What is an ETF?

Fundamentals · Jul 14, 2019

ETFs are relatively new financial instruments that were introduced in 1993 in the US and in 1999 in Europe. These financial tools create new opportunities for investors and they have become very popular nowadays.

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Today we’ll explore the essence of ETFs as well as why they are beneficial for investors.

Table of Contents

What is an ETF?

An ETF stands for exchange-traded fund, a collection of investments and assets controlled by a professional portfolio manager. These funds are traded on stock exchanges and their value changes over time. If it is a well-managed ETF the value will go up and if an ETF is managed poorly its price is expected to decline.

Such funds might consist of various assets such as:

  • Stocks
  • Commodities
  • Bonds
  • And many more

Investment companies and banks offer their ETFs for any kind of investor so they can be a good addition to any portfolio, no matter how conservative or aggressive it is. Some ETFs can be very narrow and focus on a particular thing such as healthcare stocks or EU bonds while other ETFs try to be as broad as possible, trying to hold a piece in every asset in the world.

A common type of ETF is a fund based on a market index such as S&P 500. Those funds are quite popular because they provide a tool to buy the whole index which helps to decrease portfolio volatility and frees an investor from analyzing complex balance sheets of particular companies in order to find a perspective investment opportunity.

Main ETFs Types

Here is the list of the most common types of ETFs:

  • Currency ETFs
  • Stock ETFs
  • Bond ETFs
  • Index ETFs
  • Commodity ETFs
  • Actively managed ETFs
  • Mixed ETFs

What Are The Benefits of ETFs?

ETFs usually have a predictable strategy and they are operated by experienced money managers which makes them a good option for inexperienced investors with limited capital. More experienced “macro” investors can use ETFs to gain specific exposures to different business sectors without the need to pick and rebalance a lot of assets manually.

ETF is a convenient tool for people who don’t have enough time to manage all of their assets manually.

Most of the people are not money managers and they don’t have time and skills to be active investors but that doesn’t mean they can’t invest and profit from various investment opportunities via an ETF.

Exchange-traded funds generally (but not always) have a low management cost and they may allow certain tax benefits.

An interesting example would be a fund operating in a foreign jurisdiction that has its own rules. An individual would have to spend a lot of money on lawyers and waste a lot of time learning new regulations in order to invest in this country directly. Another option would be to find an ETF operating in this particular market so you can use it in order to make an easy and secure investment in a foreign country.

How Does an ETF Work?

First of all, you have to sign an agreement with an authorized broker or an organization that has legal rights to offer ETFs. From that moment you are allowed to purchase a certain portion of an ETF which is measured in so-called creation units.

The price of those units might vary tremendously.

It is important to understand that ETFs are publicly traded and transparent, so anyone can go and check what they are ETF made of. In a case where an ETF is based on an index (let’s say it is the S&P 500), the performance of an index is a public knowledge (let’s assume it grew by 10% per year), and the goal of the fund based on such an index is to follow the index as close as possible, although no complains when a fund manager outperforms his target index. Investors would watch an ETF and use their ability to exchange the creation units for the underlying assets which will provide liquidity.

Many ETFs based on an index are marketed as a better version of the underlying index so they might say something like:

“Our S&P 500 ETF made 15% while S&P 500 index made just 10%!”

Let’s say you bought a share in ETF for $50,000. You are allowed to watch the structure of this fund and it is expected to be managed with a profit. After a year the value of the ETF became 105% compare to the year before, so you made 5% on your share of $50k, which is $2,500. Of course not all ETFs always grow and their value can fall quite dramatically. In this unfortunate case you can listen to the manager who will tell you something about “unexpected market fluctuations” or some other excuse and decide should you keep the ETF or to get rid of it and look for a better investment option.

Retail brokers and independent investors can also use secondary market in order to trade ETFs. This market is somewhat similar to bond and stock exchange meaning that the value of a traded asset may go up or down depending on many factors: change in the management team, global positive or negative events, market supply, and demand and so on.

Difference Between ETFs and Mutual Funds

It’s easy to confuse ETFs with mutual or index funds, but there are a few differences between them. Mutual funds, unlike ETFs, are not traded on the exchanges so they can’t be bought or sold instantly (it can be done only at the end of each trading day). Also, they are not as transparent as ETFs.

Difference Between ETFs and Index Funds

Similarly to the mutual funds, the index funds are not traded on the exchanges and, as it can be concluded from the definition, they always based on an index. Index funds have an advantage over ETFs in terms of lower transaction fees and commissions. All of the first ETFs were index funds, but starting from 2008, an American regulator allowed ETFs to be actively managed.

Management Fees, Trading Expenses and Costs

A downside of an ETF compared with direct investing is that it costs money to manage money. A professional portfolio manager/analyst is not cheap to hire, therefore all ETF investors has to pay some kind of management fees. ETFs require infrastructure, databases, reports and technical support services and all of those things are not free.

It’s quite interesting that a big, old and trusted funds like The Vanguard Group may have relatively low fees, despite the fact that they manage billions of dollars. At the same time, some smaller funds could ask for high fees. In any case, the fees may vary depending on the quality of a fund, its history, management, and other factors. It’s usually cheaper to manage a massive chunk of money for many people that a small and unique fund trying to beat the market.

Management fees can be a problem for a conservative ETFs with low expected returns.

What Return to Expect From an ETF?

This is a common question with no right answer because there are too many different ETFs with radically different strategies. Some of them are designed to have low but stable return and some are quite volatile and can go up and down by more than 50% in 1 year. For an ETF based on a broad selection of American stocks or an American index such as the S&P 500, the average return is somewhere around 8%.

The oldest ETFs which opened in 1993-1995 are showing a great annual return of more than 9%.

Here are some other examples of 10-years return of Vanguard’s ETFs:

  • Energy: 4.34% (1 year: -16.60%, 5 years: -7.27%)
  • Communication Services: 9.12% (1 year: 2.96%, 5 years: 2.87%)
  • IT: 18.63%
  • Health Care: 15.97%
  • Real Estate: 15.46%
  • Industrials: 15.57% (1 year: 9.28%, 5 years: 9.06%)

As you can see, the rate of return is heavily influenced by how this industry has performed in general, although a good manager can outperform the index by picking assets for the ETF in a wise way.

investing   diversification   etf   finance   management   market   portfolio

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