What is an exchange-traded fund (ETF)?
An exchange-traded fund (ETF) is a valuable financialproduct that has become increasingly popular with investors in recent years. In short, an ETF is a basket of securities that works in a similar way to an investment fund. Typically, ETFs track a specific index, sector, commodity or other asset. Unlike investment funds, ETFs can be bought or sold on thestock market in the same way as a normal share. The prices for ETF shares therefore fluctuate during a trading day – depending onsupply anddemand for the assets they contain and their performance. An ETF is therefore a security that can be traded on the stock exchange. This means that it has a unit price that allows it to be bought and sold on the stock exchange during the course of the day, and it can also be sold short. This is the big difference to investment funds, which are only traded once a day after the close of trading at net asset value (NAV).
An ETF can be set up in very different ways. For example, an ETF can be used to track the price of a single commodity. Much more frequently, however, entire indices with a large number of securities are tracked. ETFs can also be used to track certain investment strategies, such as Arc’s Innovation ETFs.
The first exchange-traded fund was the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index and is still actively traded today. A major advantage of ETFs is that they offer low expense ratios and lower brokerage commissions than buying shares individually. The popularity of ETFs is therefore also increasing worldwide, as can be seen in the following chart. Global assets under management in ETFs have risen from USD 417 billion in 2005 to USD 10,021 billion in 2021.
Development of global assets under management in ETFs from 2005-2021, source: www.statista.com
An ETF therefore holds several underlyings orassets and is therefore also a popular product when it comes to diversifying (spreading) risks. ETFs can also contain different types of investments. An ETF can focus on a certain sector or be spread across different sectors. The same applies to a global focus or a focus on a specific country. The number of investments in an ETF is also highly variable.
Types of ETFs
ETFs can be used in different ways, for example to generate income, for speculation and price increases, as well as to hedge or, in some cases, to offset risks in an investor’sportfolio.
ETFs are generally referred to as either passively or actively managed. Passive ETFs usually aim to track the performance of a broader index – either a diversified index such as the S&P 500 or a more specific target sector or trend.
Actively managed ETFs do not usually target a securities index; instead, the portfolio managers decide which securities are included in the portfolio. These funds can have advantages over passive ETFs, but are generally more expensive for investors. Actively managed ETFs and their characteristics are discussed below.
Bond ETF / Bonds – ETF
Bond ETFs offer regular income. Their income distribution depends on the performance of the underlying bonds. These can include government bonds, corporate bonds and municipal bonds. Unlike their underlyings, bond ETFs do not have a maturity date. They are usually traded at a premium or discount to the actual bond price.
Stock ETF / Shares – ETF
Equity ETFs consist of a mix of stocks that represent a single industry or sector. The goal is to create a diversified ETF that includes both strong performers and new companies with growth potential. Unlike traditional equity funds, ETFs can have lower fees and are not linked to the actual ownership of securities.
Industry/Sector ETF
Industry or sector ETFs focus on a specific sector or industry. An exchange-traded fund for the energy sector, for example, contains companies that are active in this sector. The idea behind sector ETFs is to participate in the positive developments of this sector by tracking the economic success of companies in a sector.
Commodity ETFs
Commodity ETFs invest in commodities, including crude oil or gold. Commodity ETFs diversify a portfolio and can thus provide a hedge against downturns. Commodity ETFs offer some protection in the event of a stock market slump if they are not correlated with the stock markets – although this is not always the case. As a rule, owning shares in a commodity ETF is cheaper than owning the commodity physically, as there are certain economies of scale: Insurance and storage costs, for example, are spread across all ETF investors.
Currency ETFs
Currency ETFs are pooled investment instruments that track the performance of currency pairs, which can consist of domestic and foreign currencies. They are used to speculate on the prices of currencies based on political and economic developments in a country. They are also used to diversify a portfolio. In addition, they offer importers and exporters a way of hedging against exchange rate fluctuations on the currency markets. Some of them are also used to hedge against the threat ofinflation. There is now even an ETF solution for bitcoins.
