Exchange traded funds (ETFs) are investment vehicles that track the performance of an index or other clearly defined basket of securities. The name derives from the fact that ETFs trade on exchange and can be bought or sold whenever markets are open, similar to shares.
Diversification in a Single Trade
ETFs can provide a cost-effective, transparent vehicle for gaining exposure to a broad range of asset classes, such as equities, fixed income or commodities. Given that many ETFs track indices with thousands of securities in them, they represent an efficient means to gain broad exposure - and todo so in a single trade.
Beyond the well-known asset classes, certain types of ETF also focus on specific factors, such as low volatility, dividends or market cap. Sector ETFs have also grown in popularity in recent years, as theyallow investors to gain targeted exposure to well-known areas such as technology, energy or financials. Moreover, ETFs can offer exposure to certain investments that are otherwise challenging to access. Examples include convertible bonds, infrastructure and emerging market debt.
A Variety of Applications
Investors have come to appreciate that ETFs have a range of applications. Given that ETFs can provide broad exposure to a certain region or asset class, many institutional investors use them forlong-term strategic allocations. And given that ETFs trade like listed shares and in many cases are highly liquid, they are also an ideal vehicle for expressing short-term tactical trade ideas.
In addition to these two applications, large investors have increasingly embraced ETFs for:
Cash equitisation. Managing excess reserves or periodic cash flows efficiently is an essential element of institutional portfolio management. Given that cash yields are currently close to zero, placing cash in an ETF can potentially provide a better return.
Indexed core for portfolios. Some large investors use ETFs for their core exposures and rely on active managers for more niche areas where there is the potential to add value. This so-called 'core satellite' approach has become increasingly common.
Building blocks for outcome-oriented investors. In light low interest rates and demographic shifts(e.g. aging populations and de-risking pension schemes), investors have turned to ETFs to address needs relating to yield, risk management and capital preservation.
How do ETFs Work?
An ETF is similar to an unlisted index mutual fund, or unit trust, in that it pools investments to purchase a diversified index asset base. However, the ETF adds the benefit of being traded on a stock exchange, so its shareholders can easily trade it at any time of the trading day at prevailing market prices. Unlisted funds can not offer this flexibility and are limited in how investors can buyand sell their shares.
In terms of structure, SPDR ETFs are physically replicated, which means the ETF buys the same securities as the index being tracked. This approach provides the investor with the comfort of owning the underlying assets. With physical replication, transparency is high and counterparty risk is limited.
Synthetic ETFs, on the other hand, do not hold the securities of the index they track; instead, they enter into derivative contracts, such as swaps, to execute their investment strategy. These derivative vehicles are agreements between the ETF and a counterparty — usually an investment bank — to pay the ETF the return of its index.
In comparing the two approaches, physically replicated ETFs have lower counterparty risk and higher transparency than synthetic ETFs.
Transparency and Cost
ETFs are known for their transparency. Physically replicated ETFs usually offer a full listing of their holdings, thus affording investors a clear view on their investments. SPDR ETFs will invest only in the securities that make up the benchmark index. Details of the index composition can be found in the product prospectus and holdings in the ETF are disclosed on our websites.
With ETFs, investors also benefit from transparent pricing that comes from liquid, active trading on the stock exchange. Market makers ensure that there is always a bid (buy) and offer (sell) price inthe market, so investors can always trade. As with stocks, ETF investors can place stop-loss and limit orders on ETFs. ETF shares can even be bought on margin and sold short, subject to your broker’s terms and conditions. These features are largely unavailable with unlisted index funds.
ETFs have become known as a low-cost investment vehicle, although the cost can vary greatly across providers and strategies. When assessing cost, investors need to look beyond the expense ratio, which on its own does not cover the full story. SPDR suggests considering the 'total cost of ownership' for any given ETF. The total cost of ownership takes into account the expense ratio, commissions and bid/ask spreads. Each of these three factors can erode a portfolio's total return. At SPDR, total cost of ownership has long been a key part of the value we offer investors, providing perspectives on how to perform due diligence on individual products, including our own.
SPDR: Creator of the World's First ETFs*
SPDR pioneered ETFs as a simple, cost-effective way of investing in the performance of market indices, with all the benefits of listed market liquidity. SPDR has a long history of innovation, dating back to 1993 when we launched the first US-listed ETF. Since then, we have achieved multiple other industry firsts, including launching the first listed ETF in Australia, Hong Kong, and Singapore.
Talk to Your Financial Advisor or Broker
If ETFs interest you, speak to your advisor or broker to determine if you could benefit from incorporating them into your investment plans. Your advisor can help you analyze your current investments, risk tolerance, tax situation and time horizon, and then recommend strategies to help you achieve your goals.
*ETFs managed by State Street Global Advisors have the oldest inception dates within the US, Hong Kong, Australia, and Singapore. State Street Global Advisors launched the first ETF in the US on 22 January 22 1993; the first ETF in Hong Kong on 11 November 1999; the first ETF in Australia on 24 August 2001; and the first ETF in Singapore on 11 April 2002.
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