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Creation Units and the Rise of Exchange-Traded Funds
Investment Adviser

July 2000

Exchange-traded funds, or ETFs, have been increasingly popular and now represent a substantial portion of the trading activity on the American Stock Exchange. ETFs have found favor with many investors as a vehicle that closely tracks the performance of an index while providing the ability to trade in and out of the fund on an intraday basis. To the securities lawyer unfamiliar with ETFs, though, the product is a conundrum: If they are closed-end funds, how can investors be sure that they will track the index closely? Conversely, if they are mutual funds, what is the advantage of trading on an exchange?

ETFs incorporate a key innovation: the creation unit. A small investor cannot purchase or redeem shares from the ETF. But a large investor (say, a big broker-dealer) can redeem shares from the ETF in creation units (typically, blocks of 50,000 shares). The shares are redeemed in kind, with the investor receiving pro rata holdings of the ETF¡¦s portfolio securities. Similarly, a large investor can contribute portfolio securities, of the same type and proportion held by the ETF, and receive one or more creation units. Since arbitrageurs can take advantage of any divergences that the ETF shares' trading price may have from the underlying net asset value, the trading price generally will track changes in the index value.

The investor, therefore, has lost the ability to buy and redeem shares from the fund at net asset value at the end of the day. That is a manageable loss though, since he or she instead can buy or sell shares on the open market at approximately net asset value at any time during the course of the trading day, with less risk of intervening price movements and with the ability to buy on margin. That traditional long-term investment vehicle, the mutual fund, has also become an appropriate trading vehicle for active market participants. The investor must pay brokerage fees on each trade, but in these days of discounted online brokers that is less of a factor.

At the same time, the fund no longer has to deal with cash purchases and redemptions. The fund saves most of its transfer agency expense. It also has no need for a cash reserve to meet redemptions, it doesn't have to pay brokerage fees to invest new cash contributions, and it doesn’t have to worry about the tax consequences of selling portfolio securities. The first ETF, Standard & Poor's Depository Receipts (better known as SPDRs or Spiders), has annual operating expenses of only 20 basis points (before voluntary reductions), including 3.5 basis points for Standard & Poor's license fee. That's better than most index funds. For example, Schwab S & P 500 Fund has annual operating expenses of 47 basis points (which Schwab voluntarily reduces to 35 basis points).

SPDRs and other early ETFs are unit investment trusts and pay their dividends quarterly. More recent ETFs, however, have been formed as open-end investment companies. This, of course, adds a significant complication, since open-end investment companies normally are required to price and allow redemptions of their shares daily. The SEC has proved amenable to providing exemptive relief allowing ETFs to suspend most shareholders' right of redemption and allowing affiliated persons of ETFs to purchase and redeem creation units in kind. See, for example, Barclays Global Fund Advisors, Investment Company Act Release No. 24393, 65 F.R. 21215 (April 17, 2000) (notice of application).

The ability to arbitrage ETF shares generally does succeed in minimizing the difference between the share's trading price and their net asset value, for ETFs tracking U.S. indexes. Some World Equity Benchmark Shares or WEBS (recently renamed iShares MSCI Index Fund Shares), however, have not always had the same success in tracking net asset value. According to Fund Democracy, LLC, which acts as an advocate for mutual fund shareholders' rights and interests, WEBS at times have traded at significant discounts or premiums. In response to Fund Democracy¡¦s initial opposition to a requested exemptive order, Barclays Global Fund Advisors (which sponsors WEBS) agreed to provide information concerning net asset value premiums and discounts in prospectuses and on its web site.

Mao Tse-tung, when asked his assessment of the French Revolution, replied that it¡¦s too soon to tell. While ETFs certainly have found a place in the marketplace, their advocates and critics are far from agreement on their appropriate role. Meanwhile, work continues on devising a mechanism to extend the ETF concept from index to actively managed funds.

John M. Baker
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