In the blink of an eye, exchange-traded funds have become one of the most popular investment vehicles for both institutions and individuals. Here we cover the basics of this phenomena, from the concept of an ETF to its most significant advantages.
What is an exchange-traded fund?
An exchange-traded fund can be seen as a basket of underlying assets, such as shares, bonds, commodities and indices, that are pooled together into a single entity. It divides ownership of these assets into shares, which are later sold on the open market. Each share of an ETF gives its owner a proportional stake in the total assets of the fund.
Typically, ETFs track various benchmarks, with each investment having the goal of matching the returns of the benchmark that the fund has chosen. The number of shares outstanding varies daily, depending on share creation and redemption mechanisms.
How it all started
The concept of exchange-traded funds is rather old. Its history goes back to the first closed-end fund, invented by a Dutch merchant in 1774. Throughout the years, various investment trusts were occasionally created to provide investors with the opportunity to invest in a particular type of asset on a daily basis. However, truth be told, none of these really resembled today’s ETF.
The first attempt to create something ETF-alike was the launch of Index Participation Shares in 1989. It was an S&P 500 proxy that traded like a regular stock on the American and Philadelphia Stock Exchanges. Unfortunately, even though there was quite a bit of investor interest, the product was short-lived. This early ETF prototype was targeted by the Chicago Mercantile Exchange lawyers for illegally behaving like a futures contract. It was immediately taken down off the exchanges.
In 1990, the world's first real ETF was born. This time the product was created in Canada. Tracking the TSE-35 Index, it was named Toronto 35 Index Participation Units (TIPs 35). Traded on the Toronto Stock Exchange, TIPs were instantly praised for providing low-cost exposure to Canadian equities.
The popularity of these products drove the American Stock Exchange to develop something that would satisfy SEC regulation in the US. In January 1993, the Standard & Poor's Depositary Receipts (SPDR) S&P 500 Trust ETF was developed.
For a few decades now, ETFs kept transforming the investment landscape by offering the advantages of flexibility and pooled investing. Today, ETFs are tailored to an increasingly specific array of commodities, stocks, bonds, futures, sectors, industries and regions. Some popular ETF examples include Vanguard S&P 500 (VOO), iShares Russell 2000 (IWM) and Invesco QQQ (QQQ). At the time of writing, the value of assets managed by global exchange traded funds is over $5 trillion.
How does ETF work?
As we have mentioned before, an exchange-traded fund is a marketable security. Therefore it is traded on an exchange like most other asset classes. Just as with regular stock, an ETF has a ticker symbol and a price that changes in real-time. ETFs are known to be very flexible as investors can buy and sell them throughout the day.
An ETF typically aims to produce a return that replicates or tracks a specific index, such as a bond index or stock index. Index-tracking ETFs are passively managed by ETF managers and don’t try to outperform the underlying index. They have fees and charges that are typically lower than those of actively managed investment funds.
Exchange-traded funds may have complex structures. They may be structured as cash-based ETFs or as synthetic ETFs, which involve the use of derivatives. In fact, ETFs can comprise all types of investments, including stocks, bonds, commodities or a mixture of these.
All exchange-traded funds come with a different investment focus. For example, an ETF can own hundreds or thousands of assets across various industries, or it could be isolated to one particular industry or sector. They can also vary geographically: some funds focus only on US or UK securities, while others offer a global outlook.
Although designed for individual investors, institutional investors play a key role in tracking integrity and maintaining the liquidity of exchange-traded funds. They do so through the purchase and sale of creation units, which are large blocks of ETF shares that can be exchanged for baskets of the underlying securities. When the price of the ETF differs from the underlying asset value, institutions utilise the arbitrage mechanism afforded by creation units to bring the ETF price back into line with the underlying asset value.
Types of exchange-traded funds
The most common types of ETFs to invest in are as listed below:
Why invest in exchange-traded funds
ETFs can be a valuable component for any investor's portfolio, regardless of one's level of professionalism. Here we gathered the top 10 reasons to add ETFs to your investment portfolio:
Easy access to the markets. Owning silver bullion can be quite challenging, meanwhile owning shares in iShares Silver Trust (NYSEARCA: SLV) is rather simple. Not only does this ETF bypass the bid-ask spreads of retail silver and the expense of rolling over futures contracts, but it has no storage requirements. Likewise, investors can easily approach many different hard-to-access markets through ETFs.
Instant diversification. ETFs provide instant diversification and reduce overall portfolio risk. It can be challenging to have a properly diversified portfolio with 10 individual stocks, but relatively simple with the same number of ETFs. You can also spread your money among ETFs that cover different types of investments across different industries and various locations.
Investment liquidity. ETFs are usually extremely liquid. You can buy and sell these from an investment firm or online brokerage at the current market price at any time during market hours.
Easier portfolio management. The more stocks there are in a portfolio, the harder it is to control. With the implementation of an ETF strategy, the number of stocks can be decreased, resulting in a portfolio that is less complex and easier to monitor and rebalance.
Tax efficiency. Taxes can greatly impact your returns. ETFs have lower capital gains and are payable only upon the sale of the fund. If exchange-traded funds make up a larger proportion of the portfolio, fewer capital gains will be triggered, resulting in the lower taxes. It especially makes a substantial difference for wealthy investors in higher tax brackets who want to improve their after-tax performance.
Lower expenses. With fewer stocks, there will be fewer trades and, consequently, fewer commissions. The small annual management fee for ETFs is easily recovered from the savings on commissions. Many ETFs cost less than 0.40% annually, and many of the large-cap index-based funds charge less than 0.10%.
Decreased volatility. For the typical investor with an ETF representing a key holding, the overall portfolio will likely be less volatile than one made up entirely of bonds or stocks. Due to its diversified nature, an ETF is making it less likely to suffer the price swings that are possible for other asset classes.
Better focus. In any well-designed and diversified portfolio, you will have to invest in sectors or stocks that you don’t really favour, but have to own them for diversification purposes. Using an ETF provides the necessary diversification, allowing the investor to focus on assets in the preferred sectors.
Increased sophistication. Investment strategies, such as portfolio insurance, risk budgeting, tax loss harvesting and hedging become easier to implement with ETFs.
Transparency. Most ETFs publish their holdings every day so you can find out what investments your ETF holds, their relative weighting in the fund and whether the fund has changed its position in any particular investment. This transparency can help you to easily find an ETF’s current market price and check if it is meeting your investment objectives.
If you want to learn more about ETF investing and find comprehensive information on ETF trading, check out free online courses, trading guides and financial glossary provided by Capital.com.
All you need to know about Investment portfolio:
Investment portfolio: a beginner’s guide to exchange-traded funds