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What is an ETF (Exchange Traded Fund)?

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ETFs, or exchange-traded funds, are one of the most important product innovations in the history of the investment industry. ETFs give investors a cheap and efficient way to gain diversified exposure to the stock market.

ETFs are now established as tools that can form the cornerstone of any portfolio whether self-managed or managed by investment advisors or robo advisors.

Definition of ETFs

ETFs are listed trusts that own a portfolio of securities. Typically, the fund is structured to mirror and track an index. It will, therefore, hold securities in exactly the same proportion as the index it tracks. ETFs are publicly listed on stock exchanges and can be traded like other listed shares.

History of ETFs

Before ETFs were introduced, mutual funds and investment trusts were the only way for retail investors to invest in a portfolio of securities, without actually building a portfolio themselves.

Mutual funds gained momentum in the 1970s and 1980s due to strong performance from a handful of funds. However, during the 1990s it became clear that the majority of mutual funds failed to outperform their benchmark. During this period, index funds – mutual funds that track market indexes – also began to gain traction amongst investors. These funds were designed to match the performance of an index, rather than outperform the index, but charged a lower fee for doing so.

The first exchange-traded fund was launched in 1993 by State Street Global Investors. The fund tracks the S&P 500 index with the ticker SPY, and units are often referred to as SPDRs or Spiders. It remains the largest ETF by value, with $298 billion in assets as of August 2020.

Since the introduction of the first ETF, over 6,000 funds have been launched. Funds have been launched to track popular indexes, as well as specific asset classes, sectors and investment themes. In fact, whenever there is demand for a specific type of investment, an ETF will probably be created to cater to that demand.

Examples Of ETFs

As mentioned, the first and largest ETF is the SPDR S&P 500 index fund, which holds all 500 stocks in the index, in exactly the same proportion as the index. At least five other ETFs listed on US exchanges also track the S&P500, while numerous ETFs listed on exchanges around the world track the same index.

Similar funds track the Dow Jones Industrial index with 30 stocks and the Nasdaq Composite index with 100 stocks. The largest global ETF is the Vanguard FTSE Developed Markets fund which tracks the MSCI EAFE Index. This fund holds 1,889 stocks listed in developed markets outside of North America.

The SPDR Gold Trust (GLD) which holds physical gold bullion is the most widely traded commodity ETF. The largest bond ETF is the Vanguard Total Bond Market ETF which tracks the Barclays Capital U.S. Aggregate Bond Index.  This fund holds US treasuries and government-backed mortgage securities.

Types of ETFs

Most large ETFs track headline stock market indexes like the S&P500, the FTSE 100 or the Nikkei 225. These indexes include the most valuable companies in each market and are typically weighted by market capitalization. If you invest in these ETFs you will always be invested in the largest companies in a given market. However, there are lots of other types of ETFs, structured according to other criteria.

The following are the more common types of ETFs:

  • Sector ETFs invest in specific equity market sectors like the financial or technology sectors.
  • Bond ETFs invest in government bonds, corporate bonds and high yield bonds.
  • Commodity ETFs invest in physical commodities and precious metals. Some funds like the SPDR Gold Trust holds just one asset (physical gold) while others track commodity indexes and hold a portfolio of commodities.
  • Multi-asset ETFs invest in range of asset classes. These funds are often designed to comply with pension fund regulations that limit exposure to certain asset classes.
  • Real Estate ETFs invest in REITs (real estate investment trusts) and other property related securities.
  • International ETFs invest in stocks from around the world. These funds can be further differentiated between developed and emerging markets, and whether or not US equities are included.

The types of ETFs listed above account for the largest funds. More specialized types of funds include the following:

  • Market cap ETFs focus on companies of a specific size, from large-cap down to medium, small and micro-cap stocks.
  • Industry ETFs have a narrower focus than sector funds. Examples include biotech, cybersecurity, and cannabis companies.
  • Investment style ETFs track indexes that select companies according to investment factors. These include growth, value, volatility and income.
  • Currency ETFs invest in portfolios of currencies or in individual currencies.
  • Leveraged ETFs increase the exposure of a fund by using derivatives. These funds typically provide exposure worth 2 or 3 times the fund’s assets. This means both positive and negative returns are amplified.
  • Inverse ETFs are structured to generate positive returns when an index falls, but also generate negative returns when the index rises. These can be used to hedge a portfolio, or to speculate on a market decline.

Advantages and Disadvantages of ETFs

ETFs offer investors several notable advantages, but there are a few drawbacks to be aware of.

