What is an ETF?
An Exchange Traded Fund is a pool of funds invested in a set of assets and which – like shares – can be invested in through an exchange.
What are the benefits of exchange traded funds (ETF)?
An ETF is an investment fund, usually operated by a financial services firm that owns assets, such as shares, commodities and derivatives. The fund manager divides ownership in the fund into shares that entitle the shareholder to dividends and/or other forms of profit. These shares may then be traded, either through the exchange or over-the-counter.
ETFs are usually characterized by the type of investments focused upon: an index, sector or region (currency), real estate, bonds and other fixed-income equities, commodities of one sort or another, and so forth. The benefit of investing in an ETF is the ability to concentrate a wide spectrum of investment types (different asset classes, different instrument types) that all relate to a single definable topic (sector, aim, investment type). They are also relatively inexpensive to trade (low commissions) and are often more tax efficient than the assets they cover.
The first ETFs were introduced in the late 1980s as a means of tracking stock indices. A decade later, the first sectorial ETFs made their appearance, each one covering a different sector of the S&P 500. Today, there are over 2000 ETFs trading in the US alone.
ETFs vs mutual funds
As opposed to Exchange Traded Funds, which are – as mentioned above – passively managed, mutual funds are usually more actively managed by the fund manager, i.e. the components can be reordered and traded on a regular basis. They are usually much cheaper to trade, having lower associated costs and narrower spreads, and entail a lower minimal investment level. Also, because mutual funds are actively managed, they entail a higher volume of asset transactions, meaning that capital gains taxes are higher.
Finally, mutual funds trade at the end of the day, often based on orders received throughout that day. ETFs, on the other hand, trade throughout the day and transactions can be subjected to various orders, such as limit orders, stop orders and more. However, many ETFs charge a commission on ETF transactions executed within the space of one trading day.
Types of ETFs
There are 6 main types of ETFs:
Sector ETFs will concentrate on a specific market sector, investing in shares of companies dealing in that sector, tracking indices related to it and so forth. Thus, for example, the XLV Health Care Select Sector SPDR Fund focuses on health care and owns shares in Johnson & Johnson (10%), Pfizer (5.5%), Medtronic (3.4%) and more – 100% shares all in the healthcare sector.
A dividend ETF will seek to provide high regular returns by investing in high-paying securities, regardless of sector or instrument type. An example is the VYMI Vanguard International High Dividend Yield Index Fund, which pays a 5 yield (YTD). Concentrating primarily on financial services, its holdings include Taiwan Semiconductors (3%), Toyota (1.9%), HSBC Holdings (1.3%), BP (0.99%) and more. Stocks here too make up the bulk of holdings, with 0.02% dedicated to bonds.
Rather than concentrating on a market segment or instrument type, Style-based ETFs are characterised by the investment style adopted by the manager. One can concentrate on style vs growth, capitalisation size, high/low-risk. Such ETFs are optimal diversification instruments. The IWM focuses on shares in the Russel-2000 small cap index, and includes shares of companies in the small market cap group.
Here we have ETFs that focus on commodities. Thus, iShares’ IXC Global Energy ETF owns shares in companies active in the energy sector, such as Exxon Mobil (13%), Royal Dutch Shell (8.5%) and so forth.
Currency ETFs focus on forex pairs. They provide exposure to a particular pair of exchangeable currencies through spot transactions and investing in associated government treasuries and currency-based derivatives. The EUO ProShares UltraShort Euro currency ETF, for example, includes about 20% EURUSD forwards from Goldman Sachs, another 45% from UBS and the remaining 35% in other cash assets.
Bond ETFs invest in corporate and government bonds. The main advantage here is that the fund managers will use a set of investment strategies (including early closure where possible) and differing maturity dates to maximise regular returns. The iShares TIPS Bond ETF owns a variety of US treasury bills with different face values and maturity lengths.