What is an ETF


ETFs have become popular over time among investors, and are competing with traditional other investment funds, such as Mutual Funds and Index Funds.

What is an ETF?

An ETF (Exchange-Traded Fund) is a collection of securities, that can be bought or sold on a stock exchange under a single ticker symbol.

If you want to learn more about ETFs read on.


What is an ETF in detail?

An ETF is a type of Investment Fund, similar to a Mutual Fund. With an ETF you also invest in a collection of securities like a Mutual Fund. The main difference is that an ETF can be bought and sold throughout a trading day during the opening hours of a stock exchange, while a mutual fund can only be purchased to the price at the end of the day.

ETFs usually track an index, such as the S&P500 index, or a sector such as the Healthcare sector for example, and are mostly passively managed. As the popularity of ETFs has grown there are however also some ETFs that are actively managed. Actively managed ETF’s will cost more, but might still be attractive to a trader or investor, as the ETF can be bought and sold like a stock throughout the trading day.

Because ETFs are mostly tracking an index of assets and are passively managed (there is no manager that will take daily buy and sell decisions), the fees of such ETFs are usually lower than the ones of Mutual Funds.

Some studies concluded that only about half of Fund Managers can outperform the market indexes with their active buy and sell decisions. Regardless of the performance of fund managers, the fund will still charge 1-2% management fee, which will further limit the investor’s profit.

Because of that, some investors prefer the strategy to invest in purely passively managed ETFs that track and not outperform the markets, but might still be more profitable due to fewer management costs.


What are the advantages of exchange-traded funds (ETF)?

Exchange-Traded Funds (ETF) are a cost-effective financial instrument for broadly diversified investments in various asset classes such as stocks, bonds, and commodities. ETFs usually map an index.

Nowadays there is a very large range of ETFs that display a large number of indices. For example, ETFs on stock indices of emerging countries, commodity indices, and bond indices of various kinds can be bought.

Similar to investment funds, the biggest advantage of ETFs is the broad diversification option for the investor, which can be realized with little money.

Another advantage is that ETFs are cheaper than Mutual Funds. ETFs usually do not have active fund management, and because of this, the annual fees are lower.

ETFs are traded on the stock exchange. Transaction fees are comparable to those for stock trading, and expensive surcharges are avoided.

ETFs are liquid instruments that can be traded on a daily basis because the value of an ETF share is determined several times a day. Market makers (usually banks and brokers) have the task of ensuring liquidity.

Similar to Mutual Funds, the ETF assets represent a special fund, i.e. they are not part of the bankruptcy estate of the issuing company.


What are the disadvantages of exchange-traded funds (ETF)?

As ETFs are purely passively managed, the return will be based on the return of the index. A good fund manager can achieve a higher return than the index through a skillful selection of individual stocks.

Another disadvantage is that special products such as investment strategy funds or open real estate funds are difficult to map using ETFs.

Savings plans with small regular investment sums could be more expensive with ETFs than with investment funds, since the minimum transaction fees are incurred for every installment, regardless of the order size. Certain mutual funds might be more suitable for savings plans.


What types of exchange-traded funds (ETF) are there?

An ETF replicates an index. There are essentially three methods that an ETF can use to replicate the underlying index.

The best-known method is the complete mapping of an index, i.e. the ETF owns all individual stocks according to their weighting in the index. Changes in the index must be replicated by means of stock exchange transactions, and interest or dividends must be reinvested or paid out to the investor accordingly. This method is usually used for ETFs on liquid indices with a limited number of individual stocks (such as S&P500, Nikkei225, DAX, …).

The second method is that the ETF only has a selection of individual stocks in the index according to their weighting in the portfolio. This is especially used for indices with a large number of individual stocks (e.g. MSCI World). With this approach, illiquid individual stocks with a low index weighting in the ETF are avoided in order to save transaction costs and increase liquidity.

The third method is complex synthetic replication of the underlying index. Replication of the index is achieved using a SWAP or another derivative financial instrument.

The ETF holds a basket of securities agreed with the SWAP counterparty. These securities do not necessarily have to have something to do with the index to be replicated; the basket can also contain other securities.

The return on the basket of securities is swapped with the return on the actual index with the SWAP counterparty. Put simply, the index mapping is outsourced to the SWAP counterparty and the counterparty must ensure that the return corresponds to the underlying index.

The SWAP counterparties are usually large banks. With this method, the ETF investor is exposed to the credit risk of the SWAP counterparty. In order for the ETF to comply with the strict rules of the regulatory authorities under UCITS 3, only 10% of the fund’s assets may be invested on a SWAP basis.

SWAP-based ETFs have the advantage that illiquid indices can also be mapped cost-effectively. This method is often used for commodity-based ETFs or ETFs on an index from developing countries.

As already mentioned, there are ETFs on a large number of indices in the investment area stocks, bonds, foreign exchange, money market and commodities. In the equity sector in particular, there is hardly an index that has not been made tradable using an ETF.

ETFs on country indices (e.g. MSCI Turkey), sectors (e.g. EuroSTOXX Automobile) or topics (e.g. ETF on environmental stocks) can be traded.

There are ETFs on different commodity baskets, on different currencies and bonds from different countries, currencies and maturities.

The boundary between the classic managed Mutual Funds and the index-based ETFs is disappearing more and more. There are also ETFs on investment strategies with a changing mix of stocks, bonds, and even real estate.


How can exchange-traded funds (ETF) be used for investments?

ETFs are particularly well suited, as you can invest in many different areas with relatively low investment sums. Therefore a broad diversification is achievable by owning just a few ETFs.

With ETFs, the investor can put together a tailor-made portfolio that corresponds to their own return and risk expectations, and which they can manage by themselves.

Of course, the investor can structure the portfolio as a mixture of ETFs and Mutual Funds. Mutual Funds are particularly useful in areas where good fund managers can generate additional returns, such as for example emerging market investments.

When investing in established markets such as Europe or the USA, ETFs often have an advantage over Mutual Funds due to their favorable cost structure and are a good alternative.

There are several financial institutions that offer ETFs. When choosing ETFs, one should pay attention to whether the funds are SWAP-based or not. As explained above, with SWAP-based ETFs you still have the credit risk of the SWAP counterparty (usually a bank).

Before choosing a fund, the investor should also be clear in which asset class and in which countries, regions, or industries he wants to invest.

Chris

Chris is an IT Project Portfolio Manager within the financial industry. Due to the nature of his role, he is engaged to study Financial Markets and is an active investor.

Recent Posts