Inverse ETFs
Inverse ETFs aim to realizegains from stock declines by sellingstocks short. Short selling involves selling a stock in anticipation of a drop in value in order to buy it back later at a lower price. An inverse ETF uses derivatives to sell a stock. Essentially, these are bets that the market will fall. If the market goes down, an inverse ETF goes up by a corresponding amount.
Leveraged ETFs
A leveraged exchange-traded fund attempts to achieve a certain multiple of the return on the underlying investment. For example, if the S&P 500 rises by 1%, a 2× leveraged S&P 500 ETF will return 2%. These products use derivatives such asoptions or futures contracts to leverage their returns. There are also leveraged inverse ETFs that aim for an inverse multiplied return. Such financialproducts are highly speculative and should only be used with extreme caution. It is worth consulting a specialist, such as an independent asset manager.
How do I buy an ETF?
ETFs are traded via online brokers, for example, but also via traditional broker-dealers. Shares in ETFs can be traded in the same way as shares via a normal custody account at your bank. Hands-on investors can opt for a traditional brokerage account, while investors who want to take a more passive approach can opt for a robo-advisor. Robo-advisors often include ETFs in their portfolios, although the decision of whether to focus on ETFs or individual stocks is not necessarily up to the investor.
One of the best ways to narrow down ETF options is to use an ETF screening tool. Many brokers offer these tools to help you sift through the thousands of ETF offerings. For example, you can usually filter ETFs by volume, cost, performance, holdings and also costs such as the total expense ration (TER). The justETF platform, for example, offers a useful tool for screening.
The chart shows the most popular ETFs on the market. In first place is the SPDR S&P 500:
Market capitalization of the largest exchange-traded funds (ETFs) worldwide. Status: April 22, 2022
Source: www.statista.com
Advantages of ETFs
- Costs: ETFs usually offer low cost ratios such as a low totalexpense ratio (TER) and hardly any brokerage commissions. It would be expensive for investors to buy all the shares in an ETF portfolio individually. In addition, investors only have to carry out one buy and one sell transaction, which results in lower transaction costs as investors have to make far fewer purchases. Some brokers even offer commission-free trading on certain low-cost ETFs, further reducing costs for investors.
- Access to many shares from different sectors.
- Mapping of specific sectors and themes. There are ETFs that focus on specific sectors or themes, such as sustainability concentrate.
- Risk management through diversification: An ETF on an entire stock index offers investors the diversification of an index fund as well as the opportunity to sell short, buy on margin and buy with a relatively small amount, as no minimum investment is required.
- An ETF is more tax efficient than a mutual fund because most buying and selling is done through an exchange and the ETF sponsor does not have to redeem shares every time an investor wants to sell or issue new shares every time an investor wants to buy. The redemption of shares in a fund may trigger a tax liability, so listing the shares on an exchange can reduce tax costs.
JP Morgan Chase asked 320 people what they thought were the most important features of ETFs. 60% of people felt that low costs were the main advantage. However, caution is also required here: Not all ETFs are low cost. It is worth consulting a specialist to work out an optimal investment strategy.
Disadvantages of ETFs
- Actively managed ETFs have higher fees. With actively managed ETFs, portfolio managers are more involved in buying and selling company shares and changing the holdings within the fund. These managers want to be remunerated – just like with traditional, actively managed funds.
- ETFs that only focus on one sector do not offer any real diversification of risk, depending on their composition.
- A lack of liquidity can hinder transactions.
- There are concerns about the influenceof exchange-traded funds on the market. The question is whether the highdemand for these funds is inflating equity valuesand creating vulnerable bubbles. Some exchange-traded funds are based on portfolio models that are untested under different market conditions and can lead to extreme inflows and outflows from the funds. This can have a negative impact on market stability. Since the financial crisis, ETFs have played an important role in market crashes and instability. Problems with ETFs were major factors in the flash crashes and market declines in May 2010, August 2015 and February 2018.
- Another criticism of ETFs is a certain concentration of power among the large fund companies: This is because with ETFs, the investors themselves no longer own the shares and therefore no longer own the companies, but the fund companies do. Depending on their size, certain ETF fund companies own a significant stake in a large number of companies worldwide. This gives them considerable influence over the management of these companies.