There has been dramatic growth in recent years both in terms of the size of the ETF market and the number of products available in the market. As of September, 2016, assets in Global ETFs amounted to US$3.24 trillion with the biggest market being in the United States with assets in US ETFs amounting to US$2.42 trillion1. In Europe, there has also been year on year growth with assets in European ETFs amounting to US$5362 billion as of September 2016 in relation to which Ireland is home to 54% of such ETF assets3 significantly more than its nearest rival domicile making Ireland the leading European domicile for these types of funds.

This brochure gives an introduction to ETFs and how they have evolved over time, with further details on how ETFs operate in the primary and secondary markets, UCITS regulatory requirements, listing on the Irish Stock Exchange and the ability to passport to be admitted to trading on the London Stock Exchange and finally some tax information as applicable to Irish domiciled ETFs.

You are likely to be interested in this guide if you are:

  • new to the ETF industry and seeking information on ETFs and what distinguishes an ETF from an open-ended investment fund;
  • an existing asset manager considering the setting up of a UCITS ETF;
  • participating on a ETF platform and considering the setting up of a stand-alone UCITS ETF; or
  • a non-EU ETF service provider considering the setting up of a UCITS ETF.

1. Introduction to ETFs

An exchange traded fund ("ETF") is a form of collective investment scheme which is structured to facilitate the trading of its shares on an exchange throughout the day using real time pricing in a similar manner to the way in which an equity security may be traded on an exchange. This feature distinguishes it from traditional collective investment schemes which only provide for direct subscriptions and redemptions of their shares on a periodic basis using the net asset value share.

European ETFs are established as Undertakings for collective investment in transferable securities ("UCITS") which benefit from the strong global UCITS brand and the efficient passport regime which allows UCITS to be sold on a retail basis throughout the EU.

Although it is possible to establish and list non-UCITS ETFs on certain exchanges (such as the London Stock Exchange), this brochure focuses on UCITS ETFs as historically only UCITS ETFs have been established and listed in Europe.

Historically, ETFs have been structured as passively managed funds tracking an index weighted by market capital (passive ETFs). Such passive ETFs seek to provide their investors with a return closely aligned to the return of the relevant index which they track. This may be done through physically holding a portfolio of securities in the same weighting as that held by the relevant index. This would commonly be referred to as a physical ETF. Alternatively, an ETF may seek to track an index through the use of derivatives (synthetic ETFs) or a mix of derivatives and securities (Hybrid ETFs).

The breadth of ETF products available to investors has expanded considerably as the market has grown. ETFs are now based upon a wide range of asset classes i.e. equities, fixed income commodities, currencies and alternatives. We also have seen the introduction of Smart Beta ETFs and actively managed ETFs. Although Smart Beta ETFs track an index like other passive ETFs, they do so in ways besides the traditional market capital weighted approach e.g. an index weighted by one or more factors such as dividend yield, small and mid cap companies, volatility, etc. Actively managed ETFs are ETFs where the manager has discretion over the composition of its portfolio subject to the stated objectives and policies as opposed to a passive ETF which tracks an index. Although there have been a number of actively managed ETFs established in Europe, it remains to be seen whether we will see growth in actively managed ETFs (in particular actively managed equity funds) given concerns around, inter alia, transparency requirements which apply to ETFs i.e. disclosure of the composition of the ETF portfolio on a daily basis to enable the Authorised Participant(s) and other market makers to value the ETF portfolio on an intra basis which in turn enables them to take steps to ensure the market price does not vary significantly from the net asset value per share price of the ETF and to hedge its intraday risk.

2. How an ETF Operates

2.1 Primary Market

One or more market makers (referred to as "Authorised Participants") are appointed by an ETF to (i) subscribe for and redeem ETF shares directly from the ETF but usually only in large blocks called creation units and (ii) make a market in the ETF shares in the secondary market.

Typically, subscriptions and redemptions in the ETF will be for one or multiple "creation units" comprising a designated number of shares (50,000 for example). These shares will then typically be sold by the Authorised Participant(s) on the secondary market.

Payment for a creation unit may be provided in cash4 or in-kind by the delivery of a basket of securities and other assets (i.e. cash) (the "Creation Basket") which, (i) in the case of a passive ETF that is physically replicated, closely replicates the composition and weighting of the securities held within the relevant index or (ii) in the case of an actively managed ETF, is representative of the ETF's portfolio and is equal in value to the net asset value of the ETF shares in the creation unit.

Primary market redemptions may be effected by the Authorised Participant(s) requesting the redemption of ETF shares directly from the ETF. Such redemption requests must correspond in size with one or more creation units. Once the redemption request is processed, the relevant ETF shares are cancelled and the Authorised Participant(s) will receive cash or, where redemptions in kind are processed, securities and other assets representative of the relevant index/portfolio comprised in the Creation Basket for each creation unit redeemed.

