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Exchange-Traded Funds (ETFs): Creation, Operation, and Organization under the Investment Company Act of 1940

An exchange-traded fund (“ETF”) provides securities that offer institutional investment strategies, such as those offered by a mutual fund, but makes them available on security exchanges, just like stocks.1 Consequently, this unique and dynamic investment vehicle has grown rapidly since the first ETF began operation in 1993.2 $1.4 trillion of net new ETF shares have been issued in the last 10 years—expanding the U.S. ETF industry to nearly $2.0 trillion in assets at year-end 2014.3 This blog is the second of two, examining the creation and operation of ETFs in the context of the Investment Company Act of 1940 (“1940 Act”). The first blog discussed how an ETF is created and operated, which is necessary to understand the implications of the 1940 Act. This second blog examines the creation of the first ETF under the 1940 Act and analyzes its evolution up until today.

The 1940 Act itself does not expressly contemplate ETFs.4 As a result, ETFs must receive certain exemptions from the Securities and Exchange Commission (“SEC”) to legally operate under the 1940 Act.5 However, outside of these exemptions, ETFs are subject to all of the provisions of the 1940 Act that apply to their structure, as either an open-end management investment companies or unit-investment trusts.6

A few of the more commonly used exemptions relate to redeemable shares and offering price.7 Section 5(a)(1) and 2(a)(32) of the 1940 Act require that open-end companies exchange a proportionate share of the issuer’s current net assets or cash equivalent for their redeemable securities.8 However, because ETF shares are not individually redeemable, the SEC’s exemption allows ETFs to redeem their shares in Creation Units only, as opposed to individual units. A second commonly used exemption is section 22(d), which requires dealers selling redeemable securities offered to the public through a principal underwriter to do so at a current public offering price disclosed in the prospectus.9 However, because ETFs trade on the secondary market at negotiated prices, the SEC’s exemption allows ETFs to trade at negotiated prices, and not the public offering price otherwise required.

The SEC granted its first ETF exemption in October of 1992,10, and shortly thereafter the first ETF commenced operations in January of 1993, issuing 150,000 shares to be traded on the American Stock Exchange,11 These shares, titled after the Standard & Poor’s 500 Index (“S&P 500”), an index of 500 stocks designed to represent the United States large cap equity market, were named Standard & Poor’s Depositary Receipts (SPDRs).12 These SPDR shares represented ownership in an investment trust that, in turn, owned a portfolio of shares in all of the companies of the S&P 500, substantially in the same proportion as the index itself.13 Thus, the investor of a single SPDR share was invested in the entire S&P 500.14

The first ETF exemption order for the SPDR Trust was for a unit investment trust, which requires the trust to “have a fixed portfolio or a portfolio that moves in lock step with an index.”15 However, since that first order, the SEC has continued to expand on the limits of ETFs. In 1996 the SEC issued their first order permitting an ETF to organize as an open-end management investment company, as opposed to just a unit investment trust.16 Organizing as an open-end management investment company allows ETFs to use investment advisers, enabling the fund to rely on sampling strategies to track the index’s performance, as opposed to actually acquiring all of the securities in the index.17 And again, in 2008, the SEC expanded on the ETF market by approving actively managed ETFs that do not track indices at all.18

At their onset, ETFs provided a unique and dynamic investment opportunity. Although initially limited to formation as a unit investment trust, expanding exemptions from the SEC have led to an increased role for ETFs in the market. To properly understand and analyze the benefits and risks of this expansion, it’s important to understand, first


  1. See William A. Birdthistle, The Fortunes and Foibles of Exchange-Traded Funds: A Positive Market Response to the Problems of Mutual Funds, 33 Del. J. Corp. L. 69, 69 (2008). 

  2. Id. at 71-72. 

  3. Inv. Co. Inst., 2015 Investment Company Fact Book: A Review of Trends and Activities in the U.S. Investment Company Industry 23 (55th ed. 2015). 

  4. Michael W. Mundt, An Overview of Exchange-Traded Funds Regulation 1 (The American Law Inst. Continuing Legal Educ. 2014). 

  5. Id. 

  6. Id. 

  7. See Id. 

  8. Id. 

  9. Id. 

  10. SPDR Trust, Series 1 Investment Company Act Release No. 18959 (Sept. 17, 1992) (notice) and 19055 (Oct. 26, 1992) (order)  

  11. Birdthistle, supra note 1, at 76. 

  12. Id.; Standard & Poor’s 500 Index, Investopedia, http://www.investopedia.com/terms/s/sp500.asp (last visited Sept. 26, 2015) (“The S&P 500 is one of the most commonly used benchmarks for the overall U.S. stock market . . . [and] many consider it to be the definition of the market”). 

  13. Mundt, supra note, 4 at 1. 

  14. Id. 

  15. Id. 

  16. See The CountryBasket Index Fund, Inc., et al., Investment Company Release No. 21736 (Feb. 6, 2006) (notice) and 21802 (Mar. 5, 1996) (order). 

  17. Mundt, supra note 4, at 1. 

  18. See PowerShares Capital Management LLC, Investment Company Act Release No. 28140 (Feb. 1, 2008) (notice) and 28171 (Feb. 27, 2008) (order).