What are Exchange Traded Funds (ETFs) ?
ETFs are investment funds which can be traded throughout the day on the main stock exchanges such as those in New York, Toronto, and London (UK).
ETFs are much like mutual funds but you can buy or sell them directly via your stockbroker, just like stocks.
You can log into your online stockbroking account and transact at the prices shown, which are quoted throughout trading hours.
Unlike when you buy or sell mutual funds, you don't have to contact the manager.
ETFs do not charge front-end or back-end fees and usually charge just an very low annual fee.
Due to their low cost and variety, ETFs are revolutionizing the investment market.
ETFs hold assets such as stocks, bonds, commodities and currencies throughout the world and are not limited to one market.
An ETF can invest in large US companies, another ETF in Canadian resources, yet another in gold, silver or oil.
Most ETFs invest according to an index, such as the S&P 500 Index, which consists of the largest 500 companies in the US weighted according to their capitalization.
Similarly, you can invest in an ETF which invests in major non-US developed companies in Canada, Europe, Asia and elsewhere.
ETFs publish their most recent portfolios on their websites. At any point in time, you would know what stocks or other assets the ETF holds in its portfolio. You therefore know exactly what you are going to invest in.
With a mutual fund, in contrast, you have to wait for the manager to issue its report.
ETFs are offered by the biggest and most renowned financial companies such as BlackRock, BMO, Claymore, Fidelity, State Street, and Vanguard.
ETFs are regulated and scrutinized.
This does not mean you cannot make losses by investing in ETFs or that it is a 100% guarantee that nothing can go wrong!
Regulation and monitoring by a major stock exchange, however, serves to reduce various kinds of risks as well as add liquidity.
ETFs are very popular and are likely to be around for years to come – in the US, ETFs had $ 1.7 trillion in assets at the end of 2013, 72% of total world assets in ETFs. Importantly, ETFs keep attracting investors and are showing impressive growth rates. By mid-2015, world assets in ETFs were approaching $3 trillion.
While the more is perhaps the merrier, with ETFs size does matter! The bigger the fund and the longer the track record, the lower fees are likely to be - both the management fees on pays annually as well as the bid/offer spreads on the stock exchange.
ETFalpha chooses ETFs on the basis of size, track record, and assets represented.
An ETF can be dedicated to a particular industry, such as health care, industrial companies, or utilities.
There are ETFs which go by investment strategy or take on only stocks of a particular type. Popular ETFs of this kind invest in value stocks, sector-rotation funds, and high dividend funds.
ETFs make possible diversification across geographical regions, stocks, bonds, commodities and currencies.
Within geographical regions, say the United States, one can choose to invest in an ETF shadowing a particular sector. One can also follow a particular industry sector on a global basis. When you buy an ETF which follows an index, you are often buying into the stocks or other asset mix making up that index thus getting instant and wide diversification.
Stocks in one market tend to move together – “the tide lifts all ships”, as the saying goes – but if you invest in different ETFs each of which represents a different asset class, as we do in ETFalpha, then each of these ETFs tends to have its own cycle. This means that we can pick and choose those ETFs which are likely to increase in value and get out of those that are likely to fall.
However, in extreme cases, such as at the depths of the financial crisis, even ETFs covering very different markets fell together. The high degree of correlation and the breadth of the falls baffled many experts. Such falls rarely happen but it is important that you keep such possibilities in mind when investing.
Most ETFs have low costs and fees. There are no front-end or back-end loads (charges)and management fees are usually 0.25% to 0.75% annually. Of course, you have to pay your stockbrokers' commissions but these are now often less than $10 per trade. There is also the usual bid/offer spread but with the popular ETFs which we use at ETFalpha, this spread is usually of a few cents.
The ETFs we use are very liquid.
There is usually substantial trading in the underlying stocks and in the ETFs themselves, especially the mainstream ones, those with a good track record, and those which hold substantial assets.
Part of the reason why ETFs have such low costs is that they usually just include the stocks which make up a particular index or which satisfy certain criteria. These are "passive" ETFs - they take what there is.
Recently, however, "active" or "actively managed" ETFs are being offered which try to improve on returns. Active ETFs are new, have a short record, and their performance varies a lot.
Another recent development is to issue the same ETF in two classes - one class would be a traditional ETF with low fees but the second one would carry higher charges so that your advisor gets a fee. There is nothing wrong with this as long as the issuer clearly identifies the respective ETFs and your advisor, if you have one, tells you about the fee.
Certain ETFs are rather exotic.
