25 July 2015
Sales Trader, Client Trading Services, Saxo Capital Markets
No time to trade? In 60-seconds we explain how ETFs are a ‘happy medium’ between inactive, low-yielding assets and keeping track with market growth.
What is an ETF?
ETF stands for Exchange Traded Fund. An ETF keeps you invested and tracking the movements of a specific market, with stock-specific risk largely mitigated and requiring far less trading time. In very basic terms, an ETF is a tracker product that is traded on an exchange.
How do ETFs work?
An ETF is made up of a basket of assets designed to mirror the performance of an index, sector, commodity or even a bond, and therefore replicates the price movements of those assets. For example: A FTSE 100 ETF, for example, will be made up of a basket of stocks that reflect the performance of the FTSE 100.
Do ETFs track the underlying index or asset exactly?
No. There are costs involved which means the there will always be a slight difference. Also, if you buy an ETF that tracks the FTSE, for example, it won't contain exactly the same stocks, so therefore you won't get exactly the same performance.
How do I know what assets make up an ETF?
ETFs are transparent. The listed assets that make up an ETF are published, usually daily. Just remember to do your research. Make sure it does what it says on the tin.
The range of ETFs is huge, from broad indices like the FTSE or S&P, to increasingly niche ETFs that replicate the performance of high-yield bonds or US pharmaceutical firms. Even commodities, from oil futures to corn and pork bellies, can be traded within ETFs, known as Exchange Traded Commodities (ETCs).
Investors may look to use ETFs to track a basket of currencies or hedge currency risk against their portfolio.
Why would I choose an ETF over a mutual fund?
As the name suggests ETFs are traded on stock exchange, therefore they are more transparent and easily accessible to day traders. Because they are traded on exchange, they are generally more liquid which makes them easier and faster to buy and sell.
ETFs are open ended, which means the issuer can create or redeem underlying shares to keep the ETF close to its net asset value (NAV) and accurately reflect the asset it is tracking, meaning mispricing is less likely.
You can also pursue various strategies using ETFs; hedging currency risk, reducing downside risks or multiplying exposure to price movements with the agility of a day trader.
What are the costs?
Generally ETFs are cheaper to invest in than funds because they are considered to be passive vehicles – tracking whatever the underlying basket of assets is – which requires far less human over-sight and management.
In active mutual fund management, you pay more for the fund manager to stock pick and invest the fund for you. There are passive mutual funds, but these are typically more expensive than ETFs.
What are the risks?
There are market risks such as ETFs being over-priced or undervalued, and of course risk from the underlying asset price movements. Like managed funds, the ETF providers can close access, which is a risk.
Some ETFs only mirror the performance of a basket of assets, so the ETF investor is not actually invested in that underlying asset, which can provide additional risk – though the transparency of the ETF market should allay many concerns.