The ETF – exchange traded fund – is a popular financial product used worldwide, with investors attracted by relatively low fees and the ease of buying and selling them. Given that the main drag on managed funds is usually fees, this makes ETFs an attractive proposition for investors. ETFs have now proliferated so greatly that they can appear overwhelming, and it has become necessary to remind investors they are a simple product, mostly categorised by their underlying. ETFs are available for almost any financial asset you can think of, from equities to the most unusual commodities. Their fees are not equal, and each ETF must be understood as a unique product with its own characteristics.
Types of ETF
ETFs can be divided into categories based on the underlying asset they track the price of. This provides a simple overview of the kinds of asset you can invest in using ETFs, and the relative advantages and disadvantages of each, both compared to investing in the asset directly, and compared to other ETF types. A non-exhaustive list of ETF categories is below:
Stock index ETFs
These are some of the most traded financial products in the world, with ETFs tracking the S&P500 commanding unprecedented AUM. Because they are so widely traded, these products are immensely liquid and can be bought and sold instantaneously without slippage. An index ETF holds the constituent stocks of an index in weighted proportion to try and produce for its investors the average return of the index. Some analysts are concerned this has led to a market failure where the equity market no longer assigns capital to the most competitive and successful companies, but simply those that make it onto a particular index. Falling in or out of the S&P500 or other comparable indexes used to be a matter of pride, now it will result in a massive dumping of the company stock. From the perspective of retail investors however, stock index ETFs are an unalloyed good, allowing them to achieve the returns of an index with a diversified, low-cost fund.
Themed equity ETFs
These ETFs replicate a sector, for example ‘energy’ or ‘consumer goods’, by holding a range of companies in that sector. Like stock index ETFs, this allows for retail investors to track performance without incurring heavy fees. With more esoteric sectors, these ETFs may be at times more illiquid, but they are a good general choice for investors with a view on a particular sector but agnostic on the companies within it.
Because buying individual stocks requires far more research than buying a basket of them, investors accept fund managers charging a fee in return for their expertise. The same is true with ETFs, but since the input of an ETF manager is reduced to just rebalancing, the fees are accordingly smaller, in line with those of passive mutual funds. What is unique about ETFs is the range of subtypes available, allowing access to specific themed risks. Remember that the rarer and smaller an ETF is, the higher its fees will be – for the most unusual, annual fees can be comparable to an actively managed fund.
Commodity ETFs come in a range of subtypes. For example, a metals ETF may in reality be a themed equity ETF, tracking the performance of metals and mining companies, or it may hold physical stocks of a metal such as gold. Many different commodities are tracked by ETFs, some more faithfully than other. For example, ETFs of rare earth metals or unusual metals such as uranium do not hold physical stock of the metals, but instead track their price using financial derivatives and sometimes equity holdings. Inevitably, these ETFs produce a less precise tracker, but for many unusual commodities they are the only way to access the price. On the other hand, precious metals ETFs or agricultural commodity ETFs may indeed hold physical stock of their underling, ensuring they track its price as closely as possible. On the other hand, funds with physical holdings may track higher fees.
Bonds are often neglected as a topic in finance, which is a mistake as they are the second most important asset class after equities. Bond ETFs exist that hold a portfolio of different bonds, delimited by type, with a range of expiry dates. These could come under headings such as ‘European government debt’, ‘US long dated treasuries’ or ‘AAA corporate bonds’, and hold a set of different debt instruments, continually updated as they expire. This sort of fund is more aimed at producing income than capital appreciation, and investors should pay attention to the coupon yield.
Specialised trading ETFs
2*daily price move, even 4 or six, tracking a single commodity or FX pair, these funds exist for hedgers or risk-loving speculators who want to share in the price action of an underlying asset. They work by using derivative products such as futures and options to produce double (or more) the daily price move in an underlying asset. So if the asset loses 10% of its value on three consecutive days, the holders of $100 the asset outright would be left with $79, and those of a 2* daily move ETF to the same original value $51. For this reason these products are best avoided by all but the most specialised investors, and even then only with extreme caution.
Conclusion: making sense of ETFs
The exchange traded funds market is a giant one, and inevitably there is confusion about the sheer range of products on offer. Retail traders can prepare themselves by remembering the ETF itself is a relatively simple product, and paying attention to the price movements of the underlying. Each ETF has its own fees, so you need to check the terms of the contract when you buy, but in general it is true that the ETF provides a low-cost, diversified means to access various financial markets. It is this reason which has driven their immense popularity. If ever in any doubt about a specific ETF, speak with a trusted financial advisor.