What is an ETF?

Exchange traded funds (ETFs) are similar to the funds mentioned the previous section in the sense that by holding one vehicle you would be actually holding different underlying securities except that they act like a share themselves. ETFs are openly traded on stock exchanges such as the London Stock Exchange in the UK or the Nasdaq in the US. Most ETFs aim to perform in line with a specific index (e.g. S&P 500) or commodity (like gold) and often have low management fees. An example of an ETF would be the Vanguard S&P 500 ETF (VOO) which invests in stocks that are part of the S&P 500.

Characteristics of ETFs

  • Passively managed

An ETF is passively managed since the investor can gain exposure to a particular index or commodity, without the need of using the services of a fund manager, providing that investor with the same returns as the underlying market.

In this sense it means that there is no active fund management involved and hence whatever direction the market takes, the ETF will just follow. Basically if the market plummets the value of the ETF follow instantly as there is no control on the investment since the fund's mandate is just to follow the particular index it is tracking.

  • Exchange Traded

An ETF is traded on a major stock exchange like the New York Stock Exchange or Nasdaq. If you've ever traded an individual stock, then buying and selling an ETF will feel familiar because it's traded the same way. With ETFs you will have real time pricing (like a stock) and these can be bought and sold very quickly on the market and thus considered very liquid.

  • Fund & diversification aspect

An ETF is a collection (or "basket") of tens, hundreds, or sometimes thousands of stocks or bonds or other assets in a single fund.

So, in the context of diversification, an ETF will feel similar to a mutual fund since by holding one vehicle you will actually be having exposures to various underlying instruments.

Therefore, an ETF will hold a collection of investments and if one particular stock/bond is doing badly, there is a very good change that the others are doing well and this will therefore minimize your losses.

On the other hand, when you buy individual stocks and bonds, if one goes south, your savings could take a much bigger hit in a short period.

  • Lower costs

ETFs generally have lower management expense ratios (annual operating costs as a percentage of average net assets) than actively managed mutual funds since no active management is involved. Lower costs mean more of a fund's returns go to the investor.

  • Lower minimum investment

You can buy an ETF for the price of 1 share. That price could be as little as $50 or as much as a few hundred dollars, depending on the ETF. For a Mutual Fund, the minimum investment requirement normally starts from around $3,000 and can go up to $1 million for institutional investments depending on the fund and the class involved.

  • More hands-on approach

Since ETFs trade like stocks, the investor can have more control over the price as one will be able to place limit orders, market orders or stop orders something which cannot be done with a mutual fund.

Also if for instance the investor would like to take a macro approach on a particular geographical region, sector or asset class, an ETF is very convenient as this can be done very easy due to the vast range of ETFs available. For example, if a manager wants to increase exposure into Gold, he can just invest in a GOLD ETF (e.g. SPDR GLD) to gain that exposure in a very short time span.

  • Diverse array of investments

ETFs can provide access to a wide variety of sectors and indices, while helping investors avoid “single stock risk”. The level of diversification is related to the breadth of the underlying index which the ETF tracks.

  • Ability to invest in an entire market segment

ETF fund managers may replicate the index by having the fund tracking it by “owning” every security in the index according to its set weighting, or “optimizing” the portfolio by selecting those securities that will track the index as closely as possible without having to own each individual security

Types of ETFs

  • Country/Regional ETFs: The ETF will track indices in a particular country or region. For example the iShares Core DAX UCTITS ETF tracks the performance of the DAX 30 in Germany.

 

  • Foreign currency ETFs:  These are funds that help investors gain exposure to foreign currencies without having to complete complex transactions. In some cases, this type of ETF tracks a basket of currencies, allowing an investor access to more than one foreign currency. An example would be the  iShares Emerging Markets Local Currency Bond Fund.

 

  • Sector ETFs: these will track a specific sector like for example Financials, HealthCare, Consumer Staples, Technology etc. An example would be the Technology Select Sector SPDR Fund (XLK).

 

  • Commodity ETFs:  these are similar to sector ETFs in the sense that you are targeting a certain area of the market. In this case you are purchasing gold or oil but not physically buying the commodity but the ETF would have derivative contracts in order to emulate the price of the underlying commodity. An example would be the SPDR Gold Trust (GLD).

 

  • Style ETFs : these will track a particular investment style (value or growth) or market capitalization (large cap, mid cap or small cap). An example would be the Vanguard Large Cap ETF (VV).

 

  • Inverse ETFs: These allow the investor to bet against the market and thus creating a short position in your portfolio. These funds have an inverse reaction to the direction of the underlying index or asset. An example would be ProShares Short QQQ (PSQ).

 

  • Leveraged ETFs: These are ETFs that want to outperform the actual index or commodity they track. For instance if the tracked index rises by 1%, a 2X Leveraged ETF should increase by 2% and vice versa. An example would be the Ultra S&P 500 ProShares ETF (SSO).

 

  • Bond ETFs: although not very popular, we also have ETFs which track bond indices. Bond ETFs have a difficult task when it comes to construction because they are tracking a low-liquidity investment product in comparison to shares. Another difficulty faced by Bond ETFs managers is that the tracking is more diffiicult since underlying bonds mature over time and hence the index will need to change its components much more frequently than a standard Equity index. An example would be the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD).

 

  • Exchange traded notes (ETNs): these are part of the ETFs family however they are more their own investment. ETNs are issued by major banks as senior debt notes.  This is different from an ETF which consists of securities or derivative contracts. When you buy an ETN, you receive a debt investment similar to a bond. ETNs are backed by high credit rating banks so they are considered quite a secure investment products but still not absent from credit risk. ETNs performance is similar to ETF since it tracks market index minus applicable fees, with no period coupon payments distributed and no principal protections. Similar to exchange-traded funds (ETFs), ETNs are traded on a major exchange during normal trading hours.