ETFs

UNDERSTAND THE ESSENTIALS FOR INVESTMENT

What is an ETF?

An ETF, or Exchange Traded Fund, is basically a type of fund that owns certain assets – these assets may include stocks, bonds, commodities, or futures. The ownership of the fund is then divided into shares that are traded on stock exchanges. As with any tradable shares, investors can buy and sell ETFs via stock exchanges during trading hours. Like a stock, each ETF has a ticker symbol and a price that changes in real-time.

So how does it work in practice?

There are two different kinds of ETFs:

Physical exposure (or fully replicating)

Essentially this kind of ETF attempts to track an index by buying the underlying assets of the index with the same weight as in the index, in order to mirror its rise and fall. For example, if you invest in an S&P 500 ETF, you own each of the 500 securities represented in the S&P 500 Index. Note – If the ETF provider only invests in a selection of the assets, this is called sampling.

Synthetic (or swap based)

Like a physical ETF, a synthetic ETF is designed to track a particular index. However, instead of physically holding each of the securities in the index, a synthetic ETF relies on derivatives such as swaps to execute its investment strategy. These derivative vehicles are agreements between the ETF and a counterparty—usually an investment bank—to pay the ETF the return of its index. In essence, a synthetic ETF can track an index without actually owning any of its securities. The synthetic ETFs can be a good option for harder-ta-access markets or less liquid benchmarks that would otherwise be very costly and difficult for a physical ETF to track.

Why do investors like ETFs?

So what are the advantages with investing in ETFs? Here a few reasons why investors like ETFs:

  • Diversification – compared to investing in single stocks, an ETF can give you exposure to a group of stocks, market segments or styles.
  • Lower fees – mutual funds can also give you diversification, but since ETFs are not actively managed they usually come at a lower cost.
  • Trades on an exchange – ETFs trade at a price that is updated throughout the day. An open-ended mutual fund, on the other hand, is priced at the end of the day at the net asset value.

 

So in general ETFs provide an inexpensive, transparent and convenient way to get access to many different asset classes. And this can be a good thing for ensuring diversification across your investment portfolio.

But there are some aspects to think about before investing. The first one is the price of buying and selling an ETF. An ETF has two prices, a bid and an ask. The ask price is what you will pay for the shares and the bid price is the price at where you can sell the shares. Due to the fact that ETFs trade on a stock exchange the level of liquidity in different ETFs can vary widely. For thinly traded ETFs the bid/ask spreads (i.e. price for buying and selling) can be quite wide. Furthermore, you should also be aware of the term tracking error when investing in ETFs. The difference between the returns of the index fund and the target index is known as a fund’s tracking error. So for an ETF you want the tracking error to be as low as possible. But this is not as easy as it might sound like, and many ETFs stray away from their intended index.

 

Getting started with ETFs

If you are thinking about including ETFs in your investment portfolio, it may be worth looking at some of the bigger ETF providers to understand the type of products and strategies in the market. The top five by AUM being:

 

ETFs for Responsible Investors?

Today there is a relatively wide range of ETFs available that consider or reflect sustainability strategies or priorities. In particular, we are now seeing the development of more thematically focused ‘sustainable ETFs’.  A few examples of some of the bigger themed based ETFs according to AUM are Invesco Water Resources ETF, SPDR S&P North American Natural Resources ETF and Invesco Solar ETF. That said, most sustainable ETFs follow one of the following investment strategies in order to gain the sustainability label:

Negative/exclusionary screening
the exclusion from a fund or portfolio of certain sectors, companies or practices based on specific ESG criteria.*

For example, the MSCI Global Socially Responsible Indices exclude companies involved in the following:

  • Alcohol
  • Gambling
  • Tobacco
  • Military Weapons
  • Civilian Firearms
  • Nuclear Power
  • Adult Entertainment
  • Genetically Modified Organisms (GMO)
Positive/best-in-class screening
investment in sectors, companies or projects selected for positive ESG performance relative to industry peers SG integration*

Companies scoring highly on Environmental, Social, and Governance, or ESG, concerns are given a higher weight in the index. For instance, Company A will receive a relatively higher weight than Company B if Company A’s ESG score is higher than Company’s B.

* Definition according to GSI-Alliance – View their PDF

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