An ETF (Exchanged traded fund) is an exchange-traded fund that invests in specific groups of assets. The mechanism of ETFs is quite simple. The company (the ETF issuer) holds a certain asset (for example, shares of an index or gold) and issues securities on this asset. Their price dynamics depend on the price dynamics of the underlying asset. ETFs as an exchange instrument originated in the late 1970s. The first ETF was issued by The Vanguard Group.
But ETFs only became popular in the 1990s. Now it is one of the most rapidly developing instruments. According to ETF Global’s latest data, more than half of all ETFs are in the U.S. market. That’s where the largest issuers are headquartered: State Street Global Advisers, BlackRock Inc, and The Vanguard Group.
Types of ETFs
ETFs can be classified by the type of asset on which they are issued. ETFs allow you to invest in:
- Country stock markets
- Individual sectors of the economy
- Exchange-traded commodities (gold, oil, silver, etc.)
There are also a number of ETFs with a more complex management structure. Such ETFs are called exotic or specific. Among them we can single out:
- Inverted or reversible ETFs – the price dynamics of such ETFs are inversely proportional to the price of the underlying asset. Such ETFs, simply put, “short” the underlying asset.
- Margin ETFs are the opposite of reverse ETFs; they use the long position mechanism to show higher returns than the underlying asset. For example, if the price of the underlying asset rises 1%, the price of the ETF will rise 2%.
- Volatility ETF (VIX) – An ETF that is based on a volatility index or, as it is also called, a fear index.
Price formation mechanism
The share price of an index fund will replicate the price dynamics of the assets that form the basis of the fund. The price per share of a fund is the fund’s net asset value per share. This is the calculated (fair) value of a share – a certain benchmark of an ETF’s price. The calculated price of the fund shares is published on the website of the fund or news agencies.
However, the market price of a fund’s share at the stock exchange may differ from the calculated one. This may be affected by many factors: currency exchange rates, the difference between supply and demand.
To make the market price at the exchange as close to the estimated one as possible, apart from usual buyers and sellers, the exchange has market makers – they set the prices which are close to a “fair”, i.e. to the estimated. A market-maker has to participate in the trades for at least 7 hours a day. Thus, the price of the fund’s stock on the exchange tends to the settlement price.
Peculiarities of working with ETFs
ETF is an exchange instrument, the shares of which are easy to buy. The liquidity of ETFs is quite high, so one can buy and sell shares of the fund at any time during the trading session. To do this you need a regular brokerage account or an IIS (to work with ETFs on the Russian stock exchanges).
Most ETFs are traded on the NYSE Arca. This platform is not available for trading to unqualified clients. The Central Bank of Russia does not classify some foreign ETFs (for example, on volatility) as securities, that is why at the moment there is no possibility to buy them on a Russian brokerage account.
Many ETFs, among other things, pay dividends to their holders. Dividends provide investors with a regular income that can later be reinvested in new assets, deposited, or spent at their discretion. Dividend income from ETFs is different from that paid on stocks. The underlying asset in an ETF maybe hundreds of stocks, each of which pays a dividend. For ETFs, dividends are calculated and distributed on a pro-rata basis. The downside of such a system may be the fact that the dividend yield rate can change frequently. But on the other hand, dividends come from a diversified group of stocks, which reduces risk and can yield higher returns.
Another feature to look out for is the fund management fee. However, this is not the kind of fee that a broker or stock exchange charges, and it is not additional. This fee is already included in the cost of the fund. All ETFs (as well as mutual funds) charge their shareholders a fund management fee (Expense rates). The fund issuer has operating expenses (taxes, administrative expenses, marketing, etc.) for the duration of the ETF. This fee is expressed as a percentage of the fund’s average net assets.
- First, you may encounter the fact that the price of the ETF lags behind the price of the underlying asset, but in some cases this can play into your hands. For example, in the event of a market correction, you may have time to exit your position before your ETF follows the underlying asset downward.
- Second, if you are working with complex ETFs, you may need to further analyze the structure and risks of the instrument. For example, before buying a reverse ETF, you need to analyze the leverage size and consistency with the underlying asset’s price dynamics.
- Third, there is the risk of closing the country index for the relevant ETFs. The predominant number of ETFs in the world are issued on stocks, more specifically on indices such as the S&P 500. But not all ETFs are tied to well-known indices, because it is expensive to maintain such indices. That’s why little-known indices are most often used to create ETFs.
- Fourthly, one should not forget about the risk of instrument delisting.
Reasons why ETFs should be considered
Relatively low cost. This tool allows you to invest small amounts of money in large companies. If you buy these same stocks directly, you will have to invest more. For example, shares of Apple and Facebook are worth hundreds of dollars, and some ETFs are many times cheaper, even though they include both Apple and Facebook stock.
- Diversification. ETFs allow you to invest not just in individual companies but in entire industries, countries or markets, which significantly reduces the risk of losing money.
- Liquidity. ETFs can be bought or sold quickly.
- Transparency. The structure and other information about ETFs is publicly available and can be viewed by any investor.