What is an ETF?

An ETF, or Exchange-Traded Fund, is an investment vehicle offering investors exposure to a pool of securities like stocks and bonds. Investors use ETFs to have a diversified portfolio without the need to own every share, bond, or other asset class in the market. In this brief article, we cover the main things you need to know before investing in ETFs: their characteristics, types, benefits, and drawbacks.

Overview

An Exchange Traded Fund (ETF) is a mix of securities packaged into one investment vehicle giving exposure to the broader market and traded on an exchange. It allows you to diversify your portfolio, while providing less volatility than investing in a single company. For example, when you buy a share of an ETF, the invested amount is spread across different assets inside the ETF itself. ETFs typically track a specific index, such as the Dow Jones or the S&P500, or a particular asset class (equities, fixed income), size (large-cap, mid-cap, small-cap), style (value or growth), sector (energy, technology), country, or region. This index is referred to as a "benchmark," and the ETFs' objective is to replicate the performance of their respective benchmark as closely as possible: an investment strategy called "passive investing" (the opposite of active investing).

ETFs Characteristics

Net Asset Value (NAV)

The NAV of an ETF represents the value of its holdings (including cash, shares, bonds, and other securities) less any liabilities (fees), all divided by the number of shares outstanding. It represents the fair value of a single share of the ETF.

Intraday Trading

Like stocks or currencies, ETFs can be bought and sold at any time during the day ("intraday" means "within the day"). This feature separates ETFs from index funds (and mutual funds) since the latter only allow one subscription or redemption per day. Investing in the S&P 500 through an ETF or Index Fund will yield roughly the same results (the difference will be primarily due to fees). Still, by allowing intraday trading, you have more flexibility with ETFs.

Fee Structure

Most ETFs have relatively low costs, charged as a percentage of assets under management (AUM), also known as the total expense ratio (TER). TER covers expenses related to managing the ETF, like administrative, legal, operational, and marketing costs incurred by the ETF’s management to provide this investment instrument.

For instance, if you invest $10,000 with an annual TER of 0.10%, you end up paying $10 per year for the fund manager to cover the operational costs. So, if this ETF delivered a 5.00% gross return per year, your effective return would be 4.90% after accounting for TER.

Therefore, it is a cost-effective alternative to diversifying your portfolio. The fees are deducted daily from the fund's assets, are clearly stated, and can be compared among various ETFs.

For example, if a TER is 0.2% per year, the ETF will charge 0.0006% per day (0.20%/365) and deducts the amount from the NAV.

Since they trade on exchanges similar to stocks, brokerage commissions when buying and selling apply and may vary depending on the broker and the account in which the securities are held.

ETF Documents

ETFs provide investors a high level of transparency for both the securities they hold and the investment strategy they follow. This helps non-sophisticated investors know what is in their portfolios and easily evaluate ETFs' potential returns and risks before buying them. 

Factsheet

A factsheet is a small marketing document highlighting critical information regarding an ETF, presented in an easy and comparable manner. It includes information such as the ETF’s holdings, fees, risk metrics, past performance, and details on the fund managers. 

Key Investor Information Documents (KIID)

KIID is a document required by law and contains important investor information to help you understand the nature of the ETF and the risks associated with investing in it. It includes:

• Objectives and investment policy;
• Risk and reward profile;
• Charges;
• Past performance;
• Other practical information.

Prospectus

‍The prospectus is a more detailed document than the factsheet and the KIID. It outlines the trading and settlement process, gives additional details on holdings selection and the benchmark, and explains the investment risks and other information about the ETF.

You can find those documents on the fund manager’s website, and you should have a look before making any investment decisions. Here you can find samples of: Factsheet, KIID, and Prospectus.

‍Accessibility to a Diverse array of investments

As described earlier, investors have access to various asset classes by investing in ETFs, allowing them to own assets that might otherwise be difficult to own.

Tracking and Performance

The ETF states in its prospectus the benchmark it is trying to replicate, and depends on what the ETF is meant to track and its investment style. The efficiency of the ETF is measured by a relative performance metric called tracking error. It evaluates the difference between the actual returns of the ETF and its benchmark returns.

To make it easier, check out the below table showing the performance of the iShares Core S&P 500 ETF. As you can see, the performance is slightly different, but it is very close to the benchmark.

‍Accumulating and Distributing ETFs

ETFs are flexible instruments when it comes to returning value to investors. They can either accumulate or distribute the returns:

• Accumulating ETFs: Automatically reinvest the dividends and income received back into the fund at no extra charge. So, you won’t receive cash payments, as the fund will work on compounding your returns. This can minimize the fees and taxes (no transfers are executed, and no gain is realized);
• Distributing ETFs: Payout all dividends or interest received from holdings and transfer cash to the investment account.

The choice between accumulating and distributing depends on your goals (regular or no need for cash) and your tax considerations (tax rate on capital gains versus tax rate on dividends).

Synthetic and Physical ETFs

ETFs work on replicating the performance of an index either through physical or synthetic replication. Physical ETFs are straightforward as they simply buy the index's constituents. In some circumstances, fund managers replicate the index synthetically, so instead of owning the underlying securities physically, the index's performance will be delivered by entering into a derivative agreement (called a "swap").

