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ETFs

January 27, 2021

What is an ETF?

An ETF – or exchange traded fund – is a fund formed by a basket of underlying instruments that can be traded on the exchange. ETFs are often (but not always) tracking an index and following the index methodology, providing investors a low-cost and efficient way to invest in an index without having to buy all the underlying constituents. ETFs are also useful tools for diversification by giving exposure to a range of different financial instruments, including those that may not be accessible otherwise. Many retail investors do not have the ability to directly invest in institutionally traded products like bonds, or commodities. As ETFs exist across many different asset classes (equities, bonds, commodities, and currencies) they are a way to get exposure to these markets. Within each of these asset classes, ETFs may track a broad market index or focus on a specific industry or theme.

ETFs are developed and managed by ETF issuers, which mostly are large asset managers like BlackRock and Vanguard. ETFs are often compared to mutual funds as they share some common features. Both are professionally managed funds and give investors with smaller portfolios the ability to achieve broad diversification. However, there are some key differences as well. ETFs are predominantly passively managed (tracking an index) whereas the majority of mutual funds are actively managed and try to outperform and index or benchmark. As a result, management fees on ETFs are generally lower than those on mutual funds. Moreover, ETFs can be traded on the exchange throughout the trading day, mutual funds can only be bought and sold at the end of each trading day. They are therefore also usually more liquid than mutual funds and trade at tighter bid-ask spreads, leading to lower transaction costs as well.

The ability for investors to buy ETF unit at any time throughout the trading day is a trait ETFs have in common with equity shares. Unlike equity shares however, there is no fixed amount of outstanding units available on the market. ETFs have an open-ended structure and ETF units can be created and redeemed based on demand and supply in the market. The creation/redemption process involves an authorized participant (AP) – a designated market maker appointed in this role by the ETF issuer.
The fact that ETFs behave more like shares is one of the features that distinguishes them from derivatives such as futures. As there is no large contract size and often (not always) no leverage effect with ETFs it generally makes them more suitable to retail investors than derivatives are.

What do ETFs mean for the market?

In the past decade, ETFs as an investment tool have rapidly increased in popularity among retail and institutional investors alike. This trend is mainly driven by the cost efficiency and intraday liquidity advantages provided by ETFs over mutual funds. The rise in demand for ETFs is also reflected in the large number of ETFs on the market today. Not all ETFs are created equal and there could be large differences in liquidity, fees, and number of underlying instruments. It therefore remains important for investors to properly understand the characteristics of the ETF and the underlying basket.

Example

Suppose an investor looks to get exposure to the S&P 500 index, a basket made up of the 500 largest publicly traded companies in the US. The investor places one order to invest EUR 1,000 in an S&P 500 ETF. This is equivalent to investing a total of EUR 1,000 a placing orders on each of the 500 shares in the index in a size according to their weighting in the index.