ETFs, or exchange traded funds, offer investors an efficient and cost-effective way to invest in the stock market, and in other asset classes. The first ETF was launched in 1993, but the industry has taken off since 2005 as it has become increasingly apparent that most actively managed funds do not outperform their benchmarks.
These articles take a deep dive into the mechanics of investing in ETFs, the types of ETFs, and the pros and cons of investing in them. We will also look at how to invest in ETF products and some of the best ETF investment strategies to consider.
What are ETFs?
An ETF is a basket of securities that in most cases tracks an index. The funds that hold the securities are themselves listed like stocks. This means you can trade ETFs like stocks, buying and selling them on a stock exchange. Because an ETF tracks an index, the ETF performance will be very close to that of the index it tracks. This means ETFs are passive investment vehicles, unlike mutual funds and hedge funds which aim to outperform a benchmark index. Exchange traded funds allow investors to earn the index return with lower costs than other investment products.
Why investors choose ETFs
Since 1993 over 9,000 ETFs have been launched around the world, giving investors cost-effective access to almost every conceivable combination of indices, asset classes, countries, regions, sectors, industries, market themes, and investment styles. The emergence of quantitative investing has also provided a better framework for financial advisors to create portfolios using passive investing products like index funds and ETFs as the core equity product. A complex portfolio can therefore be constructed using exchange traded funds to achieve specific investing goals.
What’s the difference between ETFs and mutual funds?
While exchange traded funds are listed on exchanges, mutual funds often are not listed and cannot be traded between two parties. A mutual fund is a single investment fund that is unitized to keep track of each investor’s share of the overall portfolio. New units are created when an investment in the funds is made and destroyed when capital is redeemed. All transactions are calculated using the net asset value of the portfolio, which is calculated daily.
Management fees are charged by the management company, which may also charge transaction fees when money is invested or withdrawn. Exchange traded funds are publicly listed on stock exchanges like any other stock. An ETF’s value changes throughout the day, with the price varying according to supply and demand as well as the value of the underlying assets. An ETF valuation is easy to calculate, and they will usually trade very close to that value.
ETF shares are issued by an ETF provider and then sold by a market maker. Passive ETFs are created as demand grows and then sold in the market like any other share.
Types of ETFs
There are now hundreds of types of ETFs available to investors on all major stock exchanges. These are some of the prominent categories:
Index ETFs track the major stock market indices like the S&P 500, Nasdaq, FTSE 100, and Nikkei 225. These initially became popular because these indices were the benchmark indices against which investments were measured. They remain popular because they are the most liquid ETFs around.
Global ETFs tend to focus on developed markets, emerging markets, or all non-US equity markets. A large number of these are exchange traded funds tracking the MSCI indices.
Sector ETFs focus on specific sectors of the economy, such as financials, utilities, or consumer goods. These allow investors to weight their portfolios to the sectors with better fundamentals or better performance.
Thematic ETFs concentrate on specific industries, market trends, and themes. Industry specific ETFs have been launched to invest specifically in A.I. (artificial intelligence), 3D printing, cannabis stocks, blockchain technology, and other topical industries. Other ETFs focus on global issues and the companies providing solutions. Examples include renewable energy, infrastructure, long-term healthcare, and water resources.
Stylistic ETFs follow investment styles like value, momentum, defensive, and dividend investing. Many of these are based on models designed to mimic the performance of successful investors or on evidence-based research.
Bonds ETFs invest in fixed income securities. There are lots of types of bond ETFs based on country, region, maturity, and credit rating. High yield ETFs are popular as they allow investors to earn higher yields, but still diversify across multiple securities.
Commodities ETFs is an exchange-traded fund that seeks to track the price movement of an underlying commodity or index. Commodities ETFs may accomplish this goal directly by holding the physical commodity, or they may track the benchmark asset’s price indirectly by using derivatives, such as futures or options contracts.
Some commodity ETFs are equity-based, which means they invest in companies involved in natural resources or the mining industry. The most popular commodity ETFs, as measured by assets under management, track the price of a single commodity, such as crude oil, gold, silver, or agricultural products, or they track an index representing a basket of many commodities.
Currency ETFs are designed to track the performance of a single currency in the foreign exchange market.
Currency ETFs can add to a portfolio’s currency diversity or can be used as a hedging strategy against the relative value of a particular currency.
Can allow investors to speculate on currency valuations by pairing them against other currencies or a basket of currencies. Unlike foreign currencies, investors can buy currency ETFs through their existing brokerage account without having to make individual currency or derivative trades.
Investors can gain ongoing exposure to the forex market without having to pay the transaction fees involved in buying and selling currencies. Because most aren’t actively managed, the management fees tend to be somewhat low.
Smart beta ETFs track more complex indices that use factors besides market value to weight their holdings. Their goal is to reduce the risk of investing in market cap-weighted indices by using fundamental data to better reflect the true value of companies. They use a combination of metrics like cash flow, turnover, volatility, and dividends to arrive at their allocation.
Multi-asset class ETFs diversify their investments across more than one asset class. They may hold equities, bonds, convertible bonds, preference shares, REITs, or any other ETF. Some of these funds hold investments directly, while others invest in asset class specific ETFs.
Inverse ETFs are constructed to appreciate when an asset price falls and lose value when an asset appreciates. This allows investors to hedge a portfolio or profit in bear markets without having to short-sell any assets.
Leveraged ETFs have gearing of 2 or 3 times, meaning they have exposure to assets worth 2 to 3 times the NAV of the ETF. This magnifies both positive and negative returns.
Volatility ETFs are constructed to track volatility indices. The largest of these, the iPath Series VIX Short-Term Futures ETN tracks the VIX index of S&P 500 option volatilities. These ETFs are used to hedge a portfolio or to speculate on volatility.
