What are Exchange Traded Funds?

Exchange-traded funds (or ETFs) are units of a trust which holds a portfolio of securities that is designed to closely track the performance of a financial market index or sector. They are listed and trade on stock exchanges is the same way as shares of a publically held company. The ETF structure allows for a diversified, low cost, low turnover index investment. The world's first ETF began trading on the Toronto Stock Exchange in 1990. There are now hundreds of ETF units trading on major stock exchanges which track most major world equity, bond and real estate indexes.

The creation and redemption of ETF units
ETFs are created and redeemed through an "in-kind" transaction made by designated brokers and the ETF underwriters, not the individual unitholders of the ETF. When a designated broker wants units of an ETF they assemble each security within the index that the ETF tracks (either buying from the market or gathering from their inventory) in the precise index weighting and then they deliver them to the underwriter. In exchange for the securities, the underwriter gives the designated broker units of the ETF. This process works in reverse for redemption.

The benefits of this 'in-kind' creation and redemption process include:

1. The process provides a mechanism to keep the market prices of an ETF close to the value of the underlying securities in the index.
   
   
2. The process establishes an open-ended potential supply of ETF units and a facility to create new units, thereby resulting in a high level of liquidity.
   
   
3. The process reduces the potential for generating unintended taxable distributions for unitholders due to cash redemptions.
   
   
4. The process minimizes operating costs by eliminating most of the transfer functions that are common for mutual funds.

Benefits of Exchange Traded Funds:

1. An ETF invests directly and proportionally in the securities that comprise an underlying market index, therefore the risk of suffering returns that are dramatically below that of the index is eliminated.
   
   
2. The management expense ratio of an ETF is generally much lower than that of a comparable mutual fund. There are also no redemption fees or deferred sales charges when an ETF is sold.
   
   
3. ETFs offer broad levels of portfolio diversification because they are comprised of all the securities that are included in a market index.
   
   
4. ETFs offer a high level of transparency which means that the holdings, structure, costs, distribution policy and daily trading volumes are known at all times.
   
   
5. ETFs are highly tax efficient since trading of securities held in the units only occurs when there are changes made to the underlying index that the ETF tracks. As a result, ETFs generally have a much lower turnover of securities in their portfolios compared to most actively managed mutual funds.