You Need To Know About ETFs
1 | Anatomy of ETFs
Exchange Traded Funds (ETFs) are structured much like mutual funds, in that they hold an underlying basket of investments in which investors have proportional ownership stakes. Like a stock, ETFs can be bought and sold on an exchange throughout the trading day. Basically each ETF is linked to a specific (predefined) index. Most famous are broad equity indices like the S&P500, EuroStoxx50, FTSE100 or Hang Seng.
The ETF will track the performance (up and down) of the underlying index. For example, if the S&P500 will gain 2% on a trading day, an ETF linked to the S&P500 will increase its value equally. Basically, the closer the price movements between the index and the ETF itself are, the better the specific ETF represents a specific market. This behavior is called “Tracking-Error”. In other words: The tracking error is the difference in total return between an ETF’s value and its underlying index. Usually the ETF will follow its underlying index like a shadow.
2 | Trading ETFs
An ETF can be traded through your bank, broker/RIA, direct market access (like most institutional investors have) or via a so-called Authorized Participant (AP) or market maker. This is a broker with the ability to create and redeem ETF units, thanks to the AP’s direct relationship with the specific ETF issuer.
ETFs can be traded during the regular trading hours of the exchange (i.e. NYSE, LSE, Xetra or SGX) – usually from 9 AM until 4 PM. When entering a buy or sell order always use price limits – hence you avoid bad surprises. Investors can buy and sell the ETF during each trading day as often as they want. There are no minimum or maximum holding periods. Of course, each transaction may cause a transaction fee charged to the investor. The fee mostly depends on the terms and conditions of the individual broker and the selected channel of order execution (i.e. online order vs. phone order). Meanwhile some brokers offer commission-free ETF trading!
3 | Creation and Redemption
While ETF trading occurs on an exchange like stocks, the process by which their shares are created is significantly different. Unless a company decides to issue more shares, the supply of shares of an individual stock trading in the marketplace is finite. When demand increases for shares of an ETF, however, Authorized Participants (APs) have the ability to create additional shares on demand. Through the so called “in kind” transfer mechanism, the AP creates ETF units by delivering a basket of securities to the ETF issuer equal to the current holdings of the ETF. In return, they receive a large block of ETF shares (typically 50,000), which are then available for trading in the secondary market. This process also works in reverse. If an investor wants to sell a large block of shares of an ETF, even if there seems to be limited liquidity in the secondary market, APs can readily redeem a block of ETF shares by gathering enough shares of the ETF to form a creation unit and then exchanging the creation unit for the underlying securities. This ETF creation and redemption process helps to keep ETF supply and demand in continual balance. The creations / redemptions provide a hidden layer of liquidity.
4 | Spreads
One important thing to which investors should look closely is the spread of an ETF. The spread is the difference between the bid and the ask price of a security. There are three main factors which influence the spread: Volatility of underlying, depth of liquidity of underlying and finally the market-maker sentiment. In other words: Extreme price movements in the underlying index will cause larger spreads.
Also, you will see wider spreads if you trade ETFs linked to a market or index which is in a different time zone. If you trade an ETF tied to U.S. stocks when the Wall Street is closed, the ETFs market maker will charge a larger spread compared to the time when the U.S. markets are open for trading. Also, ETFs linked to less liquid indexes (i.e. exotic markets or sophisticated strategies) will have larger spreads than ETFs linked to broad, high-liquid underlyings like the S&P500, EuroStoxx50 or Hang Seng.
5 | The different NAV-types
A net asset value (”NAV”) is calculated as the total value of a fund (assets plus cash and accruals minus fees/liabilities) divided by the number of shares in issue. ETFs usually trade close to their NAVs which provide investors with the knowledge that the market price closely reflects the value of the underlying assets. The activity of market makers and other traders normally ensures that the price of an ETF does not substantially deviate from the NAV.
Additionally, the stock exchange or, alternatively, a service provider contracted by the issuer calculates an approximation of the ETF value every 15 seconds. This price is called “iNAV”. Other expressions are “IIV” (Intraday Indicative Value) or “IOPV” (Indicative Optimized Portfolio Value). For investors, this means additional transparency and comparability. Professional investors can optimize their risk management by means of the iNAV.
6 | Replication Methods
ETFs can use different methods to track /replicate their specific underlying index.
Full replication means replicating an index by buying all of the constituents in exactly the same weightings as they are present in a benchmark. For example an ETF tracking the DAX30, Germany´s largest equity index, would have to buy all 30 shares equal to the DAX30 index. Full replication would also involve re-balancing the ETF whenever the index is rebalanced.
Optimisation – or partial replication – seeks to track a benchmark by investing in a subset of the index constituents whose returns are judged likely to match those of the index as a whole.
Synthetic replication – buying assets that may or may not be index constituents and entering into a swap transaction with the ETF’s sponsoring investment bank to swap/exchange the return on these investments for the return of the index.
7 | Leveraged and Short ETFs
Meanwhile leveraged and inverse ETFs have become very popular. Leveraged ETFs aim to deliver a magnified performance of a particular index. Most leveraged ETFs attempt to multiply daily index returns by two or three times. Short leveraged ETFs aim to deliver a multiple of the daily index but in the opposite direction to the underlying benchmark.
The main objective of each short ETF is to deliver the inverse or opposite performance to a particular underlying. For example an inverse EuroStoxx50 ETF would rise 5% if the EuroStoxx50 fell 5% and vice versa. Here it´s important to know, that these ETFs will be reset on a daily basis. Hence over a longer time period, the performance between the underlying and the ETF could differ significantly.
Leveraged and short ETFs are more interesting due to participate on intraday price movements or a short-term investment horizon.