETFs are designed to replicate the performance of a given index. The first ETF, launched in 1993, was the SPDR S&P 500 ETF Trust (SPY). As the name suggests, SPY aims to mirror the S&P 500's holdings and performance. These kinds of ETFs are also known as passively managed ETFs, since all the manager has to do is replicate the holdings of the chosen index.

Actively-Managed ETFs

The opposite of these passive index funds is an actively managed ETF. The managers for these ETFs are allowed—and in some cases, expected—to buy or sell assets within the ETF every day. Actively managed ETFs don't seek to exactly replicate a specific index, but they will establish a clear investment goal, usually based on an industry, region, or type of security.

Leveraged ETFs

A leveraged ETF seeks multiples on the performance of an index, sector, or region. In other words, whereas SPY seeks to replicate the performance of the S&P 500, a leveraged ETF may seek to double (or even triple) the S&P 500's returns.

No ETF's performance is guaranteed, but leveraged ETFs are especially risky, and they've prompted investor warnings from the government.

Inverse ETFs

Another relatively risky ETF is the inverse ETF. These seek the inverse return of an index. For example, when the S&P 500 falls, an inverse ETF tracking the S&P 500 rises. While risky, these ETFs can be used to hedge your portfolio or take a bearish stance on a particular index, sector, or region.

What to Look for in an ETF

It's important to understand the investments in your portfolio and how they work. Before you make any trade, ETF or otherwise, do the research.

The first aspect to analyze when considering a new ETF is to look at the holdings. There's a lot you can learn about an ETF just by looking at the assets it holds.

However, some ETFs, particularly those that heavily utilize derivatives, can be a bit complex to examine. In those cases, researching data such as the actual ETF performance, goals, and historical returns can be more important than analyzing the construction itself.

If you have any questions or concerns about any fund you may be considering, consult a financial professional such as your broker or advisor. No investment is without risk, ETF or otherwise. That's why you must understand any risk associated with the funds you consider buying.