Exchange-traded funds (ETFs) are an investment instrument that tracks the price of a market index. They are also called trackers. An index or market index is a hypothetical portfolio of investment holdings created to represent the price movements of a set of assets in a market sector. For instance, you could have an index set up for cryptocurrencies, another set up for commodities in the agricultural sector, or another one for stocks in a given country or industry.
An ETF will track the performance of underlying assets in the index. The fund manager creating or managing the ETF will either physically buy the underlying assets contained in the index’s holdings or use more complicated investment techniques to mimic the movements of the assets in the market index.
What is the idea behind an ETF?
Similar to stocks and other securities in the market, an ETF can be bought and sold on a stock exchange. The ETF can be structured to track the price of anything. This ranges from tracking an individual asset or commodity to a large and diverse collection of securities and tracking of a specific investment strategy.
However, owning an ETF (e.g. in Tesla’s stocks) does not grant you the same rights as an investor who holds Tesla’s stocks in their portfolio. While stock ETFs can pay dividends, they do not grant voting rights to the investor.
The idea behind an ETF is to grant the investor a diversification strategy whereby the investor can own fractions of shares of companies within a market index thereby gaining from the performance of underlying assets. For example, an ETF tracking the S&P 100 will give the investor exposure to the top 100 companies in the index with a single trade.
Understanding how an ETF is created
The process of creating an ETF starts with a sponsor. The sponsor can be an individual or an entity whose goal is to invest and create demand for publicly traded securities. The sponsor will file a plan with a regulator such as the U.S Securities and Exchange Commission (SEC) and once the plan is approved, the sponsor will proceed to create an agreement with an authorized participant.
The authorized market participant is usually a market maker or a large institution empowered to create or redeem ETF shares. There are cases where the sponsor and the authorized participant are the same individual or institution.
Once the agreement is set up, the authorized participant will borrow stock shares from a venue such as a pension fund, and place those newly bought shares in a trust. These new shares will then be used to form an ETF creation unit which is a bundle of stocks mostly about 50,000 shares. The trust then provides shares to the ETF. Investors holding these ETF shares will now have a legal claim of the shares held in the trust. These ETF shares, once delivered to the authorized participant, can be sold to the public on the open market similar to stock shares and other securities.
Types of ETFs
Since an ETF can be structured to track anything, as a consequence, ETFs will differ. The available range of ETFs will mostly be determined by the investors’ goals, risk appetite, and market preferences. Let’s take a look at the main categories of ETFs.
These types of ETFs are also known as sector ETFs and are used to track stocks and securities in a particular industry or sector. For example, an ETF can be created to track the stocks in tech companies or other industries such as banking or manufacturing.
A currency ETF gives investors exposure to the forex market. The investor holding the ETF shares does not have to trade any of the underlying currencies. A currency ETF can either track a basket of currencies or a single currency. Investors looking to gain exposure to the health of a region e.g. the US or EU will find this type of ETF useful.
Stock index ETFs
This type of ETF will track the performance of a given stock market index such as the S&P500 or the Dow Jones Industrial Average. Stock indices are made to represent a group of shares in a sector. Therefore, a Stock Index ETF gives investors a way of getting exposure to the price movement of underlying assets in that stock index without necessarily holding the individual assets in the index.
Commodity ETFs are made up of derivative contracts that track the price of commodities such as crude oil or gold. Owning shares in a commodity ETF enables traders and investors to speculate on the price of commodities without being concerned about the physical delivery and storage of those commodities.
There is also a subcategory of commodity-linked ETFs that track the performance of companies within the industry. For example, a commodity-linked ETF can be created to track the performance of a gold mining company.
This type of ETF is designed to mimic an underlying asset however an investor’s exposure to the underlying asset is amplified using a financial derivative. For example, a 3x leveraged ETF will maintain the investor’s capital at a $3 exposure if the underlying asset is worth $1. Therefore, if the price of the underlying asset appreciates by 100% the investor’s capital will appreciate 300%. However, losses with this type of ETF are also magnified accordingly.
An inverse ETF is designed to move inverse to the performance of the underlying asset. For instance, if the underlying asset appreciates, this ETF’s price will plummet proportional to the appreciation of the underlying asset. Inverse ETFs are used to short sell a stock or for speculating on falling prices.
Real-world examples of ETFs
Over the years, the amount of money invested in trackers has been on a steady increase. This has led to an increase in the share price of the top 10 most popular ETFs from 2009 to 2021. Here is a list of the most popular ETFs in the market.
SPDR S&P 500 (SPY)
This ETF is one of the oldest and most popular. It was launched in 1978 and tracks the stocks of the 500 companies in the S&P500 index.
SPDR Dow Jones Industrial Average (DIA)
Apart from tracking the S&P500 index, SPDR also tracks the DJIA which is an index composed of the top 30 “blue-chip” stocks in the US. The Dow Jones Industrial Average is the oldest market index in the US.
Vanguard FTSE 100 UCTIS ETF
This fund tracks the stock performance of large-sized companies in the UK. The FTSE 100 index measures the performance of these companies based on their market capitalization. The Vanguard group is another well-established investment management company with an estimated $7 trillion in global assets under management.
iShares Core S&P 500
This ETF tracks the performance of the top 500 company stocks with the largest market capitalization. The fund also features a separate ETF that tracks the results of large, mid, and small-cap equities in the US.
