With an abundance of ETFs in the market place, it can be hard to differentiate between them. ETFs can take different approaches to replicating an index and their quality can vary on many measures. Taking a simple checklist approach can help sort out the quality ETFs that best match portfolio needs.
Since State Street Global Advisors launched the first US exchange traded fund (ETF) in 1993, ETFs have grown to become an extremely popular investment vehicle for both individual and institutional investors. However, even though ETFs have grown in popularity, there is still a great deal of myth and misunderstanding about how they work, and what they offer in an investment portfolio. So what are some of these myths, and facts for investors seeking the benefits of ETFs?
Even as ETFs have grown into a multi-trillion dollar market, their benefits are still misunderstood—how they work, how they trade, and what their performance can offer investors.
ETFs offer an easy, cost-efficient way for investors to incorporate various asset classes, investment styles, industry sectors and even commodities to their portfolios.
Because most ETFs track an index, they generally have low management fees and operating expenses. Like individual stocks, ETFs give investors the flexibility to buy and sell at market price on the major stock exchanges throughout the day.
We look at some of the myths that have arisen about ETFs and why things are not always as they seem.
Fact: They trade the same way, but ETFs are shares in a diversified investment, stocks are shares in individual companies.
A stock or share is a type of security that signifies ownership in a corporation and represents a claim on part of the corporation’s assets and earnings. It can be bought and sold on major stock exchanges throughout the day at the market price. A stock’s price will generally reflect the market’s supply and demand for its shares. An ETF is generally a fund that invests in a pool of diversified assets. More often than not these pools of assets reflect a market index or asset sector to offer the same exposure to investors. ETFs are therefore designed to track or represent the performance of these market or sector indices (like small capitalisation, mid capitalisation, large capitalisation, GICS sectors, bonds, commodities like gold, emerging markets, etcetera).
Fact: Most, but not all, ETFs are designed to track the return performance of a benchmark index by holding a physical portfolio of securities that mirror that benchmark.
The majority of ETFs around the world generally use one of three techniques to achieve this goal: full index replication of the benchmark or sector; optimisation-based tracking; synthetic replication. Not all are equal, as follows. Moreover, active managed approaches are also available as ETFs.
Full Replication is where an ETF holds all the securities in the same weightings as its associated index—we call this physically-backed as it actually involves buying the underlying assets of the index in order to replicate it. Over time, the manager adjusts the portfolio to reflect changes in the index (such as the replacement of one security with another) and manages cash flow from dividends or income generation. This strategy tends to provide very close tracking with the underlying index.
Optimisation-Based uses a sampling process to create a representative or optimised portfolio of securities that looks like the benchmark or underlying index. While this approach may be more cost-efficient, it tends to carry a higher potential for tracking error than ETFs that use the full-replication method—tracking error is just unwanted deviations away from the index due to the process used to track the index.
Synthetic Replication is where derivatives and swap agreements are used to replicate the benchmark or index performance rather than the actual underlying assets. Usually, these derivatives and swaps are purchased from a counter-party financial institution so carry with them an additional element of risk not generally present in a replication approach. Typically, the counterparty will agree to deliver the performance of the associated index (minus a small spread), including capital gains and dividends, in exchange for the value of the performance generated by a pool of physical securities held by the ETF (these securities are not necessarily the same as those comprising the ETF’s index). This allows the ETF to mirror the performance of an index without having to own the actual securities, which can be advantageous when it is difficult or expensive to trade in certain markets or sectors. Synthetic ETFs are riskier than other kinds of ETFs because a counterparty could default on its obligations. However, financial regulators in most countries limit the amount of assets that can be invested in derivatives and require these ETFs to provide adequate liquidity to protect investors against default-related losses.
Actively Managed ETFs allow managers to seek active market outperformance (alpha returns) against an agreed benchmark using their expertise and processes—all other ETFs simply seek to replicate the performance of their market benchmark (beta returns). Generally, actively managed ETFs have higher expenses than replication-based ETFs, and their returns depend on the active alpha-generating skills of their manager.
Fact: Any short-term or long-term analysis of the markets will demonstrate that no particular investment category or type can consistently outperform another.
The most important adage is that past performance is generally not a reliable indicator of future performance. Performance of any security, whether it’s a stock, bond, managed fund or ETF, is determined by any number of factors, including the economy, monetary policy, market conditions, or issues affecting a particular securities asset class or industry sector.
For individual stocks, fundamentals such as earnings, valuations and financial stability will also affect share prices. For bonds, factors such as short-term interest rates, inflation and credit ratings will influence their yields. The advantage of ETFs is that they can invest in a diversified pool of assets based on an index with diversification benefits that may help to reduce the overall risk of a portfolio, as on most days the decline in price of securities will be offset by the rise in prices of other securities.
Fact: There is no significant investment research that proves that ETFs carry significantly higher risk than mutual funds.
