How to invest in etfs
As you may know, an investment fund is an institution that collects money from investors to buy assets that will generate a return if their value increases. By investing high amounts of money, an investment fund is able to keep transaction costs low thanks to economies of scale.
The second main feature of an ETF is that you can trade it on an exchange. Pretty much like listed companies, exchange-traded funds divide their ownership into shares that can be bought and sold on exchanges by placing an order at a broker like BUX Zero.
This feature distinguishes them from other investment funds like mutual funds, making ETFs generally more liquid, which means that you can buy or sell your stake in an ETF more quickly, easily and securely at any time during market hours.
Usually, an ETF invests in a basket of assets from the same class, often by passively replicating an index.
ETFs can invest in any asset class: stocks, bonds, commodities, currencies … you name it. Despite not directly owning the underlying securities, when investing in an ETF you become entitled to receive all the income they generate, be it dividends or interest payments.
Usually, an ETF invests in a basket of assets from the same class, often by passively replicating an index — e.g. the FTSE 100. In that case, fund-management costs will be very low, because the process is highly automatable. Index-tracking ETFs show therefore very low fees compared to actively managed funds, which makes them a great instrument to diversify your investments quickly, easily and cheaply.
How does an ETF work?
An ETF is a basket of assets (stocks, bonds, currencies …) whose ownership is divided into shares that are bought and sold by investors on an exchange.
Its value (called Net Asset Value, or NAV) is equal to the total value of the assets it owns, and it changes constantly with their price. At the same time though, since shares of the ETF are traded on the market themselves, their price will be determined by the interaction between demand and offer for the ETF, not by the value of its underlying assets.
So how can you be sure that the price of an ETF — say, one replicating the S&P 500 index — will track the value of the underlying basket without deviating too much from it?
That is ensured by a continuous mechanism of creation and redemption of ETF shares that involves two different players: the issuer of the fund, also called sponsor or fund manager, and a group of large institutional investors called “authorized participants”, who are often market makers.
It works like this:
Every day, the issuer publishes the list of securities that the fund needs to own together with the relative weights they need to have in order to replicate the index it is tracking. This is called a “creation basket”.
Once they have this information, authorized participants collect the stocks listed in the creation basket at the required percentages, either by buying them or by drawing them from those they hold in their inventory. They then deliver this basket of stocks to the issuer in exchange for newly created shares of the ETF, which they can sell on the market to individual investors.
This process also works the other way around: authorized participants can also sell ETFs to the issuer in exchange for a corresponding quantity of underlying securities. This is called a “redemption basket”.
Therefore, unlike stocks, ETF shares are not listed through an initial public offering. Instead, they are created and redeemed on a daily basis via this mechanism.
The symbiotic mechanism between issuer and authorized participants ensures that the ETF price doesn’t diverge too much from the portfolio it is tracking.
But why do authorized participants partake in this process? What do they earn from it?
Well, as we said at the beginning, the price of the ETF and that of the underlying basket can differ because they are driven by different forces. When the ETF price rises too much compared to the underlying portfolio, authorized participants can make a profit by buying the underlying assets, exchanging them for new ETFs with the issuer, and selling those ETFs on the market. That increases the price of the underlying portfolio while decreasing the price of the ETF, making them meet again.
This mechanism, called arbitrage, works the other way around as well: when the ETF is undervalued compared to the underlying portfolio, authorized participants can make money by buying the ETF, redeeming it in exchange for the underlying stocks, and selling these on the market.
This symbiotic mechanism between issuer and authorized participants ensures that the ETF price doesn’t diverge too much from the portfolio it is tracking.
Types of ETF
There are many kinds of ETFs, different in terms of investment strategy, asset class, geographical focus and other features. Here we look at the most important ones.
A first basic distinction can be made between active and passive funds.
Active ETFs are actively run by fund managers, who pick the assets they reckon will perform best with the aim of beating a certain benchmark. These funds tend to have higher fees compared to passive ETFs, and research shows that only a minority of them actually manages to beat the market over the long run. They are therefore way less popular than passive ETFs and make up a fraction of the total ETF market.
