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ETFs: what they are and how they work

October 24, 2022

10 min

ETFs: what they are and how they work
Intermediate

What are Exchange Traded Funds (ETFs)? They are special financial instruments, because they encapsulate other assets and products, ‘copying’ their trends and performances. Let’s find out how they work and what their advantages are, taking into consideration the differences compared to other ETPs and simple mutual funds.

ETFs: what they are and how they work

An investment portfolio can be composed of various financial instruments, each with its own returns and risks. In this respect, buying stocks, bonds or government securities allows direct exposure to an economic actor (government or corporate). Diversification is the golden rule for investing: buying stocks (shares) of a single company does not protect your capital, because profits and losses will depend on that economic actor alone. Similarly, investing in corporate bonds (debentures) of only one company does not mitigate the risk of default: you could lose the entire loan if the only debtor goes bankrupt. 

However, diversifying between several stocks and/or bonds, or adding commodities and derivatives to your portfolio in order to moderate the risk of your investment requires a great deal of capital, in-depth study and constant attention. Is there a financial instrument that already considers the market as a whole, or at least one sector? This is the case with Exchange Traded Funds (ETFs), instruments that, in their most common form, passively replicate the performance of indices. They act as benchmarks, composed of securities of the same type, not just shares or bonds. Let’s delve deeper into what ETFs are, so that we can discover their characteristics and advantages.

Market index or Benchmark

A market (or stock market) index is a basket of financial instruments consisting of different percentages of securities. The S&P500 index, for example, represents the 500 largest publicly traded US companies by averaging the returns of their shares.

The definition of an ETF can be explained in a simple way. Imagine an ETF as a box in which we put the same financial securities as an index. The value of an ETF then reflects what it contains, reproducing the overall performance of the assets. Investing in ETFs is simple: you buy and sell shares in the fund, whose base price is determined by the weighted average of the values of the individual financial instruments that make up the ETF. This value is called the Net Asset Value (NAV) and can fluctuate due to the performance of the individual underlying assets. Moreover, in the market, the price of an ETF varies according to supply and demand and may therefore deviate from the NAV.

The difference between ETFs and ETCs

A passively managed ETF does not try to ‘beat the market’, but rather to faithfully copy the trends of the benchmark. The guiding index may consist of individual stocks or bonds, commodities or the real estate market. However, ETFs are not the only ‘replicating‘ financial instruments. Exchange Traded Funds are part of the ETP (Exchange Traded Product) family, along with Exchange Traded Notes (ETNs) and Exchange Traded Commodities (ETCs). All types of ETPs are exchange traded, but there is a difference between ETFs, ETCs and ETNs.

ETNs and ETCs are not funds but debt notes: bonds issued by special purpose vehicles, which use the capital raised to invest in reference indices. Management is always passive, because the debtors only hold the underlying securities. Those who own ETNs and ETCs do not participate in a fund, but provide credit. In other words, the investor lends money to a company in exchange for financial products that they replicate:

  • The value of a basket of commodities in the case of ETCs;
  • The performance of all other types of instruments (shares, bonds, etc.) in the case of ETNs.

ETNs and ETCs behave like zero-coupon bonds, in that they generate profit from the sale or repayment of principal at maturity. In this case, investors may expose themselves to the risk of default of the borrower who issued the ETN or ETC: why then prefer them to ETFs? Basically because ETNs and ETCs can use strategies that cannot be integrated into ETFs; for example, with ETNs and ETCs it is possible to trade with leverage greater than double (x2).

Moreover, ETNs are traditional finance’s first solution for gaining exposure to cryptocurrencies without actually owning them or having to create a crypto wallet. Stringent regulation long prevented ETFs from encompassing cryptocurrencies, until the SEC and the Italian stock exchange began accepting the first Bitcoin ETFs!

The difference between funds and ETFs

A basic ETF is a fund that pools capital from various investors, but it is not synonymous with a mutual fund: what is the difference? We said that a passively managed ETF is an instrument that reproduces the performance of an index. This is because those who invest in this type of ETFs participate in a fund that merely holds securities or swaps contracts as we shall see, without selling or buying them in search of profit.

