ETF Essentials

What is an ETF?

An ETF (exchange traded fund) is a collective investment that’s built like a mutual fund—investing in potentially hundreds, sometimes thousands, of individual securities—but trades on an exchange throughout the day like a stock.

What’s the difference between an ETF and a mutual fund?

ETFs are very similar to mutual funds, but the biggest differences are that:

• Investors can trade ETFs in real-time throughout the trading day, unlike mutual funds that only trade once a day.
• ETFs have lower investment minimums. An ETF’s minimum is the price of a single share, which could be as little as £50, depending on the ETF. A mutual fund may require £1,000, £3,000, or more to get started.
• ETFs have more transparent pricing. ETFs provide real-time pricing, so you can see their prices change throughout the trading day. A mutual fund isn’t priced until the trading day is over, so you don’t know your price until after you’ve placed your trade.
• ETFs have more transparent reporting. ETFs reveal their full holdings on a daily basis, unlike mutual funds which often disclose only the top 10 largest constituents.

What exposures and strategies are available as ETFs?

The first ETFs tracked broad stock indices like the FTSE 100 and S&P 500. Over time, ETFs developed to offer exposure to all major asset classes (equities, bonds, REITS, currencies, commodities, ESG) as well as sectors, geographic regions, single countries and systematic investment strategies aka “smart beta”. The new generation of ETFs are extending the approach to include emerging investment themes (such as Social Media, Robotics or Future Cars) and even active investment strategies.

Do ETFs hold the underlying stocks or securities? 

It depends… If an ETF is Physically Replicated (see below) then it will hold the underlying stocks or bonds that comprise the index. This is not the case if the ETF is Synthetically Replicated (see below). Investors should refer to the KID and prospectus for more information on a specific fund and call the ETF issuer if they have questions.

Who can buy/invest in an ETF?

Any investor including institutions and private individuals can invest and trade in ETFs as long as the ETF is registered for sale in their country.

How do you invest in an ETF? 

For individual investors, there are four main ways to buy an ETF:

• Financial advisors: provide advice on ETF selection and trade on behalf of clients.
• Stockbrokers: buy and sell ETFs on stock exchanges on behalf of their clients. For UK investors, London Stock Exchange provides a “Find a Broker” tool.
• Execution only platforms: online services that allow you to invest in stocks, bonds and ETFs without offering advice. Examples of UK execution only platforms on which you can trade ETFs include: AJ Bell, Charles Stanley, Interactive Investor, IG, Hargreaves Lansdown and SelfTrade.
• Online investment managers: sometimes called “Robo Advisors” provide ETF model portfolios or discretionary options.

What are the advantages and risks of an ETF?

The key benefits of ETFs include:

• Transparency: ETFs disclose their holdings on a daily basis meaning investors know exactly what assets the ETF holds.
• Liquidity: the ability to trade an ETF in real-time throughout the trading day.
• Costs: ETFs are typically cheaper to own than a mutual fund with an equivalent exposure.
• Diversification: ETFs provide investors with the ability to invest in an entire market index which could cover a broad range of asset classes, sectors and geographies. This enables investors to spread their investment and reduce risk compared with investing in single stocks.

The key risks of ETFs can include:

• Capital risk – like all investment products, the value of an ETF can go down as well as up.
• Tracking difference – Even after charges are taken into account, ETFs may not track an index perfectly. The difference between fund return and index return is called ‘tracking difference”.
• There may be other risks that are specific to the exposure of an ETF – for example Frontier market risk, sector risk, credit risk or currency risk. These will be made clear in the Key Investor Information Document (KIID) that is published on every ETF issuer website.

How can I use ETFs? 