How do ETFs work?
Exchange traded funds are issued by ETF providers like BlackRock, Vanguard, and Invesco. Each ETF has a specific mandate which specifies the index the fund tracks and the securities it can hold. As demand increases or decreases, issuers will create or redeem new shares, and buy or sell the underlying securities.
To ensure liquidity, ETF providers allow market makers to make a market in their ETFs. Market makers are authorized to buy and sell ETF shares in the stock market, with some limitations regarding the bid-offer spread they must maintain. They earn a profit by buying at the bid price and selling at the offer price. Some automatic ETF investing programs allow investors to buy ETFs directly from the issuer without trading on the stock market. However, for the most part, investors buy and sell ETFs in the open market, and pay commission to their stockbroker.
ETF issuers charge an annual management fee, which is deducted monthly from the fund, causing the NAV of the ETF to fall slightly each month. Other costs, including administrative fees and operating costs, are also deducted from the fund. This is why annual management fees and expense ratios are slightly different. Interest and dividends accumulate within the fund and are then distributed to shareholders if the mandate dictates.
Advantages of ETF investing
Diversification: ETF investing allows individuals to diversify across asset classes and within an asset class. They make effective asset allocation cost effective and easy for ordinary investors. They also remove the risk and time required to select individual stocks.
Lower fees: Fees can erode investment returns significantly, which is the major advantage of long-term ETF investing. ETFs are far cheaper than mutual funds, and for most individual investors they are also cheaper than owning a portfolio of shares.
Liquidity: Most ETFs are very liquid and do not trade at a discount or premium to their NAV. This lowers the trading costs that many other investment products incur.
Time: A final advantage is the time that can be saved by buying an ETF rather than buying a basket of individual shares. Besides the costs involved, replicating the SPY S&P 500 ETF would require 500 separate trades.
Themes: Exchange traded funds allow both investors and active traders to gain exposure to specific market themes, industries, sectors, regions, countries, and asset classes without the cost and risk associated with buying individual securities.
Tax efficiency: ETF investors only pay tax on the overall capital gains they make when an ETF is sold, rather than on individual trades within the fund. This is more efficient than holding a portfolio of shares or holding mutual funds.
Disadvantages and risks of ETF investing
When it comes to the disadvantages and risks of ETF investing, most of the risks apply to individual funds rather than ETFs in general. However, there are a few drawbacks to the industry as a whole.
No chance of outperformance: ETFs track indices and can therefore never outperform them. This means ETFs can only be used to earn beta (market returns) and not alpha.
Possibility of lower index performance: As more money flows into index funds like ETFs, this may ultimately lead to the indexes themselves generating lower returns. If stocks move up and down within an index, the overall index return may be very low, while ETF investors will miss out on the opportunities available to active investors.
Product specific risks: As is the case with any investment product, there are good ETFs and bad ETFs. Funds that are too concentrated on specific types of shares are prone to bubbles and bear markets. Chasing the best-performing ETFs can also result in buying a basket of overvalued stocks just before they crash.
Another fund specific risk of ETF investing is buying funds that invest in illiquid assets. When liquidity dries up these funds struggle to liquidate positions and doing so puts further pressure on the price of the underlying securities.
Finally, ETFs with high fees may not justify those fees. Most broad market ETFs have very low management fees which are barely noticeable when compared to the average returns of the index being tracked. However, specialist ETFs with higher fees should only be considered if the likely returns justify that fee. When it comes to short-term ETF trading, trading commissions are more of an issue than management fees. Whether or not it’s viable to trade an ETF depends on the commission being paid, the bid offer spread, and how they relate to potential profits.
ETF investing strategies
There are several approaches one can use for ETF investing, and there is a little more to effective investing than simply using historical ETF returns to pick the best ETFs to invest in.
A static-weighted ETF investment strategy is suitable for long-term investors who do not want to spend a lot of time managing their portfolios. With this approach, you would decide on a suitable weight for each type of asset class and invest in one ETF within each asset class. A portfolio could look something like this:
- Developed market equities 40%
- Emerging market equities 20%
- Developed market long-dated bonds 10%
- Emerging market bonds 10%
- Real estate funds 10%
- Short-dated bonds 10%
Once you have picked a suitable ETF for long-term investing for each category, the portfolio is invested accordingly. After that the portfolio would only need to be rebalanced periodically, to bring it back in line with the original allocation. A more active version of the above strategy can be constructed by only holding each ETF when it is trading above its 100 or 200-day moving average and moving to cash if it falls below. This will prevent major losses but may result in slightly lower long-term performance.
A rotational momentum strategy can also be used to trade exchange traded funds more actively. A watchlist of ETFs with exposure to different assets and sectors is first created. Capital is then rotated every month into the two or three top-performing funds over the previous three months. When using this strategy, it’s best to avoid funds invested in speculative sectors or stocks.
ETF value investing entails investing in funds when the market prices of most of an ETF’s holding are well below their intrinsic value. ETF investments can also be made on an ad-hoc basis in funds that have excellent long-term fundamentals and are reasonably priced. Investing small amounts in funds focusing on new and emerging industries like big data, artificial intelligence, or the internet-of-things, offer high potential returns, with limited risk.
Exchange traded funds are now an established part of the investing landscape. They offer a cost-effective method of building diversified portfolios and gaining exposure to a wide range of underlying investments. Investors do however need to be realistic about what can be achieved using ETF investing alone.
Passive funds are an effective way of earning beta, but growing capital faster will still require investing in active funds, hedge funds, and innovative solutions like the Data Intelligence Fund with a long/short strategy based on big data analysis and artificial intelligence or custom portfolios.