ETFs (Exchange-Traded Funds) are financial products designed to track an index like the S&P 500, a stock market index tracking the stock performance of 500 large companies listed on exchanges in the United States. It’s a basket of securities you can buy or sell through a brokerage account.
How Do ETFs Work?
To accomplish their objective, ETFs must get exposure to the index through physical or synthetic replication. The physical replication involves buying the underlying assets present in the Index. Using the S&P 500 as an example, it would involve buying a small piece of each of the 500 companies.
However, some ETF providers use an “Optimized sampling” because some stocks have a low market capitalisation. So, instead of buying 500 stocks, it buys 400 stocks, for instance. This is done so that the replication is not affected (low tracking error).
Synthetic replication involves using swaps to get the same exposure without actually owning the underlying assets. The number of ETFs using this format is relatively low; one of the few advantages comes from lower costs.
Are ETFs Only for Experienced Investors?
Not at all! Actually, it is the other way around (they’re designed for the everyday investor as well). ETFs are very simple: you get market exposure in exchange for a very small annual fee.
There is no need to worry about anything since the ETF will automatically adjust according to the new index constituents (there is rebalancing). Besides, you have a +80% chance of beating most active funds (professionally managed) in the long run.
How Do ETFs Differ From Mutual Funds and Index Funds?
An ETF can be traded intraday. So, you can buy or sell at any second during market hours. The mutual funds’ closed-ended format behaves exactly the same (you can trade intraday), but it is actively managed, whereas most ETFs aren’t. Besides, you have an opened-ended format for mutual funds where you still have active managers, but you can only subscribe or redeem the fund once a day.
Finally, the index funds are similar to ETFs because of their index tracking (passive approach) but act the same as opened-ended mutual funds since you can only “trade” them once daily.
What are the Differences Between Passive and Active ETFs?
Passive ETFs limit themselves to replicating any index (no intervention, no decision making), while an active ETF involves having a portfolio manager (or a team of people) making decisions on how to allocate the ETF (over or underweight certain sectors, industries or geographies)
What Pitfalls Should Beginners (and Experts) Watch Out for When Investing in ETFs?
On an ETF, I would watch out for five things:
- Assets Under Management (AUM) being higher than $100 million, because it decreases the likelihood of it being liquidated. It may result in a taxable event and you will need to find another ETF.
- Fees. Find the index you want to track and look for the ETF with the lowest TER (Total Expense Ratio). The cheaper, the higher the expected returns.
- Distinguish between price and NAV (Net asset value). Look at an ETF as a “package” traded in the market with a price (market price). Sometimes, the market price of the package may deviate from what is inside the package (known as NAV). Market makers and Authorised Participants will not allow these values to deviate a lot because they profit from this arbitrage opportunity. Still, you should know that momentarily that can happen.
- Be careful with leveraged ETFs. These are complex investment products that are generally used by more experienced investors since these can amplify both the returns as well as the losses of your investments.
- Finally, you should look for a regulated low-cost broker to invest in ETFs through a broker comparison tool. This one is not directly related, but it can help you save huge amounts of money over time. You probably will invest every month and be charged a commission each time you place an order will harm and delay your investment goals.
About the Author:
Franklin Silva is a CFA Level III Candidate with 3 years of experience in Wealth Management as a Fund Research Analyst and the Host of the “Edge Over Hedge” YouTube Channel.