One of the reasons that ETFs have grown in popularity is their flexibility. Common uses for ETFs include:

• Asset Allocation: Asset allocation can be difficult for individual investors to manage given the costs and assets required to achieve proper levels of diversification. ETFs provide investors with exposure to broad segments of the equity, fixed income, commodity, currency and REIT markets and cover a range of thematic, style and size spectrums, enabling investors to build customized investment portfolios in-line with their financial needs, risk tolerance, and preferences. Both institutional and individual investors use ETFs to conveniently, efficiently, and cost effectively allocate their assets.
• Trading Tool: The intra-day trading offered by ETFs enables ETF users to gain short-term exposure to a wide variety of markets. Historically, investors have relied heavily on derivatives to achieve short-term exposure. However, for many investors, derivatives are not always a practical solution. The large denomination of most derivative contracts can create headwinds for investors, both institutional and private, from using them to gain market exposure. In this case and in those where derivative use may be restricted, ETFs are a practical alternative.
• Cash Equitisation: Investors typically seek exposure to equity markets, but often need time to make research and decide on their investments. ETFs provide a “parking place” for cash that is designated for equity investment. Because ETFs are liquid, investors can participate in a market while deciding where to invest the funds for the longer-term, avoiding potential opportunity costs.
• Hedging Risks: ETFs are an excellent hedging vehicle because they can be borrowed and sold short. The smaller denominations in which ETFs trade relative to most derivative contracts provides a more accurate risk exposure match, particularly for small investment portfolios.

Types of ETFs

What is an Index ETF? 

The most common type of ETF, providing market capitalization weighted exposure to a stock or bond index like the FTSE 100, CAC 40 or S&P 500.

What are Smart Beta ETFs? 

Most stock indices, and the ETFs which track them, weight their constituents according to market capitalisation. Smart beta indices and ETFs use a variety of different methodologies to weight the constituents and alter the risk/return profile of the basket. Examples include Equal Weighting, Fundamental Weighting, Volatility Weighting and Factor Weighting.

What are Thematic ETFs?

Thematic investing follows certain social, economic, or demographic trends that are popular in society, providing exposure to a theme or idea that falls outside of traditional industry classifications. Examples of investment themes that are accessible via ETFs include Cloud Computing, Ecommerce, Robotics, BlockChain and Renewable Energy.

What are Active ETFs? 

While most ETFs provide exposure to a rules-based index, Active ETFs provide exposure to the discretionary strategy of an asset manager.

What are the differences between ETFs, ETCs and ETN’s? 

An ETC is traded on a stock exchange, like a stock, but tracks the price of a single commodity or currency (or a commodity or currency index). This allows investors to gain exposure to commodity markets without buying futures contracts or the physical commodity. ETCs have a share price that moves up and down as the price of the underlying assets fluctuate in value.

ETNs are debt notes issued (normally) by a bank. When you buy an ETN, the bank promises to pay you a certain pattern of return. If you buy an ETN linked to the price of gold, for instance, the value of that ETN in line with the gold price. As an ETN is guaranteed by a bank or other financial institution, the investor is also exposed to the counterparty credit risk of that institution.

What is physical replication and what is synthetic replication?

Replication is the means by which the ETF delivers the exposure that it promises. Physical replication is the most straightforward – the ETF portfolio manager will own the underlying stocks or bonds that comprise the index exposure. In some cases, the index construction makes it hard or expensive to buy all of the underlying securities and an ETF may need to be synthetically replicated. Instead of owning the underlying securities, the index performance will be delivered by a swap provided by an investment bank.

What happens if an ETF shuts down? 

Typically, the ETF provider will make an announcement about the dates the ETF will stop trading and when the fund’s assets will be liquidated. The notice is usually about 30 days, giving investors time to find replacement investments or ETFs and to alter their trading strategy. Once the ETF closes then it will take some time for the ETF to go through the liquidation process. If you are the owner on record at the time of the ETF delisting, you will get the cash equivalent value of the fund’s assets at the time of sale (liquidation), not the value of the final closing price on the last day of trading.

There will be a few days lag between the closing bell and the actual execution of the fund’s liquidation. So there could be slight discrepancies in those prices, as well as some risk. So, your final cash values could be different than the closing trading price as they are truly based on the liquidation price. In other words, the prices of the securities in your fund could increase or decrease during the time period between the last trade and the final liquidation date. So definitely consult with your broker or about the values once the process is complete.

For more information on Closed ETFs, please click this link