Global X Cannabis ETF
This ETF tracks the performance of the cannabis index giving investors exposure to active companies in the cannabis industry. Global X fund management was founded in 2008 and has over $30 billion under management.
The Invesco QQQ
This ETF tracks the Nasdaq 100 index which typically comprises top 100 stocks in technology companies. Invesco has been in existence for the past 20 years.
How to invest in ETFs
Investing in ETFs has become a popular move among investors as ETFs offer exposure to a broad market while only using a single investment instrument.
To get started, you will need a broker to place an order for your purchase of ETF shares. You must conduct your due diligence to find an investment that is favorable to your risk appetite.
One of the biggest advantages of investing in ETFs is their lower average costs as it can be expensive to buy all the stocks held in the ETF portfolio. Brokers typically charge a commission for each trade you make and some brokers offer no commission on trading low-cost ETFs.
You will also be expected to pay a management fee to the publisher for the maintenance of the ETF. However, this is typically integrated with the price of the ETF as ETFs usually have a low operating and management cost.
Be sure to also set aside funds for transaction costs to your broker when you buy and sell ETFs.
Active and passive ETF management
You can also invest in an actively managed ETF where the portfolio manager is actively involved in the buying and selling of company shares to change the portfolio’s holdings in the ETF to generate higher returns. This will translate to higher costs than a passively managed ETF. Therefore, you should determine how the funds are managed before making your investment.
In addition to giving investors a diversified means of getting exposure to market movements of a stock, ETFs also benefit from companies that pay dividends. ETF shareholders are entitled to a portion of earnings allocated by companies. Therefore, an ETF shareholder will receive dividends proportional to their holdings and may even get a residual value in case a company in the fund is liquidated.
Advantages of ETFs
Here is a look at some of the main advantages of ETFs.
The fact that most ETFs only track the index results in a passively managed fund that is far less time-intensive and therefore cheaper to manage. They also feature low associated marketing, distribution, and brokerage expenses making them cost less than traditional mutual funds.
Compared to mutual funds, ETFs don’t distribute capital gains to investors when the assets are sold. Therefore, the investor only has to file for capital gains when they liquidate the ETF shares they bought. This makes an ETF more tax-efficient than a mutual fund as buying and selling of ETFs happens on an exchange. Mutual funds on the other hand incur a tax liability each time an investor sells their shares.
ETFs are flexible given the fact that they can be traded like stocks. Compared to traditional investment funds, ETFs can be traded at any time with different order types such as stop-limit order, market order, or a stop-loss order. They can also be bought on margin or short trades.
With an exchange-traded fund, an investor can diversify their portfolio across an entire industry or market through various indexes. With a single trade, an ETF can offer traders and investors exposure to a broad range of markets and asset classes thereby reducing the effects of volatility.
Downsides of ETFs
Like any other financial instrument, ETFs also come with some downsides.
Lack of liquidity
The fact that ETFs are centered on particular industries can lead to the creation of fairly niche ETFs with low trading volumes. This hinders trading especially for traders and investors looking to place big orders.
Risk of volatility
Volatility affects all financial instruments and ETFs are no exception. In some cases, volatility can result in drastic losses as is the case with leveraged ETFs that amplify profits and losses.
FAQs about ETFs
What is the difference between an ETF and an investment fund?
While an ETF and an investment fund are designed with a composition of underlying assets, they feature different forms of management. An investment fund requires a fund manager to achieve above-average results by buying and selling underlying assets. This takes up more time. An ETF manager on the other hand only needs a passive investment strategy as the ETF tracks the values of the underlying assets.
Are ETFs a good investment?
ETFs are a good investment for the diversification of your portfolio. They also feature lower costs when compared to conventional funds plus they are flexible and tax-efficient.
How is the price of an ETF determined?
An ETF’s value is determined by the value of the index that the ETF is tracking. This is referred to as the net asset value (NAV) which is the aggregate value of the underlying assets in the market index. The net asset value of an ETF is calculated daily based on the most recent closing prices of the underlying assets.
How do ETFs make money?
Given that ETFs track the values of underlying assets in an index, the price appreciation of those underlying assets will reflect in the price appreciation of the ETF. Additionally, you can make more money by owning an ETF with stocks that generate dividends.
Conclusion: ETF market outlook
ETFs have grown increasingly popular among investors leading to the emergence of many new funds. However, some of these new funds have low trading volumes thus hindering investor’s capacity to buy and sell shares. There are rising concerns about the impact of ETFs and their role in inflating the value of stocks. Given that some ETFs are built on untested portfolio models, concerns are emerging about the impact of these ETFs in fragile market bubbles.
Overall, ETF trading offers investors a great way to capitalize on shorter-term price movements in an industry. Other ETF instruments such as leveraged and inverse ETFs, while risky, can amplify returns. It is important to consider the risk of ETFs as some feature underlying assets that are heavily concentrated in one industry or assets that are highly correlated to each other.