Exchange Traded Funds: A White Paper         Page 5
Nasdaq Joins In

In 1999, the SEC issued the Nasdaq-100 Trust Order under the unit investment trust structure. While the Nasdaq-100 is similar in structure to the Diamonds, the Nasdaq-100 uses a modified capitalization-weighted index as the underlying index. This modification was done for policy reasons so the Nasdaq-100 ETF itself is indirectly managed in a limited but significant way. The Nasdaq-100 trust gained quick acceptance in the marketplace.

Also in 1999, Barclays Global Fund Advisors applied to the SEC for an Order covering about 50 ETFs. Barclays calls their products "Exchange Traded Funds". Barclays, having learned from its WEBS partnership with Morgan Stanley, uses the investment company structure to create what are best described as enhanced indexes based on Russell, S&P, and Dow Jones Indexes. In its petition to the SEC, Barclays gives itself as much discretion as possible over managing the products while still being able to call the products index-based investments.

HOW EXCHANGE TRADED FUNDS WORK

Overview

The first ETF, LOR's Index Trust SuperUnit, was originally created by a financial intermediary as a security offered to institutional investors. Current ETFs use the same underlying structure as the Index Trust SuperUnit. Thus, the underlying structure of ETFs is very different from the structure of open-ended mutual funds originally designed by investment managers to offer investments to the general public.

Creation Units

Unlike mutual fund distributors, the sponsors of ETFs do not sell ETF shares to the public for cash. Instead, the ETF sponsors exchange large blocks of ETF shares in-kind for the securities of the companies that make up the underlying index plus a cash component representing mostly accumulated dividends. The large block of ETF shares is called a "Creation Unit" which is exchanged for a "Portfolio Deposit" of stock and the "Cash Component".
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