Cash creations and redemptions are generally required for ETFs where there are concerns regarding the liquidity and trading costs of underlying securities which may result in higher bid offer spreads offered by the Authorised Participant(s). Cash settlement is also required for Synthetic ETFs.

2.2 Secondary Market

The ETF shares will be listed / traded on an exchange (such as the London Stock Exchange or Deutsche Boerse, etc.,) where they can be freely purchased and sold, with the settlement of trades in ETF shares on an exchange being facilitated through one or more recognised settlement systems, for example, CREST, Clearstream or Euroclear.

As a result, investors can buy and sell ETF shares in large or small amounts through the exchange on a real time, intra-day basis without attracting subscription or redemption charges.

The price of ETF shares traded on the secondary market will be determined by the market but should correspond approximately to the net asset value per share of the ETF based on the value of its underlying assets. Generally an indicative net asset value ("INAV" i.e. estimate of the value of an ETF share based on the relevant day's holdings as disclosed in the relevant ETF's Creation Basket) is issued by or on behalf of the ETF at regular periods intra-day. This enables investors in the secondary market to determine whether the market price of the ETF shares is a fair reflection of the price of the ETF's holdings. The bid/offer spreads offered by the Authorised Participant(s) allows it to cover the risk of buying/redeeming shares in the primary market (in order to settle trades in the secondary market) at a price different to the price which the shares are sold/bought on the secondary market. The Authorised Participant(s) create a market by providing bid and offer prices and facilitating the trading of shares on the secondary market.

In the event that the market price of a UCITS ETF's shares on an exchange significantly vary from its net asset value, the ETF is required to make sure that appropriate processes are in place in order to allow investors who have acquired their ETF shares on the secondary market to sell them directly back to the UCITS ETF5. Accordingly, procedures in these circumstances need to be put in place and agreed with the ETF, its service providers and Authorised Participant(s).

2.3 Pricing and arbitrage

As both the underlying securities and the ETF publish closing prices and the ETF's portfolio holdings are disclosed, Authorised Participant(s) and other market makers can take advantage of the disparities between the net asset value per share of an ETF on the one hand and the price of ETF shares on the secondary market on the other hand. For example, if the shares of an ETF that deals in specie begin to trade on the secondary market at a discount to the value of the underlying portfolio of the ETF at any time during the trading day, the Authorised Participant(s) and other market makers can capture the difference by (a) purchasing ETF shares on the secondary market while simultaneously selling short the securities in the Creation Basket and redeeming creation unit(s) with the ETF at the end of the day at the net asset value per share and using the underlying securities in the Creation Basket to close out the short positions. Similarly, if the shares of the ETF begin to trade on the secondary market at a premium to the value of the underlying portfolio of the ETF, the Authorised Participant(s) and other market makers may profit by shorting ETF shares in the secondary market, purchasing the underlying securities that make up a Creation Basket and subscribing in kind for ETF shares on the primary market in creation unit size denominations and delivering the ETF shares on the secondary market to settle the short position. This arbitraging activity can operate as a market force ensuring that the ETF prices do not vary to a significant extent from the prices of the underlying securities where the disparities in price present an opportunity to the Authorised Participant(s) to earn an arbitrage profit.

Market makers may also engage in arbitrage activities that do not necessarily require them to engage in creations or redemptions with the ETF. For example, if a market maker believes that an ETF is overvalued relative to the ETF's underlying portfolio, the market maker may sell ETF shares, buy the underlying assets of the ETF and if the trading prices move toward parity, close out the positions in both the ETF shares and the underlying assets of the ETF. The market makers would therefore realise a profit from the relevant movement of these trading prices without engaging with the ETF for the creation of units. Similarly a market maker could buy ETF shares in the secondary market and sell the underlying assets of an ETF in an attempt to profit when an ETF's shares are trading in the secondary market at a discount to the underlying assets of the ETF.

However, an Authorised Participant's / market maker's ability to take advantage of disparities in price may be limited by the liquidity and trading costs of the underlying assets of the ETF which in addition may result in wider bid-offer spreads.


As detailed above, ETFs in Ireland are currently established under the UCITS regime which benefit from the principle of mutual recognition within the EU and can be marketed in other EU member states under the UCITS "passport" once authorised in one EU member state.

While a UCITS may be established as a unit trust or common contractual fund, the listing on an exchange has historically generally resulted in an ETF being constituted in Ireland as a variable capital company (VCC) with limited liability. An alternative corporate structure (the Irish Collective Asset - management Vehicle ("ICAV")) is now also available to ETF promoters as a result of the enactment in Ireland of the Irish Collective Asset – management Vehicles Act 2015.

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1 ETFGI website

2 ETFGI website

3 Irish Funds, June 2016

4 Payment for a creation unit is provided in cash in the case of a synthetic ETF and usually provided in kind in the case of a physical ETF in order to keep the ETF's transaction costs low. The latter also presents opportunities to generate income by the ETF entering into securities lending transactions

5 ESMA source. ESMA Guidelines on ETF and Other UCITS (ESMA/2014/937 EN)

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.