What is an ETF?

What is an ETF?

ETF is an acronym for Exchange Traded Fund. An ETF in its simplest form is a portfolio of stocks. Unlike investing in individual company shares, you can easily buy one share in an ETF that contains a portfolio of stocks. The Largest ETF as of writing this in January 2021 is the SPY ETF which follows the S&P 500 and has over $315Billion in assets.

Key Points 

  • ETFs  have lower fees compared with mutual funds
  • Many ETFs provide excellent diversification benefits
  • ETFs are easy for retail investors to purchase
S and P 500 2015 to 2021

An introduction to ETFs

E – Exchange, T – Traded, F – Fund. 

Unlike traditional methods of investing, you are able to buy shares in ETFs as they are traded in financial markets. So, for example, before ETFs were invented, if you wanted to invest in the S&P 500, you would invest a proportion of your investment in each of the 500 companies, even now with digital trading, this would be time-consuming. When you wanted to take your money out of the stock market, you would repeat the process of selling each of the 500 stocks. With an S&P 500 ETF Tracker, you are able to invest in the 500 stocks with one transaction. Exchange Traded Funds make diversification possible for retail investors with much lower fees

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Investing in the Markets with an ETF

An ETF is a portfolio or basket of stocks that in their simplest form track stock market indexes. When you see FTSE100 or S&P 500, these are collections of top-performing stocks. Stocks are gathered in all different kinds of groups, from their geographical location to industry sectors and lots of places in between. So much so, as of 2017, and according to Bloomberg, there are now more Indexes than Stocks.

ETFs essentially track these indices, if the FTSE100 goes up and you have bought an FTSE100 ETF, you will realise these gains. Unfortunately, as with all types of investing if the FTSE100 falls, you will also realise these losses.

If you have ever invested in a mutual fund, these are similar to ETFs, but instead of Professional Money Managers deciding where to invest your money, ETFs rely not on the luck or skill of fund managers, but the performance of the underlying companies.

In addition to this, ETFs can be sold without large fees, so if you invest it can often be simpler to take your money out compared with mutual funds.

All in all, owning an ETF generally leads to less work, diversifying across a large section of stocks, rather than picking one or two out is also less risky.

How did they change the investing landscape?

In order to understand the premise of investing, it is first important to distinguish between fundamental analysis and technical analysis.

Fundamental analysis is when we try to understand the ‘fundamentals’ of a company, in fancy words, this is when we what to evaluate securities by measuring the intrinsic value of a company. This could include, looking at profits, opportunities, the current financial climate for this stock amongst other things.

Technical analysis is when only the stock price and volume are the only inputs. Investors try to follow trends and that all known fundamentals are incorporated into the price. Graphs and previous patterns are used to predict what a stock might do in the future.

Both fundamental and technical analysis have proven track records and failures, Warren Buffet might be the most well-known fundamental investor, his company looks at the fundamentals of a company and buy stocks that he feels have long term prospects. Technical analysis is given less exposure to the media so famous analysts in this area of investing are often less well known.

The problem with these strategies is whilst both have proven to be popular, they take a considerable amount of skill, and often argued luck, in order to make sustainable risk-adjusted returns.

We do not profess to have superior knowledge of the future direction of stock markets, nor will we ever recommend a get rich quick stock pick. We will however educate our readers on the basics of investing and low-cost strategies that can help get you started on the investing ladder.

Who created Exchange Traded Funds? 

ETFs are not a new financial product anymore, what is new, is that it is easier than ever before for novice investors to invest in the financial markets. ETFs originated in North America, but now versions of them pop up all over the globe in every financial market. Created by financial institutions, regulators have also played an important part in protecting investors who invest in them. The first ETF was introduced in Canada, specifically, in 1989 on the Toronto Stock Exchange. One of the most well-known ETFs, the SPDR (SPY ETF) which tracks the US S&P 500 never came along until a few years later.

Are there ETFs that do better than the market?

Generally, the job of an ETF is to track an underlying benchmark, this is what we see with most ETFs. However, there are certain types of ETFs whose job it is to outperform a benchmark, i.e. generate more than the average 8% that we have seen in the stock market, these are often called “Actively Managed ETFs” and can be seen as a hybrid between mutual funds and index-tracking ETFs.

What other types of ETFs are there?

There are many types of ETFs coming onto the market almost daily and in every sector imaginable.

We have ETFs that follow sectors of stocks, investment strategies, commodities, bonds, the housing market, currencies, and cryptocurrencies.

When was the first ETF in the US?

Investing in ETFs is not new, the first US ETF tracked the S&P 500 and was launched 28 years ago in 1993. Actively managed ETFs took longer to be approved and have been around since 2008.

How many ETFs are there?

There are thousands of ETFs, for those tracking indices, i.e. passive ETFs, there are approximately 1700 different types in the US. With hundreds in the UK also.

How do ETFs track the market?

To follow the market, ETFs generally buy their constituents, this is either done by buying all of the stocks, i.e. if in the S&P500 there 500 companies, then an ETF may buy the 500 companies. This is much cheaper and more efficient than if an individual investor wanted to buy the 500 companies. ETFs can also just buy an optimised sample of the S&P 500. This is where they may buy a subset of the companies but just the right amount so they can still track the market well. Think of two similar companies, Pepsi and Coca-Cola, perhaps these stocks perform in a similar manner, so the ETF may only include one of these in the basket of stocks.

The reason why this is done as it is often cheaper to buy fewer stocks, this is one of the reasons why costs are much lower with ETFs. The main drawback of this, is the is some risk that the ETF error, the difference between the benchmark and the ETF might differ. Take our Pepsi and Coke for example, if we only include one, with the thought that they will move in similar directions and make similar returns, what if there is a scandal at Pepsi that Coke capitalise on, or vice versa and we only have one of them in our portfolio. Generally, though, passive ETFs perform well in tracking the index.