Fun Fact

The first ETF was launched in 1993 on the American Stock Exchange: initially called tracker, its objective was to replicate the S&P500 index. In Italy they have been traded since 2002 on the ETFplus market section. 

Passive management is therefore the main difference between mutual funds and ETFs. Traditional funds seek to outperform the reference index. Investors’ money is considered as a single capital and used to buy and sell securities, actively exploiting the best bargains on the market. Moreover, ETFs can be traded freely, during the opening hours of the stock exchange, while entries (purchase) and exits (liquidation) from an investment fund are limited to a few moments. Finally, the value of a mutual fund is declared only once a day, whereas the market price of an ETF can always be monitored.

Memo

There are also actively managed ETFs, which are newer and less common than passively managed ETFs. These funds adopt more complex investment strategies, which do not simply replicate a benchmark index but instead seek to outperform it. The best performance would come from selecting specific securities from the index, then actively selling and buying them in order to anticipate or react to market changes and earn higher profits. This article, for simplicity’s sake, will discuss only passively managed ETFs.

In the next section we will elaborate on the accessibility and cost benefits that this difference between funds and ETFs entails, as well as the other advantages that investing in ETFs might provide.

Investing in ETFs: advantages and types

An ETF portfolio has the natural advantage of being diversified, considering several financial instruments are held at the same time. Individual equity and bond ETFs can be further differentiated.

Equity ETFs, for example, are distinguished by:

  • Sector – they are exposed to a specific ‘market segment’, e.g. related to technology, healthcare, telecommunications or transport;
  • Country or macro geographical region – North America, Europe, emerging markets, there are also so-called World ETFs, which take the world economy into account;
  • Investment style – they can replicate indices of high dividend stocks, fast-growing stocks, or highly speculative stocks such as leveraged short ETFs.

Bond ETFs, on the other hand, replicate indices based on:

  • Rating – the borrower’s degree of reliability or creditworthiness, i.e. the likelihood that the credit will be repaid (AAA, BBB upwards, etc.);
  • Type of bond – such as zero coupons or convertibles;
  • Sector: government or corporate bonds, with further variability within the two groups;
  • Maturity of the underlying bonds – at 3 years, 5, 10, over 20.

Finally, commodity ETFs can be divided between:

  • Precious metals – gold silver and platinum;
  • Energy commodities: there are natural gas ETFs, oil ETFs, or even for renewable energy;
  • Agricultural products: sugar, coffee, wheat, but also live cattle.

Memo

Equity and bond ETFs can be qualified as either distribution or accumulation. Distribution ETFs give investors back the dividends and coupons accrued by the companies belonging to the index. Accumulation ETFs, on the other hand, reinvest the capital generated, which is why they are also called compound-interest ETFs.

Furthermore, any type of passively managed ETF has a precise type of index replication: full replication ETFs consider all the stocks that make up the benchmark, reproducing exactly the performance of the index. Optimised replication ETFs, on the other hand, are composed of only the largest companies in the benchmark, so the replication of the performance is not as accurate.

To choose between the two ETFs, you should consider the management costs: optimised replication has lower prices, because it manages fewer securities. In this respect, the costs of investing in ETFs are the second advantage of the product. Passive management lowers fees to a few percentage points, compared to, for instance, actively administered funds.

Another advantage of ETFs is transparency, as investors can monitor any aspect of the instrument: type of replication, risk and return, fund composition. In this respect, we can recognise a difference between physical ETFs and synthetic ETFs: the companies issuing the first type of ETF actually hold the securities belonging to the reference index, i.e. physical ETFs actually buy stocks and bonds. Synthetic ETFs, on the other hand, are composed of derivative instruments that replicate the benchmark; in particular, they enter into swap contracts with other financial institutions and banks. This exposes the ETF to counterparty risk, because the issuers of the derivatives may not honour the contract, but this is only a special case. In general, investors in ETFs are guaranteed a return of capital, as we have seen in the difference with ETNs.

Finally, the biggest advantage of ETFs is their simplicity, both in operation and in access to instruments. Now that we understand what ETFs are, we know that their purpose is to replicate the performance of an index. Moreover, shares in an ETF can be purchased directly on the stock exchange and freely traded.

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