An Exchange Traded Fund (ETF) is a financial instrument loved by investors because of its diversification, transparency, and liquidity. It is a type of security that involves a combination of other securities – which can be stocks, bond ETFs, index funds, or else – which tracks an underlying index.
It became quite popular recently as many ETFs have been constructed following various themes and are traded on different stock exchanges.
The fact that they’re composed of different securities makes them already diversified to some extent, making them a strong option for the less qualified investors. They are also tax efficient compared to actively managed mutual funds.
However, each Exchange Traded Fund (ETF) can have different returns and specificities, so it is very important to examine their content before making your investment! You will pay or receive current market prices when buying or selling ETFs. The current market price may fluctuate from the net asset value.
But what is an ETF exactly? Let's take a closer look.
Definition & characteristic
In less than 25 years, exchange-traded funds (ETFs) have become one of the most popular investment instruments. Seen as a cheaper and better alternative to mutual funds, ETF proposes an easy way of diversification for investors.
As of today, the ETFs market represents $1 trillion in assets and the numbers of new ETFs launched increases every year.
But what is behind ETFs? An Exchange Traded Fund is a financial instrument that represents a basket of different securities, such as stocks for example, that sometimes aim to replicate the performance of an index, a commodity, a specific segment, or just about anything. This product is in a way very similar to mutual funds. Both instruments consist of a mix of various assets and represent a common way for investors to diversify. However, the main difference is that a mutual fund can only be purchased at the end of the trading day. On the other hand, an ETF can be day-traded like an ordinary stock.
For example, a very popular ETF is the SPY (SPDR S&P 500 Trust ETF) which aims to track the S&P 500 index. Composed of diversified assets in different fields such as technology, financial services, or healthcare, this ETF has become one of the most popular in the world and one of the best-rated. Over 10 years, the SPY has generated an average income of 11.04% per year. In light of this success, more and more investors are turning to ETFs.
ETFs trade on the stock exchange like shares and can therefore be bought or sold at any time during trading hours. Their price follows the evolution of the index and varies constantly throughout a trading session. If it increases, so does the value of the ETF. If the index falls, the ETF loses value.
ETF can track market indexes, but not only that. They can also be conceived to track industry, a commodity, or another fund. For example, you could have a tennis ETF composed of only tennis-related assets. ETFs generate lower levels of capital gains compared to actively managed funds. That’s what makes ETFs interesting: endless possibilities.
Main types of ETF
As we have seen, there are hundreds of different types of Exchange Traded Funds that are used for income generation, speculation, or hedging. Here are some of the main types of ETFs.
United States ETFs: These ETFs track such indexes as the S&P 500, Dow Jones, Nasdaq-100, or other US indexes.
Foreign ETFs: Some ETFs track other countries’ stock indexes such as the French, Japanese or German indexes.
Bonds ETFs: This type of ETF includes government and corporate bonds. Investors need to spread their portfolio. Holding an ETF that provides steady return at potentially low risk could be an investment of choice.
Industry ETFs: You can track a specific industry such as technology, health care, or energy for example.
Commodity ETFs: Invest in commodities such as gold, silver, or crude oil.
Currency ETFs: Currency ETF represents either one single currency or a basket of currencies.
However, as stated before, there are hundreds of different types of ETFs. As ETFs are security baskets, it is very important to know what they contain to be certain of your investment. The general rule of buying what you know and understand applies.
ADVANTAGE & DISADVANTAGE OF TRADING ETFs
ETFs are transparent and liquid which makes them easy to trade and understand. Therefore, they are particularly suitable for private individuals who wish to build up their assets over the long term. Choosing whether to trade etfs or not depends on your investment objectives and intentions such as whether you want to trade in the long-term or short-term.
Good diversification with lower fees
Firstly, an ETF represents a lower average investment cost, as buying all the securities held in an ETF individually would cost a lot more than buying an ETF composed of them. Moreover, the transaction cost is also lower. An investor needs only to execute one transaction to buy and one transaction to sell the collection of securities. Other costs to consider are the operations and management fees of the fund, which are generally lower with ETFs.
