What is an ETF?
We Answer Your Questions About ETFs.
Frequently asked questions:
ETF is the abbreviation for “Exchange-Traded Fund”. An ETF is an investment fund that tracks the performance of an index, a commodity (for example gold), or a basket of securities. The biggest difference between an ETF and a mutual fund is that an ETF, like the name says, is traded on a stock exchange and can be traded intra-day. Mutual funds also typically have an element of “active management”, with a fund manager making decisions about what securities to buy, while an ETF only replicates the performance of a market index. See our article on the difference between ETFs and mutual funds.
The level of assets in Exchange-Traded Funds has now surpassed those held by hedge funds for the first time, highlighting how their explosive growth has upended the global fund management industry since the financial crisis. Assets in global exchange-traded funds topped $3 trillion at the end of the first quarter 2016 for the second time after first doing so in May 2015.
There are a number of factors that are important to consider when evaluating investments in different ETFs. We have therefore compiled a list of the biggest difficulties when selecting ETFs. The most important factors are:
- Tracking difference/ tracking error
- Replication method (synthetic vs. physical)
You can find out more about how Scalable Capital select the best ETFs from a universe of more than 1,500 for our client portfolios in our section explaining our investment universe. Additionally, we continuously optimise your portfolio by dynamically adjusting the allocation of ETFs.
When buying and selling ETFs investors must be aware of the transaction charges of different providers. At the same time, since ETFs are traded on exchanges, there are brokerage charges. The liquidity of an ETF will further determine the size of the bid-ask spread (the difference between where investors are willing to buy and sell), which is a further cost factor to consider.
In addition to the costs related to the purchase or sale of an ETF, the ETF providers also charge an annual management fee for the administration of the ETF. These charges are typically much lower than those of traditional mutual funds, and are still trending down. A range between 0.05 percent and 0.7 percent per year can be expected, depending on the asset class and the individual ETF provider.
You should also keep in mind that the transaction charges for buying or selling ETFs are much higher for private investors than for a professional investment manager such as Scalable Capital. The reduced transaction costs ultimately benefit our clients, as we are able to offer them a fixed fee covering all portfolio adjustments we might make on their behalf.
The “tracking error” describes the difference between the return of the ETF and the return of the index the ETF is benchmarked against. Tracking difference is sometimes interchangeably used with tracking error. Tracking error strictly speaking refers to the standard deviation of the tracking difference.
There are various reasons why an ETF might not be able to replicate an index perfectly, for example it might be too costly to correctly replicate very illiquid securities that are part of an index.
Liquidity measures the ease of entering and exiting a position in a security. The liquidity of an ETF is driven not only by the trading volume of the ETF itself, but also by the ease of obtaining and selling its underlying assets. As mentioned above, if some of the securities that are included in an index have very low daily trading volumes and therefore very low liquidity, they might not be included in the ETF, resulting in a tracking error. Liquidity in turn drives the bid offer-spread in the market price of the ETF.
ETFs have enjoyed increasing popularity over recent years and therefore the number of ETF providers has increased notably. As of August 2016, the five largest providers by Assets under Management (AuM) globally are BlackRock, Vanguard, SSgA, Invesco PowerShares and Charles Schwab.
Assets Under Management ($ bn)
A synthetically replicating ETF refers to an index fund that tracks an index without buying the underlying assets of the index.
Using synthetic ETFs, fund managers can replicate an index with less or no tracking error. Some indices, such as certain commodities indices or Emerging Market indices can only be replicated synthetically, as the investor cannot buy the underlying securities physically; an example could be crude oil.
Synthetically replicating ETFs hold margin (also called “collateral”), and enter into a swap (i.e. an exchange transaction) with a counterparty, typically an investment bank, where the counterparty (investment bank) agrees to pay the ETF issuer the performance of the reference index underlying the synthetic ETF and in return the ETF issuer pays the investment bank the performance of their collateral basket. Through the involvement of a third party, synthetic ETFs carry counterparty risk. That's why Scalable Capital prefers physically replicating ETFs where possible.
We have compiled more information on the differences between physical and synthetic ETFs in our blog.
Physically replicating ETFs replicate their underlying index by buying the securities that are in the underlying index.
In the case of 100 percent replication (“full replication”) securities are bought exactly according to their weighting in the underlying index. This is possible for indices which consist of a manageable amount of liquid securities, for example the FTSE.
If the index comprises of many securities, for example the MSCI World, which includes 1,600 different stocks, only certain securities are bought; “partial replication”. In this process, securities that are representative of the index are sampled and the selection is optimised by picking securities that have the highest correlation with the underlying index - these securities, however, do not actually have to be part of the underlying index in the first place.
ETFs are seen to be more transparent, lower cost, and over the medium term better performing than the majority of traditional, actively managed mutual funds, whilst being just as safe. The higher fees of actively managed funds lead to returns being further compressed compared to the index benchmark. As a result, in the medium term actively managed equity funds rarely outperform a passive investment fund. In short:
- Transparent: Investors can monitor their performance at any time.
- Low Cost: Managing these funds does not require a big team of analysts, managers or back-office staff so there is no need for high management fees.
- Performance: Several studies have shown that many active fund managers underperform the selected index which they are benchmarked against.
One of the key aspects to consider is diversification, often described as the “only free lunch in investing”. Securities typically react in different ways to market events. In a scenario where individual asset classes are volatile, a diversified portfolio will be sheltered from losses: the impact of losses in one asset class can be offset by gains in another. Lack of diversification in a portfolio is one of the most common mistakes investors make.
There are five dimensions to diversification:
- Regional diversification
- Industry diversification
- Currency diversification
- Diversification in size (smaller and larger companies)
- Asset class diversification (Stocks, Bonds, Commodities, Real Estate)
Yet, another question prevails: how should the different ETFs be weighted? The overall goal of the investor is to achieve the highest return for a chosen risk level - or to take the least possible risk for a specific return. That is why you have to consider your own risk tolerance when investing in an ETF portfolio. How much depreciation of your assets would you be willing to take in a bad year (e.g. the worst in 20 years)? The risk of your portfolio is heavily dependent on the ETFs you choose and the weight you allocate to them. When measuring the risk within your portfolio, practices used in financial econometrics will come in handy and benefit you greatly in order to assess your risk tolerance. Robo Advisors can facilitate this process by using advanced technology. At Scalable Capital, we assess your risk tolerance and clearly quantify the downside risk of your personalised portfolio.
However, risk and correlation within your portfolio can change over time, due to the impact of market events on the individual ETFs. Rules of thumb such as “more bonds equals less risk” might not hold and cannot guarantee a constant risk level. Therefore, we continually monitor our clients’ portfolios and dynamically adjust them to keep their level of risk constant over time and make sure it exactly matches their selected risk category.
Our proprietary risk management technology allows us to manage client portfolios with an approach that retail investors wouldn’t be able to achieve on their own: we continuously calculate and project risk based on the latest data in order to optimise our clients’ portfolio allocation.
Finally, you should consider all costs involved in setting up an ETF portfolio. At Scalable Capital, we offer hassle-free investment with full transparency over costs, no lock-in and no hidden fees.
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