Exchange traded funds (ETF) guide

Senior Analyst Rob Lee explains ETF basics

Exchange-traded funds (ETF)

An ETF is an investment vehicle on stock exchanges, they hold assets such as stocks or bonds and is valued approximately at the same price as the net asset value of its underlying assets. Most ETF’s are index tracking and are attractive because of their low cost, tax efficiency and stock like features.

Large institutional investors, authorised participants, actually buy or sells the shares of an ETF to/from the fund manager normally in large blocks for long term investment or more typically as market makers on the open market. Individual investors using retail brokers trade ETF shares on this secondary market.

The ETF offers public investors an interest in a pool of securities and other assets similar to mutual funds although the shares in an ETF can be bought or sold throughout the day like stocks on an exchange through a broker.

Investment uses

ETF’s provide diversification, low costs and tax efficiency of index funds while holding onto the features of ordinary shares. ETF’s can be utilities for long term investment or asset allocation and for frequent trading using market timing investment management.

Low costs are found due to the vehicle not having an actively managed element and because ETF’s are buffered from costs of having to buy and sell securities to accommodate purchases and redemptions of share holders.

Flexibility for buying and selling at current market prices any time of the day, unlike mutual funds and unit trusts, as a publicly traded security their shares can be purchased on margin and sold short enabling hedging, stop orders and limit orders.

Divesification, ETF’s inherently provide exposure across the entire index, industry sector, bond indexes or commodities.

Types of ETF

Index ETF: Attempts to track the index by holding in its portfolio either the contents of the index or a sample of securities in the index.

Commodity ETF (ETC Exchange Traded Commodities): Invest in commodities such as precious metals and futures. Commodity ETF’s are index funds tracking non-securities indexes.

ETC’s trade just like shares, are simple and efficient and provide exposure to an ever-increasing range of commodities and commodity indices, including energy, metals, softs and agriculture. However, it is important for an investor to realize that there are often other factors that affect the price of a commodity ETF that might not be immediately apparent; for example, buyers of an oil ETF such as USO might think that as long as oil goes up, they will profit roughly linearly. What isn’t clear to the non-professional investor is the method by which these funds gain exposure to their underlying commodities. In the case of many commodity funds, they simply roll so-called front-month futures contracts from month to month. This does give exposure to the commodity, but subjects the investor to risks involved in different prices along the term structure, such as a high cost to roll.

Bond ETF’s: Exchange-traded funds that invest in U.S. Government bonds are known as bond ETF’s. They thrive during economic recessions because investors pull their money out of the stock market and into U.S. Treasuries.

Exchange-traded grantor trusts: An exchange-traded grantor trust share represents a direct interest in a static basket of stocks selected from a particular industry.

Leveraged ETF’s: Leveraged exchange-traded funds (LETF’s), or simply leveraged ETF’s, are a special type of ETF that attempt to achieve returns that are more sensitive to market movements than non-leveraged ETF’s.

Tax efficiency

ETF’s in the United Kingdom are protected from capital gains tax by placing them in an individual savings account (ISA) or self-interest personal pension.

Trading

Perhaps the most important benefit of an ETF is the stock-like features offered. Since ETF’s trade on the market, investors can carry out the same types of trades that they can with a stock. For instance, investors can sell short, use a limit order, use a stop-loss order, buy on margin, and invest as much or as little money as they wish (there is no minimum investment requirement).

For example, an investor in a mutual fund can only purchase or sell at the end of the day at the mutual fund’s closing price. This makes stop-loss orders much less useful for mutual funds, and not all brokers even allow them. An ETF is continually priced throughout the day and therefore is not subject to this disadvantage, allowing the user to react to adverse or beneficial market condition on an intraday basis. This stock-like liquidity allows an investor to trade the ETF for cash throughout regular trading hours, and often after-hours on ECN’s (Electronic Communication Network). ETF liquidity varies according to trading volume and liquidity of the underlying securities, but very liquid ETF’s such as SPDR’s (Standard & Poor’s Depositary Receipts tracking the S&P 500) can be traded pre-market and after-hours with reasonably tight spreads. These characteristics can be important for investors concerned with liquidity risk.

Another advantage is that ETF’s, like closed-end funds, are immune from the market timing problems that have plagued open-end mutual funds. In these timing attacks, investors trade in and out of a mutual fund quickly, exploiting minor variances in price in order to profit at the expense of the long-term shareholders. With an ETF (or closed-end fund) such an operation is not possible—the underlying assets of the fund are not affected by its trading on the market.

Investors can profit from the difference in the share values of the underlying assets of the ETF and the trading price of the ETF’s shares. ETF shares will trade at a premium to net asset value when demand is high and at a discount to net asset value when demand is low. In effect, the ETF is providing a system for arbitraging value in the market. As the initial costs are one-off, the ETF vehicle offers some cost advantages over other forms of pooled investment vehicles.