Most Robo-advisors use physical ETFs rather than synthetic ones when creating their portfolios.

Fund domicile

It’s worth knowing the registered country of the ETF you want to hold to avoid tax complications at a later stage. Most ETFs are domiciled in Ireland and Luxembourg due to their sound reputation and expertise in fund management and are under the European UCITS framework (which follows highly regulated standards). Moreover, these jurisdictions offer many advantages in terms of taxation and regulations. 

Authorized participants and market makers

An authorized participant is a financial institution managing the creation and redemption of ETF shares in the primary market. They help keep the ETF’s price in line with the value of its underlying securities.

A market maker is an entity (broker-dealer) that can transact with clients and provide them with buy and sell quotes.

‍Tax Efficient

Two factors make ETFs among the most tax-efficient investment instruments:

• Low portfolio turnover: ETFs are generally passively managed, which means they have lower turnover than actively managed strategies, so they minimize investors’ exposure to tax on capital gains;
• The ability to execute in-kind redemptions: Redemptions can be handled by delivering various securities rather than cash, which allows most ETFs to avoid tax on capital gains that arise from selling securities in cash.

Types of ETFs

ETFs can track two types of indexes: the marketas a whole, such as the Dow Jones Industrial Average and the S&P 500, or amore targeted subset of the market. We will list below some of the most commonly used ETFs by investors:

Equity ETFs

ETFs that track Equity indexes cover companies in various sectors. You can also invest in targeted Equity ETFs that give you exposure to specific industries, such as technology or healthcare. Moreover, they can be classified based on:

• Size: large-cap companies (market capitalization greater than $10 billion), mid-cap companies (market capitalization between $2 and $10 billion), and small-cap companies (market capitalization between $300 million and $2 billion);
• Style: growth companies or value companies;
• Geography: ETFs based on the country in which the company is listed.

You can find ETFs that use a combination of the above classifications to construct the ETF, like the "Schwab U.S. Large Cap Value ETF."

Bond ETFs

Bond ETFs invest exclusively in fixed income securities. They give investors access to the bond market while also ensuring that they get regular payments. Some examples of the sub-types of bond ETFs include:‍

• ‍Corporate Bond ETFs: invest in bonds issued by companies;
• Treasury Bond ETFs: invest in bonds issued by governments;
• Floating Rate Bond ETFs: invest in bonds having floating rates where the interest payments change periodically based on a specific formula;
• Zero-Coupon Bond ETFs: invest in bonds that do not pay any coupons but are usually purchased at a steep discount;
• TIPS Bond ETFs (Treasury Inflation-Protected Security): ETFs seeking to track the performance of an index composed of inflation-protected US Treasury Bonds.

‍Commodity ETFs

ETFs providing exposure to various commodities using futures contracts or the underlying commodity itself. Commodities include precious metals like gold and silver, energy resources like oil or natural gas, and agricultural goods such as wheat, sugar, or grain.

Sustainable ETFs

Sustainable ETFs focus on investing in companies screened based on factors related to socially responsible investment (SRI) principles. Thus, companies have high standards for environmental, social, and governance (ESG). For example, the iShares MSCI KLD 400 Social ETF (DSI) seeks to track the investment results of an index composed of US companies with positive ESG characteristics.

Pros & Cons of ETFs

Pros

• Transparency: You can check everything in the ETF documents;
• Low Cost: Usually ETFs charge up to 1.00% as fees on AUM;
• Diversification: You own a portfolio of securities;
• Tax efficient: Reduced capital gains tax ifyou choose accumulating ETFs;

Cons

• Trading Costs: In addition to the annual management fee, you are exposed to trading fees (since ETFs trade like stocks), such as commissions paid to the broker and the bid/ask spread;
• Tracking error: Ideally ETFs should have the same performance as the benchmark, but in some cases, the performance does not match, creating a tracking error.

How to choose the right ETF?

ETFs are a good way to start your investment journey, but choosing a suitable ETF depends on your profile and investing style. It is important to evaluate your investment goals and objectives and to define which asset classes you want to focus on. For example, whether you want to track equities, bonds, or commodities, and which sectors and regions you want to gain exposure to.

Then you need to determine the characteristics of the ETF that best suits your investment objective and compare the characteristics of the various ETFs available.

Bottom Line

After describing the basics of Exchange Traded Funds (ETFs), here's a quick summary of what you should keep in mind. ETFs are a pool of securities that give you exposure to specific asset classes, sectors, and regions. They track specific indexes and try to replicate their performance continuously, and are a low-cost option to build a diversified portfolio and gain exposure to any asset class. Although they have a low fee structure, you might incur additional trading costs as they are traded on exchanges like stocks. They are ideal funds for new investors and suitable for those unwilling to track the market daily.

If you are unsure how to invest in ETFs or don't want to select a specific ETF yourself, you can open an account with a Robo-advisor that automatically allocates your funds to a list of ETFs based on your profile. So you can benefit from the advantages of this investment vehicle without having to do the research and assess the options available.

You can know more about robo-advisors, how they work, what services they offer by reading our introductory article "What is a Robo-advisor?", or you can check our reviews page for an unbiased opinion on several robo-advisors.