Introduction to ETFs
ETFs (Exchange Traded Funds) are financial instruments which essentially bundle together multiple stocks or bonds or even REITs (Real Estate Investment Trusts). There is a wide variety of ETFs available on the market and therefore, one should carefully research all the features of any ETF before deciding to buy it. [1]
ETFs were first created in 1993, in order to take advantage of the increased interest in passive investing. They were therefore traditionally quite similar to index funds [2], with the main differences to the retail investor simply being ease of trade in that index funds are priced once a day whereas ETFs are bought and sold on an exchange like a stock. This is due to how ETFs work though, which is a little bit more complicated.
Instead of the usual transfer of ownership involved in buying equities, ETFs go through a process called creation and redemption. They are often limited to more sophisticated customers (ie institutional investors or finance professionals), as they tend to be more complex financial instruments and regulation is adequately tighter. Those who are allowed to trade them are called Authorised Participants (APs). APs buy shares of the underlying assets of the ETF and sell them to the ETF for the same price equivalent, in return for shares in the ETFs-called creation of additional ETF shares. Redemption is just the reverse process. These processes also explain how the pricing of ETF shares remains relatively close to its Net Asset Value (NAV), rather than at premiums or discounts due to speculation as is common in equity markets (considered inefficiencies in the market). When the ETF is trading at a premium, APs will be looking to create additional ETF shares due to being able to receive a higher value ETF share in return for the shares bought at the underlying asset price on the open market. This filters through in a simple demand supply mechanism to bring the price of the ETF back down. The reverse is true for redemptions being attractive when it is trading at a discount.
While ETFs were traditionally based on passive strategies, new, more complex structures have been created to incorporate more active strategies. This has made them appealing to an increasingly larger audience, especially as they have also tried to branch out into areas of further diversification and complexity, to the likes of even rivalling futures contracts. This has resulted in them having now over $4.8 trillion invested in the US ETF market alone and $5 trillion worldwide as of 2018. With more and more investors seeing the benefits of investing in ETFs, growth is predicted to continue to $12 trillion globally by 2023. [3,4,5]
Currently there are a plethora of ETFs available on the market, all the way from passive to active strategies, with diversification being offered by sector to geography. Some typical ETFs offered by asset class would be Bond ETFs, Industry ETFs (sector-based), Commodity ETFs, Currency ETFs and Inverse ETFs (shorting stocks). Various structures also allow for more exotic investment vehicles to be held, such as derivatives. These tend to be in synthetic ETFs [6] , which use derivatives and swaps to replicate the performance of underlying assets. As with other more exotic products, the risk of investing in these is higher, as such strategies expose investors to counterparty and collateral risk.
ETFs carry many advantages over mutual funds and OEICs (Open Ended Investment Companies), which is what has really driven their growth. Both of these investment vehicles allow investors to pool together funds, which can invest in stocks, bonds or other financial instruments. These include transparency [7] , liquidity and competitive fee structures. ETFs are required to publish their holdings on a daily basis unlike mutual funds, which only have to do so once a month, allowing investors to have a much better idea of what underlying assets they actually own. This also discourages investment managers from utilizing certain, more risky and short term strategies in order to show healthy results quarterly at the risk of long term detriment. In terms of liquidity, ETFs can be bought and sold whenever markets are open [8], with prices not being fixed per day, and therefore responding quicker to market events.
The diagram here shows how Smart Beta strategies inherently skews the results of the fund, with a wide range of outcomes, thereby making them very thinly veiled ‘active’ strategies rather than passive at times.
They also tend to have lower management costs (especially for passive ETFs), however, brokerage costs can sometimes reduce this advantage, depending on the overall amount invested and investing strategies employed. This is on top of the usual advantages of diversification, in that by buying an ETF share which tracks an index, allows you to benefit from the overall returns to the index, rather than being at the mercy of one or two individual companies. This also reduces the costs of diversification, in that the transaction fee is only charged once, instead of multiple times as one were to buy all the individual stocks separately. There are certain downsides though, including liquidity risks for specific ETFs which are traded less frequently (a possibility considering the sheer variety of ETFs available) and the risks associated with ETFs based on more exotic instruments. Furthermore, the legal structure in terms of taxation and reinvesting dividends also differs between them and should be duly noted.
Other types of ETFs which exist include Smart Beta ETFs [9], which are essentially a combination of active and passive strategies, where they use specific financial metrics to create their own indexes and benchmarks to follow. Whilst being considered somewhat passive, it does technically still very much defy the idea behind it of tracking economic growth, by instead choosing its own metrics similarly to how one chooses their own stocks in a fund. ETFs also have distinct benefits during transition periods between fund managers, as it is a great way to quickly reinvest money in a diversified manner rather than keeping it as cash, which diminishes in value as inflation occurs [10]. This is before the new manager may have ascertained the real risk profile and requirements of a customer or group of customers, to be able to adequately conduct research and decide on the actual financial instruments to make up the new fund or other investment vehicle.
The ETFs market is dominated by 5 large providers, with BlackRock’s iShares leading the group. Other firms, however, do provide strong advantages in specialised niches in the market. There has been an increased variety of and focus on ESG based ETFs, as more and more investors take into account sustainability. Newer ETF trends also focus on technological advances, such as those which focus on AI, robotics and blockchain.
This diagram demonstrates how sector specific ETFs also result in different returns over time, as they are at the end of the day, dependent on the underlying asset [11: https://www.fool.com/investing/etf/2019/01/05/the-3-best-sector-spdr-etfs-of-2018.aspx]. SPDR stands for S&P Depository Receipts and means that it is based off the S&P 500.
Overall, ETFs cover a wide array of investment strategies and are an ever increasingly prominent way of investing and as with any other investment product, should be carefully considered both as part of a portfolio and for the tangible benefits it offers.
Quick Note: Exchange Traded Notes similarly exist, with the underlying security being debt based rather than equity.