The big warning sign with actively managed ETFs is that they often have higher fees compared with index trackers, and again, it is great if the ETF outperforms the benchmark, but this is not always the case.

What is a tracking error?

A tracking error is when the ETF does not exactly replicate the benchmark that is trying to follow. This may generate returns higher or lower than the index, so a tracking error can be positive or negative.

What are the advantages of index tracking (or investing in ETFs)?

One of the main advantages is the diversification benefit. Individual investors are usually long-term investors, we are saving for retirement or a future point in time and do not necessarily need our portfolio to make money this year, but just would like to grow and make money over a number of years.

Investing in an individual stock may make you more money in particular years, but it can also cause greater losses.

How much is invested in ETFs?

Lots of money is invested globally in ETFs, however, most investors still use mutual funds. According to the Investment Company Industry (ICI), in 2019, $4.4 trillion was invested in the US in exchange-traded funds, compared with $21.3 trillion. In the US, approximately 8% of households own ETFs.

What are the key differences between ETFs and Mutual Funds?

  1. You can sell ETFs on the secondary market, just like buying and selling a stock, so when it’s time to cash your money out, it is often easier and more transparent with an ETF?
  2. Investment aims – ETFs often try to mirror the market, while mutual funds try to earn as much as possible (as is well documented, many mutual funds, unfortunately, do not earn more than the market over a prolonged period of time).
  3. Mutual funds generally have a higher minimum investment, making ETFs more accessible to novice investors who would just like to get started.

How can an ETF be traded?

The price of an ETF is traded just like a stock and its price is determined by supply and demand. Therefore it is possible for the price of an ETF to deviate from its fundamental value, substantial deviations are short-lived. One thing with ETFs is that because they are transparent, informed investors know their value, therefore, if an ETF is expensive, it will be quickly sold by professional investors until the price falls back to its true value, and if it is cheap, it will be quickly bought. Investors generally need not worry about ETFs being above or below their fundamental value due to the transparency of ETFs.

When an ETF is traded on the secondary market, i.e. buying or selling an ETF, investors do not need to interact with the ETF directly. So you are just buying the “shares” in the ETF off somebody else who wants to sell them. Do not worry though, the main ETFs have lots of people willing to buy and sell so you can always cash in or cash out at a time that is right for you.

Do only retail investors invest in ETFs?

You may think that it was only retail investors that invested in ETFs, but this is not the case. In recent years more and more banks, institutional investors, and others have seen the advantages and cost-effectiveness of ETFs and these are used as an investment vehicle for all times investors.

What are my other investment options?

Due to the numerous financial assets available to investors, there are a number of options when deciding on how to invest in the stock market. In this short note, we will take a closer look at the types of financial investments that are open to novice and seasoned investors alike.

Mutual funds – is a commonly given name to investment companies, and they are amongst the largest players in the market. Reports from academic literature suggest that in the United States, as an example, assets managed by mutual funds have overtaken $10 trillion.

So investing in a mutual fund, you essentially hand your money over to an investment company, this company use professional asset managers who will allocate your money on your behalf. If these asset managers make a profit, then your investment will go up, if not, your investment will go down.

In simple terms, it is similar to holding stocks, this time the stock is in the mutual fund and the business’s primary activity is to try and make money using various financial assets.

So does this mean that the mutual fund can be risk risky with my money, and are they guaranteed to make profits?

First, as we will always profess, financial markets are dependent upon a number of factors, and whilst there are numerous funds with strong track records, no investment is without risk. Even when it’s professional asset managers behind the asset allocation.  So the short answer to the second part of the question is no, mutual funds are not guaranteed to make money. To answer the first part, the answer is a little bit more complicated. Policies of mutual funds change throughout the world, whilst certain countries have strong regulators who do a better job at protecting investments, others do not. Every mutual fund from a reputable company will have a specified investment policy. These should be studied before you invest and it will describe the fund’s policy and strategies on investing. For example, the risk factors, the investment styles, and strategies, among other things should be included.

To make things even more complicated, there are also ‘management companies’, these companies manage a number of funds and the advantage of this is that investors can receive diversification across a number of funds. In a similar manner to diversifying across stocks, if one fund is performing poorly, there may be some advantage in having investments in a number of funds in the hope that not all will perform poorly. Mutual funds also invest in different types of assets so you are potentially covering more assets across the spectrum of financial investments when diversifying across funds.

What is the downside to Mutual Funds and Management Companies?

The simple answer is fees, generally, the fund works in a way so that they have to make a profit before you see a return on your investment. It is important to find the correct balance between the fees mutual funds charges and the returns you are likely to receive.

If you want to learn more about mutual funds, why not join our ACFI101 course which will have a specific module on how to read and understand the investment policies and strategies of Mutual Funds.

Frequently Asked Questions

How do stock markets work?

Investing in the stock market is essentially investing in companies. Companies are listed on the stock market and when you buy shares you essentially become a part-owner of the company. For large corporations, most retail investors hold a tiny percentage of the company.

The main issue with this and a mistake many novice investors make is that they will invest all of their savings into a small number of companies. However, holding a large portion of your investment pot in a small number of companies is highly risky. Investing in ETFs, what our website advocates for low cost and lower risk investments, diversifies your portfolio. Through ETFs, it is a low-cost way to investing across hundreds of companies at any one time. Then if the average value of the companies within the ETF increases your investment also increases, although they can go down as well.

In the UK, there are over 3000 companies to invest in that are listed. The FTSE 100 is an index of the hundred largest firms listed on the London Stock Exchanges. These companies are not necessarily ‘British’ and it also provides an opportunity for international diversification.

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