Investment Objective
ETFs follow a wide range of investment strategies and objectives. Understanding the basics is critical, such as: What the ETF seeks to achieve, against what benchmark, and how this will be achieved, what assets it will buy to achieve this, and what risks the ETF takes to generate performance.
What Does the ETF Seek to Achieve?
Index-based ETFs typically seek to track the performance of an index. How these indexes are constructed matters to the performance of the ETFs tracking them. For example, an index might weight its holdings equally; by market capitalisation; by dividends; or through many other mechanisms.
Actively managed ETFs seek to outperform a particular benchmark or index by making active decisions to accept and reject securities and assets, rather than invest in the overall market.
What Assets Does the ETF Buy to Achieve its Objectives?
You should also assess how the ETF seeks to achieve its investment strategy. For both index and active approaches, what assets will it buy to replicate the index performance (index), or outperform the index performance (active).
An ETF may invest in the underlying securities in the index it tracks, known as physically-backed ETFs. Alternatively, it may invest in a representative sample of securities in the index. Some ETFs may also employ derivative instruments to track an index, rather than the underlying securities or assets. The chosen approach may affect how well the ETF tracks the index (tracking difference), and its overall risks.
What Risks Are Associated with the ETF?
Like all investments, ETFs are subject to risk. The principal risks are typically those associated with the ETF’s investment objective, and the assets it acquires to meet these objectives. Risks can also include currency, interest rates, the impact of economic growth, and other factors that impact the market, and the assets.
One risk of index-based strategies is tracking error (the difference between the return of the ETF and the return of the index it tracks) —more on this in Question 6.
Another risk for all ETFs is premium/discount volatility (that is, disparity between the market price of ETF shares, and the market value of the underlying assets — net asset value or NAV). Disparity can occur because shares are traded on the exchange, and temporary sentiment and market volatility can drive prices beyond NAV. However, with most ETFs the price should usually correct again towards NAV over time. The longer the investment term generally, the less relevant these types of movements are for the investor.