Pros of ETF investing:

  • The most obvious advantage of ETFs is that fees are substantially lower than mutual funds. Equity indexes have risen over the long term, while few investors have managed to consistently outperform those indexes. ETFs allow you to earn the market return for as little as 0.1% a year.
  • Most ETFs offer instant diversification with just one investment. For a portfolio to be well diversified it must include at least 20 stocks from different sectors. If you buy an ETF that tracks a market index with at least 20 constituents, you are effectively buying a diversified portfolio.
  • ETF investing is very efficient in terms of time and trade costs. You do not need to spend time picking and trading individual shares and you do not need to pay commission on each underlying share.
  • ETFs offer tax advantages too. If you own individual stocks you may be liable for capital gains tax when you sell each share. In the case of ETFs, you are only liable for capital gains tax when you sell the ETF.
  • Finally, ETFs allow you to start investing sooner. Investing in mutual funds requires some knowledge and investing in individual stocks requires even more knowledge. Very little knowledge is required to begin investing in ETFs that track market indices.

Cons of ETF investing:

  • Most ETFs will only generate the market return and will not generate additional returns.
  • Commissions are payable when you buy an ETF, unlike no-load mutual funds that do not charge commissions.
  • Specialized ETFS like leveraged, inverse, sector and industry funds all come with unique risks.

ETFs vs Stocks

ETFs are listed on stock exchanges just like other stocks, and they trade just like other stocks. So, what is the difference between the two?

Traditional stocks represent shared ownership in a company. The value of the stock represents the value of the company’s assets, and/or its future profits. ETFs give their holders shared ownership of a basket of securities. The value of the fund reflects the price at which these securities are trading. The price at which an ETF trades is determined by supply and demand, but is usually close to the net asset value of the underlying holdings.

ETFs vs Mutual Funds

ETFs and mutual funds are both products that allow investors to invest in a portfolio of securities with just one transaction. There are however several differences. The most notable differences are the following:

  • In most cases ETFs passively track an index, while a fund manager actively manages a mutual fund. However, some ETFs are actively managed, while some mutual funds are index funds that are passively managed.
  • Mutual funds charge higher management fees as they are more expensive to manage. Mutual funds require larger teams of fund managers and analysts than ETFs.
  • When you invest in a mutual fund, you invest at a price equal to the NAV (net asset value) of the fund. When you buy an ETF, the price is determined by the market, though in practice the price will usually be close to the NAV.

How ETFs Work

ETFs are created and managed by two types of companies, the ETF Issuer and Authorized Participants.

Well known ETF issuers include iShares, Vanguard, State Street and Invesco. These are the companies responsible for launching, underwriting, and marketing ETFs. Before a fund is launched, the issuer chooses an existing index, or creates a new index for the fund to track. A legal entity to hold the securities is then created and funded.

Authorized Participants (APs) are banks or brokers responsible for the day to day management of the fund. This means they are authorized to create or redeem shares and act as market makers for the ETF shares. APs quote a bid and offer price, above and below the fund’s NAV to ensure there is always liquidity for investors.

When demand rises, the AP will create new ETF shares and buy the corresponding securities to be held by the trust. Likewise, when there is too much supply, the AP cancels shares and sells the corresponding securities. If there is any change in the index, the issuer will instruct an AP to buy or sell securities to ensure that the fund mirrors the index.

Management fees are deducted from an ETF’s NAV on a daily basis. Because the annual management fee is spread across an entire year, the daily adjustments are very small and barely noticed. Dividends and other income are distributed at monthly or quarterly intervals.

ETF Investment Strategies

There are several ways to go about investing in ETFs. One of the simplest for long term investors is dollar cost averaging (DCA). In this case, you can simply invest a fixed amount at regular intervals.

If you plan to build a portfolio of ETFs, you may decide to use a strategic asset allocation strategy. In this case you would decide on the percentage of your portfolio you want to hold in each ETF or in each asset class. You then make subsequent investments in the funds that are below their target weight, thus bringing the portfolio in line with the target allocation over time. You can also rebalance the portfolio at regular intervals to keep the allocation in line with the target allocation.

A slightly more active approach is tactical asset allocation. In this case, the weighting of each fund or asset class can be adjusted as market conditions change.

The core/satellite strategy combines ETFs with individual stocks. In this case, a core holding of ETFs is combined with a smaller portfolio of individual shares. This approach seeks to generate some outperformance through stock selection while earning the market return from ETFs.

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What is an ETF (Exchange Traded Fund)?

Conclusion

Exchange-traded funds are the cheapest and most efficient investment products that allow you to earn the same return as broad market indexes. They can also be used to build a portfolio with diversified exposure to specific asset classes, sectors, industries, and investment themes. Perhaps most importantly, they are a means to begin investing with very little capital or knowledge.

 

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Richard Bowman is a writer, analyst and investor based in Cape Town, South Africa. He has over 18 years’ experience in asset management, stockbroking, financial media and systematic trading. Richard combines fundamental, quantitative and technical analysis with a dash of common sense.

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