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ETPs (Exchange Traded Products) may provide exposure to stocks, bonds, commodities, currencies or a variety of long-only and long-short strategies. ETFs typically invest in a portfolio of physical securities. Index-tracking ETFs normally hold a portfolio of securities that closely resembles, but does not necessarily fully replicate, their benchmark index and use the same techniques of index management of physical securities as index-tracking open-end mutual funds.

While ETFs typically provide exposure to an index, they can, like regular open-end funds, be vehicles for providing exposure to many different types of investment strategies, including active management. ETFs that pursue traditional active management strategies are less familiar than index-tracking ETFs, but are becoming increasingly more common. Unlike most open-end and closed-end funds, ETFs generally disclose all or substantially all portfolio holdings on a contemporary basis. Portfolio transparency risks revealing information about changes in an ETF’s portfolio that may be market-sensitive and, therefore, raise the cost of executing future transactions. This may make it difficult to pursue certain active investment strategies, such as stock selection using small-capitalization stocks, through ETFs. Other active strategies less subject to front-running risk, such as yield curve positioning using very liquid bonds, may be pursued through ETFs with less risk of adverse consequences.

Like open-end funds, most index-tracking ETFs provide exposure to standard indices that weight components based on their market capitalization. Standard indices are generally designed to be as representative of a particular market segment as possible — that is, they try to look as much as possible like the market segment as a whole and do not overweight securities with characteristics deemed particularly desirable (such as low volatility or high liquidity) that are possessed by only a portion of the securities in the market segment. Some index-tracking ETFs, however, provide exposure to benchmarks that are themselves expressions of “active” investment strategies that have been reduced to systematic rules. Such non-standard indices do not purport to look like a market segment as a whole, but instead emphasize securities within a market segment that exhibit particular characteristics sought by investors, such as low price-to-book-value ratios or high dividend yields. The rules of non-standard indices used as ETF benchmarks may be very simple (such as holding all component stocks at equal weights rather than market capitalization weights to emphasize components with smaller market capitalizations) or relatively complex (such as screening and/or weighting components based on multiple investment factors like sales, cash flow and book value). Conversely, a number of ETPs seek simply to provide exposure to an asset class, but do so in a manner that does not require an index (for example, ETPs that track the value of a currency or a metal). These ETPs physically hold the benchmark asset and do not seek to add value through any investment process. Although they are not index-based, they closely resemble index-based ETFs and can be thought of as passive investments. As shown in Figure 1.1, the variety of investment exposures available through ETFs can be viewed across two dimensions: passive versus active investing, and index versus non-index-based exposure. This distinction could potentially be further delineated in that “active” ETFs could be divided between funds that track a published alpha-seeking index and funds wherein the ETF manager explicitly implements subjective portfolio decisions. One could argue that the former is “passive” at the level of the execution, but tracks an index construction process that happens to be active.

 etf investment universe

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