All About Exchange-Traded Funds

  • Oct 17, 2019 BST
  • Team Kalkine
All About Exchange-Traded Funds

Exchange-traded fund (ETF) is a type of exchange-traded investment fund. The units of an ETF are traded in the same way as stocks are traded on an exchange. Just like an index fund, ETF represents a basket of assets such as bonds, stocks or commodities. It generally operates with an arbitrage designed to keep its market value around its net asset value. An ETF generally tracks an underlying index. By owning units in an ETF, an investor receives two important advantages, first the diversification of risk by investing in an index fund plus the flexibility of trading in multiple classes of financial assets. ETF’s can be of different types. Index ETFs, Stock ETFs, commodity ETFs, bond ETFs, currency ETFs, Actively Managed ETFs, Inverse ETFs and leveraged exchange-traded funds.

Active investment (active investing), also called active management of a portfolio of financial assets is a strategy for making investments in order to surpass the benchmark index. Investors and mutual funds that do not seek to transcend benchmark index often invest in index funds that seek to adhere to this index. Active investment (active investing), also called active management of a portfolio of financial assets is a strategy for making investments in order to surpass the benchmark index. Investors and mutual funds that do not seek to transcend benchmark index often invest in index funds that seek to adhere to this index. Active investment (active investing), also called active management of a portfolio of financial assets is a strategy for making investments in order to surpass thebenchmark index. Investors and mutual funds that do not seek to transcend benchmark index often invest in index funds that seek to adhere to this index. Active investment (active investing), also  called active management of a portfolio of financial assets is a strategy for making investments in order to surpass the benchmark index. Investors and mutual funds that do not seek to transcend benchmark index often invest in index funds that seek to adhere to this index.

Exchange traded funds are different from Index funds in that they are actively managed. Active management of a portfolio of financial assets is a strategy for monitoring investments in order to generate excess returns that surpass the returns delivered by a benchmark index during a particular period. Investors and mutual funds that do not seek to transcend benchmark indices often invest in index funds that seek to adhere to a particular index.

Exchange traded funds are also not anything resembling passively managed funds. Passive investment management is a financial strategy whose main idea is to minimize and avoid the adverse consequences of a lack of proper prediction of future asset prices. Through passive investment a well-diversified portfolio of major types of securities is managed without attempting to achieve better returns than other investors. The downside of this strategy is that the returns generated are often lower than actively managed funds.

Benefits of ETFs

  • An ETF provides the benefits of easy diversification, low expense ratios, and tax efficiency similar to that of an index funds while still imparting the benefits of direct investments in stocks. Among the major benefits of ETFs are.
  • Lower cost – because they are pooled investment vehicles, they benefit from economies of scale with regards to brokerage and other related expenditure.
  • Highly liquid – The units of these funds are traded on the stock exchanges just like shares and provide immediate liquidity to investors.
  • Tax Break – While short term action in share trading may attract taxation, Investing in ETF for long term gives tax benefits akin to long term Equity investing, while the fund manager takes suitable short term trading action in securities held in the fund to preserve and create value for the shareholders.
  • Diversification – ETFs provide diversification benefits to the shareholders similar to that offered by the mutual funds.

Types of ETFs

  • Index ETFs – These types of ETFs try to emulate the performance of a particular index. Such a benchmark Index may be a stock-based index, bond-based index, a commodities index or a currency index. These ETFs incorporate either all the components of the index it tracks while constructing their portfolios or a select few of those components. Such funds may also use derivative instruments such as futures, options and swap contracts in a restricted manner if their fund managers believe that these will help them achieve the investment objectives of the funds.

Stock ETFs - These are the most popular types of ETFs. These ETFs follow major stock indices like the FTSE 100, FTSE 250 or the S&P 500 indices to name a few. Further variations in these type of ETFs is also seen, for example large cap group ETFs – Funds tracking and emulating large cap stocks in an index,  Mid Cap group ETFs - Funds tracking and emulating mid cap stocks in an index, small cap group ETFs - Funds tracking and emulating small cap stocks in a reference index, growth ETFs - Funds tracking and emulating growth stocks in a representative index. Then there can also be other criteria like dividends and specific sectoral focus which can become criteria for constructing appropriate ETFs.

These funds may or may not pay a dividend to their subscribers depending on actual receipt of dividends from invested assets.

Bond ETFs – These types of ETFs invest in fixed income securities of various types. They may invest in corporate fixed income securities or government fixed income securities of various maturities. These types of funds provide stable rate of return to its investors.

These types of funds are most popular during economic downturns, when equity and other similar security-emulated funds deliver a dismal return. These funds will provide a stable rate of return which could very well beat returns derived from the rest.  Because of this characteristic of performing well during periods of economic downturn, they are sometimes preferred as contrarian investments.

Commodity ETFs – These types of ETFs invest in commodities like, bullion, important industrial metals, crude oil, natural gas and agricultural products. These types of funds are different from equity and bond ETFs in the sense that they do not invest in financial securities but in physical assets, whose prices are determined by demand-supply equilibrium in their respective markets.

These funds may not give any intermediate returns to their investors except for capital gains when an investor sells his holdings in the fund.

Currency ETFs – These types of ETFs invest in currencies of different countries. These funds seek to gain from temporary mismatches in the currency exchange rates among different currency combinations. Many of the advanced markets in the world also have active currency markets where these ETFs are domiciled. While the underlying assets of these ETFs work in money markets their units are traded like shares in stock markets.

Inverse ETFs – These types of ETFs invest in various types of derivative instruments of underlying assets that form part of the index being tracked. These funds try to benefit when the underlying securities underperform in their respective indices.

Leveraged ETFs – This type of ETFs use leverage to gain from market movements. When the markets are going up and the benchmark indices are rising, the fund manager would try to bring in more leverage to benefit from the buoyancy in the markets and would try to reduce his leverage when the index is declining. This type of funds is highly risky and often make use of advanced derivative instruments like equity swaps which may require rebalancing and reconstruction to achieve the returns desired by the fund managers.

Performance of ETFs

ETFs have traditionally have not performed as per expectations in the past. These Funds have more often than not deviated from their benchmark returns by several percentage points. The most common criticism against ETFs are the elected benchmarks for performance measurement. Many a time the Fund managers will choose obscure and untested indices to compare their performances against and justify a dismal absolute performance. There have also been allegations that these funds have been used as instruments for market manipulation.

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