ETFs: The complete picture
Exchange-Traded Funds have been a hot topic in the financial press for several years now, primarily due to their rapid growth and the impressive performance of various ETFs. This article will look at some of the more popular misconceptions about ETFs and explain why there is a lot more to them than meets the eye.
How do ETFs work?
The first myth concerning Exchange Traded Funds is that they are investment funds that trade during regular stock market hours on an exchange like a stock or share. Most ETFs seek to provide their investors with either exposure to asset classes such as commodities or indices, while others track specific countries or sectors of the economy.
These ETFs typically hold assets such as bonds, stocks, commodities or other financial instruments and do not directly trade on stock exchanges. Instead, the ETF issuer will try to replicate the performance of a specific index or asset by investing in that market or sector themselves. The fund manager controls the replication process within strict guidelines set out by the ETF’s prospectus.
What is the purpose of an ETF?
The purpose of an Exchange Traded Fund is actually to replicate its assets as closely as possible through a system known as creation/redemption, which works like this. When an ETF investor wants to buy units of a fund, they pay a premium over the value of those units; this allows the managers of an ETF to create new units and sell them to investors for profit.
Conversely, if an investor wishes to redeem their units for cash from an investment fund, the managers must first sell their assets and then return them to the investor. This process prevents an Exchange Traded Fund from being declared insolvent. It is technically impossible for a fund manager to run out of money if they have enough assets that back up their units.
The SPDR Gold Trust
Another common misconception about Exchange Traded Funds is that investors can buy shares in them on a stock exchange, bypassing any brokerage fees associated with buying individual stocks or bonds.
Only one ETF trades directly on a primary stock market – The SPDR Gold Trust – which allows investors to trade gold bullion without paying storage costs or broker’s commissions. However, new versions of this ETF have been launched, which track other commodities such as silver and oil, but they are traded over-the-counter in the same way as individual commodities.
ETFs trade like shares on exchanges
Most ETFs can only be bought from investment firms, and investors will typically have to pay a brokerage fee when they buy or sell them, just as they would any other type of investment. It is also important to note that because ETFs trade like shares on exchanges, their prices may deviate slightly from the underlying assets they represent due to market forces.
It means that an investor who buys a share in a fund that tracks the S&P/ASX 200 index by paying $2 per unit will not necessarily gain exactly 2% return if the ASX200 rises by 2%. The value of each ETF unit is based on its net asset value (NAV), which considers the fund’s holdings, accrued dividends and any deductions for other fees.
ETFs are passively managed
Another big difference between Exchange Traded Funds and traditional managed funds is that ETFs are passively managed, meaning their managers only have to buy assets that replicate an index or benchmark. It makes it much easier for ETF managers to track market changes and outperform actively managed funds over time because they do not have the added expense of personnel required by active fund managers.
ETFs are traded on exchanges
Finally, it should be remembered that Exchange Traded Funds are traded on exchanges just like stocks, so their prices will fluctuate throughout the day as investors buy or sell them. It means that an investor could potentially gain exposure to a particular asset class through an Exchange Traded Fund without actually owning that asset, which is cheaper and easier than investing in the physical product or derivative.