Exchange-Traded Funds (ETFs)

Exchange-Traded Funds (ETFs)

I. What are Exchange-Traded Funds (ETFs)?

• Definition: An investment fund designed to track the performance of a specific index, sector, or asset class.
• Trading: Shares of ETFs are bought and sold on stock exchanges, similar to individual stocks or investment trusts.
• Index Tracking: The primary goal of most ETFs is to replicate the performance of a benchmark index (e.g., S&P 500, FTSE 100).
• Open-Ended Structure: Unlike closed-ended investment trusts, ETFs are open-ended funds, meaning the fund size can grow or shrink as investors buy or sell shares.
• Passive Management: ETFs primarily use passive management, which means they follow an investment strategy that aims to match rather than outperform the market.

II. Passive Investment Management in ETFs

• Core Principle: Seeks to match the performance of a broad-based market index.
• No Active Decisions: Portfolio managers do not actively pick stocks or make decisions about which securities to buy or sell.
• Index Mirroring: The fund aims to hold a portfolio that mirrors the composition and weighting of its chosen index.
• Trading Focus: The ETF trades only to maintain alignment with the tracked index.
• Market Capitalisation Weighting: Most index tracker funds are based on market capitalisation-weighted indices, where the largest stocks in the index by market value have the biggest impact on the index value.
• Replication Methods: ETFs seek to track their underlying index using either physical or synthetic replication.

III. Index Replication Methods

1. Physical Replication

• Definition: The ETF directly holds the securities that make up the underlying index.
• Tracking Methods:
  • Full Replication:
    • Holds each constituent security of the tracked index in the same weighting.
    • Most accurate but also most expensive (suitable for large portfolios).
  • Stratified Sampling:
    • Holds a representative sample of securities from each sector of the index.
    • Less expensive than full replication, but is subjective, and potentially encourages bias towards particular stocks.
  • Optimisation:
    • Uses sophisticated computer modeling to find a sample of securities that will closely mimic the characteristics of the tracked index.
    • Lower cost but statistically more complex than full replication

2. Synthetic Replication

• Definition: The ETF enters into a swap agreement with a counterparty to exchange the returns of the tracked index.
• Swap Agreement: The fund manager enters into an over-the-counter (OTC) derivative swap agreement where the returns on the index are exchanged for a cash payment.
• Counterparty Risk: The investor is exposed to counterparty risk, which is the risk that the swap provider may fail to meet their obligations.
• Advantages: Responsibility for tracking the index is passed onto the swap provider, and costs are generally lower than for full replication methods.

IV. Trading and Pricing of ETFs

• Trading Venue: ETFs are bought and sold on stock exchanges through brokers.
• Pricing:
  • ETF share prices generally reflect the value of the fund’s underlying investments.
  • ETFs can trade at a premium or discount to the underlying investments but the difference is usually minimal.
• Investor Returns:
  • Dividends paid by the ETF.
  • Potential for capital gain (or loss) upon sale.

V. ETF Charges

• Bid-Ask Spread:
  • Difference between the price investors pay to buy and the price at which they can sell ETF shares.
  • Generally very small (e.g., 0.1% to 0.2% for an ETF tracking the FTSE 100).
• Annual Management Charge:
  • Deducted from the fund.
  • Typically low (e.g., 0.5% or less).
• Brokerage Commission:
  • Charged by stockbrokers when buying or selling ETF shares.
  • Varies depending on the stockbroker

VI. Advantages of ETFs

• Diversification: Access to a wide range of securities through a single investment.
• Low Costs: Generally lower management fees compared to actively managed funds.
• Transparency: Holdings are usually disclosed daily.
• Liquidity: Can be easily bought and sold on exchanges.
• Tax Efficiency: Can be more tax-efficient than actively managed funds.
• Flexibility: Offers exposure to various asset classes, sectors, and strategies.

VII. Disadvantages of ETFs

• Tracking Error: ETFs may not perfectly track their target index.
• Counterparty Risk (Synthetic Replication): Exposes investors to the risk of swap providers failing to meet their obligations.
• Market Risk: ETFs are subject to market fluctuations and can lose value.
• Limited Active Management: ETFs have no ability to outperform an index, as they simply seek to match it.

VIII. Types of ETFs

• Broad Market ETFs: Track broad market indices like S&P 500 or FTSE 100.
• Sector ETFs: Focus on specific sectors like technology, healthcare, or energy.
• Bond ETFs: Track a specific bond index or segment.
• Commodity ETFs: Track the price of commodities such as gold, oil, or agricultural products.
• Currency ETFs: Track the value of specific currencies or baskets of currencies.
• Factor ETFs: Track specific factors such as value, growth, momentum, or low volatility.
• Thematic ETFs: Track new themes and trends like robotics, or AI.
• Active ETFs: A new type of ETF that seeks to outperform a benchmark index (rather than match).

In Summary

Exchange-Traded Funds (ETFs) are versatile investment vehicles that combine the diversification of a fund with the ease of trading on a stock exchange. They primarily employ passive management to track the performance of specific indices or sectors and use either physical or synthetic replication methods to do so. Their transparency, low fees, and liquidity make them a popular choice for a wide range of investors. However, investors should be aware of the risk that they may not perfectly track the chosen index.