Because most ETFs are designed to replicate the performance of an associated index, their overall risk level should not be significantly higher or lower than that of the index itself. Investors should evaluate their level of comfort with the unique risk and volatility characteristics of a given index, market, industry sector or asset class of interest before investing in an associated ETF. Further, the risk and volatility level of any pooled investment vehicle, whether it is an ETF or a managed fund, is determined by a number of factors, including:
In the case of active managed funds, the manager’s ability to beat-the-market by picking individual securities, assets or sectors.
Fact: Nowadays, with the technology and competition in the broking market (online and otherwise), brokerage is now cheap compared to the past. The same applies for all publicly traded assets.
Trading any asset too much will create transaction costs like brokerage that can deplete returns. The purest form of ETF investing involves investing for the long-term return offered by markets and indexes. The longer an investor holds their ETF, the more the broking costs become negligible. When compared to mutual funds, while investors don’t pay brokerage commissions when purchasing and redeeming managed fund shares, certain share classes do carry either up-front sales loads or back-end redemption charges that compensate brokers for selling these funds. In addition, many funds charge ongoing fees to compensate brokers, record keepers, transfer agents and other entities for marketing and servicing costs. Indeed, depending on the amount invested, the commissions an investor may pay for trading shares of a particular ETF may actually be less than the sales charges, bid/ask spreads, and management fees they would be charged by investing the same amount in an unlisted mutual fund with a similar strategy. Managed funds may incur additional costs that may not be readily apparent to investors. For example, some managed funds can raise their investment management fees if their managers outperform their benchmarks. And managed funds with high turnover rates may declare higher capital gains distributions, which can increase an investor’s tax burden depending on where the funds are domiciled, whereas most passively managed ETFs have lower turnover rates, which generally result in lower taxes where applicable.
It’s important for investors to consider both immediate and future costs — commissions, spreads, sales charges, management fees, and tax implications — when evaluating the suitability of any kind of investment.
Fact: ETFs usually offer some of the lowest bid/ask spreads in the market largely due to trading demand, and market makers maintaining a constant bid and ask price in the market.
The bid is the price at which a buyer is willing to purchase ETF shares, and the ask is the price at which a seller is willing to sell ETF shares. The difference between the bid and the ask is the spread, which is a cost of trading in any security in addition to any applicable brokerage commission costs. The wider the gap, the more a buyer or seller has to reach in price to match with a seller or buyer, hence the more it costs. Like anything sold in a public marketplace, the bid/ask spread for any exchange traded security, whether it’s a stock or ETF, is governed largely by supply and demand, the availability of information about the securities and investors’ reactions to geopolitical or market and economic events.
Larger and highly liquid ETFs tend to have tighter spreads than ETFs that invest in less liquid asset classes or are thinly traded. As trading volume in an ETF rises, competition reduces spreads and allows investors to buy and sell shares in a more cost efficient manner. ETFs that trade in international securities often have wider spreads because many overseas markets are closed when the ETFs are trading, making it difficult for investors to access updated information on the securities in which the ETF invests. Generally, bid/ask spreads are of less concern to long-term investors. However, those who are concerned about spreads may wish to use stop or limit orders when purchasing or selling shares of ETFs, or any other security, particularly in periods of high market volatility.
Fact: ETFs are effective investment tools for all types of investors from short-term traders to those investing for long-term financial goals, such as retirement or their children’s education.
Their unique structure as commingled investment vehicles that can be bought and sold at market prices gives ETFs the flexibility to be used to execute a variety of investment strategies, without the added expenses of active management.
Fact: Excessive market trading is not specific to ETFs. It happens with all traded assets, from Bitcoin to Apple, due to the market, algorithmic traders, high-frequency traders, hedging trades, speculation, and short sellers, amongst many others.
The broad universe of asset classes, investment styles and industry sectors represented by ETFs have made them attractive vehicles for executing strategies designed to capitalise on pricing efficiencies in a given market. However, investors were engaging in short-term trading long before ETFs were introduced to the market. While ETFs have become a tool that investors use to execute decisions, the average trading volume of ETFs represents only a fraction of all securities transactions on any given day in the market.
Fact: They may seek this, but history shows that any given asset class, investment style, active or passive vehicle may outperform any other over a given time frame.
If the last decade has proven anything about investing, it’s that the only thing you can predict about the market is that it will be unpredictable. Any given asset class, investment style, active or passive vehicle may outperform any other during a given time frame. Moreover, past performance is no guarantee of future results. In any case, past performance alone should never be the sole criteria for determining whether an active mutual fund or passively managed ETF is an appropriate choice for you. Other factors should also be considered, such as:
Over the years, ETFs have grown to become an option for executing both short and long term investment strategies. Understanding their unique characteristics is an important step toward determining whether ETFs can be an appropriate choice for your portfolio and the role they may play in helping you achieve your own investment objectives.