For example, if an investor wants to invest in the SMI stocks, he is not obliged to buy the 20 securities contained in the Swiss SMI stock market separately. Through an ETF on the SMI, he can buy shares of all the securities listed on this index in a single transaction. As a result, the resulting transaction costs are significantly lower.
High flexibility and liquidity of exchange traded funds
Like equities, ETFs are liquid investment instruments. It is possible to buy and sell ETF shares during the opening hours of the market. The market makers are committed to guaranteeing bid and offer prices. Every ETF provider needs at least one market maker. Many ETF issuers, however, work with several market makers to ensure additional liquidity in the trading of their ETFs.
ETFs contain a huge variety of different investment categories. From the US to foreign markets or from different industries or even very specific stocks, investors have a wide variety of choices to invest their money in the field they are interested in.
ETFs are transparent. Many ETF providers publish the composition of their portfolios on their websites daily. Conventional funds only do so every six months, as they wish to keep the composition of their portfolio secret.
Although ETFs have many advantages, they may present unpleasant surprises to their investors.
The main issue is the management fees. Indeed, not all ETFs are cheap. Interested investors should look carefully at the ETF's expense ratio. They might find that the ETF is rather expensive to invest in, a fee that might hurt their earnings.
This mainly concerns actively managed ETFs where portfolio managers actively buy and sell different company shares and change the holdings. Actively managed funds will have higher costs than a passively managed one. The investor needs to be aware of these details when investing. Looking at the expense ratio versus the rate of return to make sure it is worth investing in.
How to choose the right ETF?
As we have discussed, there are many different ETFs. To find the right ETF, investors need to take a systematic approach.
Define a Strategy
One of the most important factors when establishing an investment is its strategy. In other words, it is the distribution of your investment in different assets (the portfolio). Investors need to look at their ability to take on risk and what return on investment they can expect.
Nowadays, an investment strategy can be implemented exclusively with ETFs. A multitude of ETFs are available on the stock exchange; and they represent a wide range of asset classes, markets, and currencies. This represents a broad diversification of assets to invest in.
As seen, there are various advantages to implementing an investment strategy exclusively using ETFs: ETFs are low cost and can be traded daily, and the risk of significant underperformance with their index is virtually excluded. Also, someone already made the diversification for you.
Examine the nature of the ETF with care
Logically, most people will focus on the ETF's expense ratio or asset management. Of course, these criteria are important when making your choice, however, to choose the right index is crucial.
Not all ETFs are the same! It is very important to know the content of the ETF but also the distribution of the ETF. Some index weights their holding more or less equally, while others hide riskier investments behind big names. It is crucial to know the composition of the portfolio ETF.
To get an idea of the performance of an ETF, it is advisable to look at the historical returns and price fluctuations of the underlying index, considering the longest possible period.
Check the replication quality & its type
An ETF does not accurately replicate the same performance as the index it replicates. Differences of more than one pip per year between the ETF and the index may exist.
To be able to compare the replication quality of the ETF, it is important to compare its performance with that of the index. If they are very different, please be careful!
In addition to checking its quality, it is important to look at what type of replication it is. By this, we mean physical replication and synthetic replication.
The difference is that in physical replication, the ETF invests in the same securities as those contained in the index with the same individual weighting. Synthetic replication is invested in financial derivatives and is, therefore, more complicated.
The choice between physical and synthetic replication must be made on a case-by-case basis. The risks of physically replicating ETFs are often considered to be lower, but in some cases, synthetic replication can be more appropriate.
With their many advantages over more "traditional" investments, exchanges traded funds are enjoying tremendous popularity. Their diversification and the balance of risk they offer to make them an excellent choice for investors.
Every type of investor can be interested in ETFs. If you lack time or knowledge, ETFs offer an excellent, uncomplicated investment alternative.