Passive ETFs instead are funds that passively replicate an index (of any asset class), which is why they are also referred to as index trackers. Since their replication process doesn’t need any human decision making, passive ETFs have lower fund-management costs and therefore lower fees than active funds. That makes them a great instrument to diversify one’s investments easily and cheaply, and is the main driver of their popularity among investors. Since they represent the vast majority of ETFs out there, we’ll focus on them from here on.
Passive ETFs can be categorized by asset class. Here the most common ones:
- Equity ETFs: funds designed to track a particular stock index like the S&P 500 or the DAX. They can be focusing on a specific sector, industry, market cap, geographical area or on other features (dividends, growth …). Therefore, next to ETFs with broad exposure like those tracking the MSCI World index, you’ll find funds investing only in a particular subset of shares like healthcare stocks from Europe for example.
- Fixed-income ETFs: funds built to provide exposure to bonds of any kind. They can track broad bond indices like the Bloomberg Barclays US Aggregate Bond Index or focus on specific types of fixed-income assets like government bonds, corporate bonds (also from a single sector), municipal bonds, or a mix of these. They often invest in assets with a specific maturity — short, mid or long term, a specific credit rating and from a specific geographical area.
- Commodity ETFs: funds that track the price of a commodity (such as gold, oil or natural gas), or of a basket of commodities. In the case of precious metals, the fund can hold the underlying assets physically by storing them in a vault, while in all other cases it will have to gain exposure to their price variations by buying future contracts.
- Currency ETFs: funds designed to invest in a specific currency or baskets of currencies.
These were the most common types of ETFs you can find on the market. They are more than enough to build well-diversified, long-term portfolios for investors with any kind of risk/reward preferences. However, there are also some other more complex funds providing exposure to more sophisticated strategies.
- Alternatives ETFs: funds designed to allow investors to trade particular strategies (like long/short equity, currency carry or equity market neutral), trade volatility or hedge against inflation.
- Inverse ETFs: funds that enable you to profit from a decline in a certain index or asset.
- Leveraged ETFs: funds that allow you to invest in a basket of assets with leverage.
Pros and cons of ETFs
Compared to other investment tools like mutual funds or stocks, ETFs show several specific perks that are at the basis of their growing popularity among retail investors. On the other hand, they also feature some risks that you should be aware of.
Pros of ETFs:
- Accessibility: the minimum investment can be lower than 10 euros.
- Broad exposure: they provide exposure to tens, hundreds or even thousands of different securities, allowing for a degree of diversification otherwise very expensive to obtain.
- Cost-effectiveness: passive ETFs in particular charge very low fees thanks to low managing costs and economies of scale.
- Simplicity: you can trade them as easily as you trade stocks throughout trading hours with an app like BUX Zero.
- Transparency: ETFs are required to publish their holdings daily, while their market price is constantly updated and made available to the public.
Cons of ETFs:
- Tracking error: although ETFs usually manage to track their underlying index quite well, technical issues or disruptions in the creation and redemption mechanism can generate discrepancies.
- Fund closure risk: if the fund closes, investors can be negatively affected in fiscal terms because the closure could force them to realize gains, creating a tax event for them. Plus, they’ll have to find a new way to invest that money.
- Counterparty risk: depending on their replication mechanism, some funds could bear this kind of risk. ETFs can replicate the underlying index in different ways, the most common ones being full replication, sampling and synthetic replication:
- Full replication: the ETF replicates the index 1:1.
- Sampling: the ETF holds only a selection of the securities in the index.
- Synthetic replication: the ETF replicates the index by using a financial derivative. A fund like this has some level of counterparty risk because it doesn’t own the underlying securities.
- Possible risk of illiquidity: ETFs investing in illiquid instruments, like high-yield corporate bonds or leveraged loans, can become illiquid themselves in times of market stress, turning out difficult to sell timely and at a convenient spread.