A leveraged ETF multiplies the daily movement of the asset class it invests in. If the securities in the asset class go up by 1%, then a 2-times leveraged ETF will go up by 2%. If the securities go down, of course, the ETF will double the fall. Leveraged ETFs usually deliver what they promise quite well over the short-term, but not so well over the medium- and long-term.
Inverse ETFs go down when the market they invest in goes up, and vice-versa. Again, they perform better in the short-term than over longer periods.
Thus you can short a market by investing (i.e. going long) in an Inverse ETF. For example, if you think the Dow Jones Industrial Average will fall, you can buy the ProShares Short Dow30 ETF (DOG). If the DJIA actually falls, DOG will rise. If you are wrong and the DJIA rises, DOG will fall.
Exchange Traded Notes (ETNs) are said to be similar to ETFs but, in fact, are very different. The names are alike and can be confusing, especially to newcomers.
While ETNs track the same indices tracked by ETFs, when you buy an ETN you are not buying units or shares in the trust or company owning the portfolio of underlying securities. You are only buying an obligation of the issuer and your investment is only as good as the credit of the issuer.
ETFalpha does not use ETNs.
Where did Exchange Traded Funds come from? How did ETFs develop?
It is said that the first investment fund appeared in the Netherlands, developed by a merchant called Adriaan van Ketwich around 1774. He called the fund Eendragt Maakt Magt, which means “unity creates strength”.
King William I liked the idea and launched his own funds in 1822. Later, investment funds appeared in Scotland, Switzerland, other parts of Great Britain, France, and eventually the United States towards the end of the 1800s.
Basically, therefore, the investment fund was an idea that spread quickly and very widely in less than 100 years, not least because of its great intuitive appeal.
An investment fund pools investors’ money and invest the money in securities, be they stocks, bonds, or other financial instruments.
The general name for investment funds is Collective Investment Funds – this term indicates that the fund not only contains investments but that the money has been raised from various investors, the “collective” body of investors. The investors can be individuals or institutions.
Why do collective investment funds make such intuitive sense?
There are many reasons, but a few stand out. Collective investment funds enable an individual investor to invest even small amounts of money. This small amount, however, will benefit from exposure to the hundreds of securities within the fund.
This usually provides two main benefits: first, the investor will benefit from very wide diversification, and second, the securities can be professionally managed or formed to shadow a popular stock index, such as the S&P 500.
Diversification, as we know, is the cheapest, and probably best, insurance you can get for your investment portfolio. At ETFalpha we diversify big!
If you look at certain investment newsletter rankings you will often notice that these newsletters come from all over the world. Interestingly, some of them come from very small islands, often in the Caribbean. The reason for this is that there are two types of collective investment funds: onshore investment funds and offshore investment funds. Both manage big amounts of assets and both are important.
While onshore investment funds are often registered and listed in one of the larger countries with developed financial markets, such as the United States, Canada, the United Kingdom, Germany, and France, the other offshore investment funds are registered in small countries, often islands, which give investors various tax or other cost benefits.
The latter offshore investment funds often invest in the same stocks and securities which their onshore brethren do but for financial or tax planning purposes, their investors chose to go through an offshore jurisdiction.
More and more, exchange traded funds are starting to dominate investment leagues, such investment newsletter rankings, because ETFs have three main advantages over other collective investment funds.
First, you do not need to apply to the manager of the fund to invest in an ETF. You just log into your online stockbroking platform (or call your stockbroker) and buy or sell an ETF just as you would a normal stock, say Coca Cola or PepsiCo.
Second, for the authorities to allow a fund to trade on the click of a mouse, they ensure that ETFs are fully transparent – investors know how an ETF invests and what securities it holds at any one time. This transparency simplified the structure and investment process of ETFs and led to very drastic reductions in costs.
ETFs usually charge much lower management expenses than do other investment funds, such as mutual funds, and there are no entry or exit fees. Furthermore, although like all other stocks traded on a stock exchange ETFs have a small bid-offer spread, this spread is often measured in pennies if the ETF is a big one.
Third, the fund in an ETF is not closed to new investors but is open: as new investors buy a particular ETF, more units of the ETF are created. Conversely, as investors sell, the ETF shrinks.
Many of the original collective investment funds were so-called Closed Funds. Once a closed fund issues shares to investors and collects money, the size of the fund is limited to that original amount of money collected. With Open Funds, however, money from new investors can flow into the fund at any time and divesting investors can take their money out.
The most popular form of open collective investment fund is the mutual fund. Mutual funds reached their peak popularity in the 1980s and 1990s but recently ETFs have been making huge inroads into the market albeit mutual funds are still popular.
If you are still in doubt or have any difficulties, please contact us.