In this post I would like to highlight the characteristics and features of Exchange Trade Funds (ETFs) and more importantly, how they can be used as an investment vehicle as part of one’s portfolio. Although ETFs are considered as a recent financial innovation they have been around since the 1980s. Having said that, their popularity has increased mainly in the last decade or so.

What is an ETF?

The textbook definition  of an ETF  is that it is a fund that tracks indexes like the NASDAQ-100 Index, S&P 500, Dow Jones, etc. but trades like a share. When one buys shares of an ETF, he/she would be buying shares of a portfolio that tracks the yield and return of its underlying index. The main difference between ETFs and other types of index funds is that ETFs don’t try to outperform their corresponding index (known as active management), but simply replicate its performance (known as passive management). They don’t try to beat the market, they try to be the market. In short, buying an ETF is like buying a fund that trades like a share on a stock exchange.

Although most ETFs are broad in nature you can also find narrow ETFs that focus on a particular sector or group of related companies. For example, one can use an ETF to invest in the oil industry by buying an ETF that tracks the price movements of companies that operate in the oil industry. By doing so, an investor would be investing his/her money in a wide range of companies and not just into one or two companies, which is especially advantageous if his/her desired allocation of funds to such an investment is small.

ETFs vs Traditional Funds

Since ETFs trade intra-day, meaning that you can buy or sell an ETF anytime during market hours, one can use ETFs for intra-day trading. This is a major advantage that ETFs have over a normal mutual fund such as a regular bond fund (see more about bond funds here). A regular fund would use what is known as forward pricing, meaning that if an investor wishes to buy or sell a mutual fund, the price at which the investment would be bought or sold would be the end of day’s price, which is always unknown.

Another advantage of ETFs over regular funds is their lower costs. Since ETFs are passively managed as they simply replicate a portfolio as opposed to trying to outperform it, they benefit from lower costs. A traditional fund’s expense ratio is usually around the 1.40% per annum level, while that of an ETF is typically more around the 0.40% level. The higher costs of normal funds are due to the following items: a management fee, shareholder accounting expenses at the fund level, service fees like marketing, paying a board of directors, and load fees for sale and distribution.

ETFs can also be more tax-efficient than mutual funds because most of the tax on capital gains is paid on sale and completely up to the investor. Even if an ETF sells or buys shares while attempting to mimic the basket of shares it is tracking. This is because the capital gains from in-kind transfers, seen in ETFs, do not result in a tax charge, and therefore can be expected to be lower compared to mutual funds.

Other Features of ETFs

Two other features of ETFs that are important to note originate from the fact that they trade like shares. So like shares, one can buy an ETF on margin and one can also short an ETF. In simple terms, buying on margin means that the investor borrows the money (normally at a fee) with which he/she then buys the investment. Shorting means that the ETF is ‘borrowed’ and sold, with the intention of buying at a later stage. So if for example, an investor is expecting the price of gold to fall, such an investor could short (or sell) a gold ETF and then buy it back at a later date (hopefully at a lower price).

Both buying on margin and shorting are not possible with traditional funds, but whether this is an advantage or not depends on the outcome of the result. For example, if an investor borrows €5,000 to buy an ETF on margin and the value of that ETF subsequently falls and is sold at €4,700 the investor would still have to pay back the broker the original €5,000 plus borrowing and brokerage fees. Shorting could be a bad thing if the price of the ETF actually goes up. If an investor shorted (i.e. sold) an ETF at a value of €5,000, and subsequently the value of the investment goes up to €5,500 when the investor comes to buy it, that investor would have lost €500 from the trade.

An ETF could also use leverage in order to magnify the returns on a portfolio. So for example, an investor could buy an ETF that trades 3 times the DAX (the DAX is a stock index that represents 30 of the largest and most liquid German companies that trade on the Frankfurt Exchange). This means that for every 1% movement in the level of the index, the ETF moves by 3 times that amount, i.e. 3% in this example. This feature actually adds risk since it magnifies the returns, both the positive ones and the negative ones.

Top ETF Providers

Investors can find ETFs on any investment imaginable, from the more traditional types such as bond fund-like ETFs and stock exchange trackers to more avant-garde options like Fishing ETFs. Something to keep in mind when investing through ETFs is that the more narrow and small ETFs will have the bigger difference from the actual value of the portfolio they track and their actual trading price. It is normally best to stick to the larger based ETFs for more reliable pricing. Below is a list of the top-5 ETF issuers as at July 2015:

The Bottom Line

ETFs are a great option to get access to a diversified portfolio of assets at a lower cost than if one had to build their own similar portfolio. One can use more focused ETFs to get a wide exposure to a particular market, such as a Natural Gas ETF if one wanted exposure to natural gas. They have some advantages over more traditional funds, however they are simply passive investments and will not try to outperform the market like traditional funds will.

Like any other investment they still have to be used with caution since certain features can actually increase rather than decrease risk in an attempt to achieve better returns. Like with any other investment it is always advisable to get professional advice from a licensed investment service provider when considering ETFs. If you used correctly and with full understanding of the way they work ETFs can be a good addition to any investors’ portfolio. 

KD

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