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 really taken off since 2005 as it has become increasingly apparent that most actively managed funds do not outperform their benchmarks.
This article takes 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?
- Why investors choose ETFs
- What’s the difference between ETFs and mutual funds?
- Types of ETFs
- How do ETFs work?
- Advantages of ETFs
- Disadvantages and risks of ETFs
- ETF investing strategies
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
Over the past few decades it has become evident that the vast majority of actively managed funds don’t outperform their benchmark. Research also highlighted the impact of fees on the long-term performance of investment portfolios. It therefore became apparent that investors are better off earning the returns of the index if they can pay a lower fee.
Since 1993 over 5,000 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 which 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 a 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, who 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:
Headline 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 on 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.
Commodity ETFs invest in specific commodities like gold, silver and oil. Some invest in the actual commodities, while others hold shares of companies that produce them. For example, if you decide to make a gold ETF investment you could invest in the SPDR Gold Trust which tracks the gold price, or the VanEck Vectors Gold Miners ETF which holds shares in gold producing companies.
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.
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.
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.
Finally, 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.
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 they 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 authorised 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
The following are some of the major advantages of ETF investing:
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.
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.
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.
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.
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.
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.
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, it’s possible that this will 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 justifies that fee. When it comes to short term ETF trading, trading commissions are more of an issue than managements 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 portfolio. 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 on a monthly basis 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 adhoc basis in funds that have excellent long-term fundamentals and are reasonably priced. Investing small amounts in funds focussed on new and emerging industries like big data, artificial intelligence or the internet-of-things, offer high potential returns, with limited risk.
Conclusion: ETF investing as effective way of earning beta
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 on 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, innovative solutions like the Data Intelligence Fund with a long / short strategy based on big data analysis and artificial intelligence or custom portfolios.