The Exchange-Traded Funds Manual

Gastineau, who was involved in exchange-traded fund development at the American Stock Exchange, wrote the standard technical reference on how these instruments actually work.

The mechanical content is the substance. The creation and redemption process, in which authorised participants deliver or receive a basket of underlying securities in exchange for large blocks of fund shares, is what keeps the fund's market price close to its net asset value, and Gastineau explains why this arbitrage works and under what conditions it breaks. He covers the tax consequences of in-kind redemption, which allows an exchange-traded fund to dispose of low-basis securities without realising gains for continuing holders, and which is the structural tax advantage over mutual funds in the United States.

He also covers the regulatory history and the exemptive relief each structure required, the differences between unit investment trusts, open-end structures and grantor trusts, the trading costs and spreads that determine an investor's real cost, the index licensing arrangements, and the specific problems with fixed income and international products where the underlying does not trade when the fund does.

Gastineau is critical of index construction and of the reconstitution effect, arguing that funds tracking published indices are forced to trade at times when everyone knows they must, which costs holders measurably. He proposed alternatives.

The book is from 2002 and the product set has expanded enormously since, including leveraged, inverse, actively managed and thematic products the book does not cover. The mechanics it explains are unchanged.