What is an exchange traded fund (ETF)?

Exchange traded funds (ETFs) are investment funds which hold a collection of underlying assets, such as shares, commodities and bonds. ETF portfolios are held by corporations which issue shares (a portion of ownership) of the fund. These shares give investors exposure to the underlying assets. For most ETFs, the strategy is passive style management.

ETFs can track a broad index, sub-sector of that index or an industry sector, for example financials, commodities, or energy stocks. Gold and crude oil ETFs are one example of gaining exposure to underlying commodities, as well as more scarce water ETFs.

Although ETF trading sometimes pays dividends, a majority of those earnings are kept within the fund. Investors are entitled to a portion of the profits, for example through earned interest. ETFs are transparent, as all fund holdings are declared on a daily basis.

ETFs are quoted on exchanges and can be bought and sold like any other share or stock. The fund’s share price very closely follows the price of the underlying assets. If they wish, investors can adopt buy and hold strategies with ETFs for long-term growth.

Depending on regulations, the legal structure of the fund will usually be an investment company or corporation. Varying structures often exist side by side in the same jurisdiction.

The popularity of ETFs has been on the rise since they first appeared. From 2006 to 2017, net issuance of these funds in the US has gone up from $74 billion to $471 billion. In the first quarter of 2016, global assets under management for ETFs amounted to $3 trillion across 64 exchanges in 51 countries globally.

Creation and redemption

Fund shares are created and redeemed by authorized participants (APs) – usually banks or other financial institutions. These institutions buy the underlying assets to create the portfolio. Once the portfolio is ready, the assets are turned over to the fund. The fund then exchanges the portfolio for newly created ETF shares. APs can also redeem shares when they return them to the fund in exchange for the underlying assets.

APs have a lot of buying power, as ETF shares are usually issued in large blocks. Due to the capital needed, individual investors are unlikely to be able to finance the operation. This mechanism of creation and redemption is essential to keep the price of the fund in line with the real value of the underlying assets.

The capability of APs to create and redeem shares means that if the price of the fund deviates from its fair value, the AP can step in and take advantage of the price differential. For example, on occasion, the fund may see buyers push the price of its shares above the aggregate value of its underlying assets. If this happens, at some point it may be profitable for the AP to buy the underlying assets and sell shares of the ETF in exchange for shares that are valued higher. The creation of new shares adds to the supply of ETF shares and brings the price of these shares in line with the underlying value.

The same can happen if the share price of the ETF falls below the aggregate value of its assets. At some point, it may be profitable for an AP to buy the ETF shares and redeem them for the underlying assets at a discount to the current market price. This functionality guarantees that the price of the ETF’s shares does not deviate much from the actual market value of its assets.

Taxation

ETFs may be subject to different tax treatment than other fund structures, depending on jurisdiction.

One should also remember that if the ETF is not in the same jurisdiction as where it is being traded, the ETF may apply a withholding tax. Sometimes this tax rate can be as high as 30%.

What is the difference between ETFs and mutual funds?

Exchange Traded Funds offer cost efficiency because of the way the fund is set up. APs bear the costs involved in buying the underlying assets, whereas a mutual fund will pay fees to the bank or financial institution every time they buy or sell assets. The AP then profits from the bid-offer spread of the quoted shares.

Depending on jurisdiction, ETFs may offer a more tax-efficient alternative to conventional mutual funds. The US provides some tax benefits when investing in ETFs, compared to traditional funds, but the same is not true in all jurisdictions.

Traditional funds tend to be more broad-based when it comes to the assets it contains in order to satisfy diversification of risk. This is compared to more specific ETF assets. With ETFs, one can gain exposure to a portfolio as specific as a smartphone index or live cattle index. The extensive range of ETFs allows for more control in one’s diversification strategies.

Some ETFs also offer leverage, and there are also funds that invest in short positions. So if a trader is bearish on a specific market or assets, they could buy shares that profit from a fall in price. These funds can be used to hedge long positions already held or to make speculative investments to the downside.

Traders can also hedge a specific sector of a broad index ETF. If one is long an ETF tracking the S&P 500 but concerned that a particular sector within the index will perform poorly, they could find an ETF that tracks the inverse return of that sub-sector. Buying shares in that ETF would hedge a fall in price of the original ETF.

Advantages of ETFs

Exchange Traded Funds are a low cost investment choice.

ETFs are also easy to enter and exit. The funds are traded over an exchange and shares can be bought and sold with relative ease, as compared to the redemption schedules of some mutual funds. Ease of execution, combined with a vast sample of asset classes and diverse investing strategies, offers a lot of flexibility.

High minimum investments are often required to enter mutual funds. ETFs do not have such limitations. This means that even a small portfolio can be diversified at an efficient cost.

Assets are usually liquid and transparent, and fund holdings are declared daily. This means that investors will not have to forego a significant discount to the fair NAV when exiting a market. At the same time, when demand is high, one would not have to pay a large premium to gain access to the fund's assets.

ETFs also offer easy access to interest-rate securities. Exposure can also be gained from mutual funds, but when interest rates are on the rise, fund performance begins to suffer. Recently institutions have been offering funds that have negative duration. In simple terms, this means that these funds gain in price when interest rates are on the rise. It is possible to find ETFs that are set up to gain in price when interest rates go up.

Disadvantages of ETFs

While ETFs have many advantages, traders should also be aware of any risks associated with them. Traders should consider that when investing in exchange traded funds, in some countries they may be limited to large-cap stocks only, given the narrow range of stocks in the market index. Being exposed to only a limited range of stocks may mean an investor loses out on potential growth opportunities.

The benefits of investing in ETFs also depend on what type of trader you are. Intra-day trading opportunities created by ETFs could benefit short-term traders, but will be less suitable to a trader looking to profit in the long-term.

Finally ETFs, like any other investment, can also be affected by market liquidity. It is important to assess the spread between the bid and the ask price. If there is a large spread, this can be a sign of an illiquid investment.

Summary

Exchange traded funds offer a comparatively cheaper way to invest in a myriad of assets and indices. They offer transparent pricing, where the NAV of ETFs is calculated on a daily basis and holdings are public and published daily. ETFs are also easy to enter and exit as the shares are quoted and traded on exchanges. All these factors contribute to making ETFs an efficient diversification vehicle. The diversification factor offered from the wide range of investment targets runs down to smaller portfolios, which are out-sized by many mutual funds.

Source: CMC Markets UK