What are ETFs or Exchange Traded Funds? An ETF is another way to own a basket of stocks, or bonds, or other securities. They are an alternative to mutual funds and all a smart investor needs to know is, when held for the long term, there are no important differences. This video provides a beginner’s guide to what exchange traded funds are, how they work, when to use them, and their drawbacks.
Summary of video: What is an Exchange Traded Fund? What are ETFs?
- Another simple way to buy a share of a large index of stocks, like S&P 500.
How do they work? (video at 1:35)
- You can buy as little as one share, or as much as you like.
- You buy just like a stock.
- Annual costs are very low because they take away the fund manager.
Problems with ETFs (video at 6:47)
- Potential one-time transaction costs include bid-offer spread and broker commissions.
- ETFs, like mutual funds, have small tracking error compared to a market index.
- Potential currency issues for foreign assets.
- Not all ETFs are good, passive, and low-cost. Stay away from ETFs that are not essentially equivalents to low-cost mutual funds that follow a broad market index.
Transcript of What is an Exchange Traded Fund? What are ETFs?
What are ETFs?
Tim: One of MoneyWeek’s favorite investments is the exchange traded fund, or ETF. In this video I’ll do a beginner’s guide to what exchange traded funds are, why we like them, and in fairness, why they’re not perfect in every situation. They do have one or two drawbacks, and it would only be fair of me to point out what they are.
What is an exchange traded fund or ETF? In short, it’s a security, normally a share, that simply tracks an index, a basket of stocks, or something like a commodity, say gold. What’s the point of that? The point of that is this. If you want exposure to, say, the S&P 500 index or the FTSE 100, what better way to get it potentially than to simply buy one share through your broker listed at the London Stock Exchange so it’s nice and easy to get a hold of, it’s got similar charges attached to buying a normal share in a standard company, and that gives you exposure to an entire index, or something that might be quite difficult for you to buy and sell in the commodities market. That’s the point of exchange traded funds in a nutshell. These are listed shares typically that give you exposure directly to something else, and that something else is typically an index, a basket of, say, shares, or a commodity.
How do ETFs work? (video at 1:35)
How do they work? Basically I could telephone my broker and say I want to buy an exchange traded fund, and I need to pick one. They all have names. Now the earliest ones had snazzy names. A spider [SPDR] was a fund that tracked the S&P 500. A diamond was a fund that tracked the Dow Jones 30. That’s financial markets wizards being a little bit exciting about the way they name products, but these days there are loads of ETFs that track all kinds of indices, so I need to be sure about what I’m asking for. If I want something that tracks the S&P 500 I might indeed ask for the spider, which is named after the [software] code that’s used to denominate it and separate it from other shares.
Now, my choice is do I want the sterling-listed exchange traded funds, I want to buy a sterling share, or I could buy a US one if I’m a US investor. In other words words, exchange traded funds are available on all major exchanges in the relevant currencies. As a UK investor I might decide to pick up a share that tracks one of the major indices. Then what do I do? What happens next? The idea is that if the underlying index moves up by 1%, then the share moves up by 1%.
Here’s the beauty. I could be buying a very small amount of the share. The index could be something big that represents loads and loads of companies but I can just buy one share, say if I’m a US investor, one dollar, and if the index goes up 1% that share price rises 1%. The index falls 1%, the share price falls 1%. Or if in theory the gold price goes up 1%, the share goes up 1%, down one, down one. That’s the theory.
What’s the point of that? Remember, it’s that I don’t have to get involved in the underlying asset. I can just buy the share and use that as a proxy for the asset itself. Buying shares is straightforward. Everybody knows how to buy shares once they’ve got a bit of experience. I’m going to expect to incur similar sorts of costs to buying, say, a Man United share. I’m going to potentially pay the bid-offer spread, a little bit of commission to my broker. Do see my video on how to buy shares if you’re not sure about that, but one benefit of exchange traded funds is you don’t pay stamp duty. You don’t pay that half a percent up front you pay on most other shares.
Now I have it. I’ve got a share in my portfolio that simply mirrors the performance of the index that I’ve chosen. Advantages: it’s a simple product, up 1%, down 1%, mirrored in the performance of the share, and it’s relatively cheap. Charges on exchange traded funds, unlike say an alternative, the unit trust, which is something your broker might push at you because the commissions tend to be a bit higher, charges for exchange traded funds, annual management fees tend to be quite low. Most have an annual management fee or a total expense ratio of less than 1%, and lots actually do much better than that and have an expense ratio of less than half a percent. That’s pretty damn competitive. Half a percent, that could be a third of the price of investing in something like a unit trust for example.
You’ve got something that’s simple, that’s cheap. You can buy in any denomination. The minimum’s one share so you could buy one share, or ten shares, or 100 shares. You got flexibility there, and it’s liquid. Unlike, say, buying a unit trust, which is another type of fund that can track things, you can buy and sell exchange traded funds any time of day while the market’s open. You don’t have to wait for a valuation point as they call it with a unit trust, which might only be twice a day or something. You can just trade them like a normal share any time of day. Lots and lots of advantages.
Now, it would be misleading of me to say that it’s all one way traffic, and that what you should do is ditch everything else in your portfolio and buy exchange traded funds. However, exchange traded funds are brilliant, particularly in well known developed markets. Because basically, all you’re going to get from the exchange traded fund is tracking or following the underlying index or commodity. Immediately critics would say you’re not going to beat the market with one of these things, are you? The market on average goes up 1%, the share will go up 1%. It won’t go up 10%. If you want to beat the market, these things are not so good, are they? That’s true, but they do offer a very cheap, easy way of tracking a market. The reason they’re cheap is you’re taking away the fund manager. These are so-called passive instruments. All that means in technical terms is there’s typically a computer program monitoring the underlying holding. Whether that be shares in an index or a commodity like gold, there’s not a fund manager sitting there taking investment decisions as your cash flows in and out of the exchange traded fund. That’s what keeps the costs low.
Now on the flip side, these are passive, they track, so you’ll meet the performance of an index but you won’t beat it. In theory, if you want to beat the market our managers would say you need to pay them to do exactly that, but since so few of them actually do ever beat the market, we’d say given a choice we’d take the low cost tracking exchange traded fund instead.
Problems with ETFs (video at 6:47)
Problems. If you want to beat the market, ETFs won’t do it. Do they perfectly track the underlying asset? Is it a bit of a simplification to say that if the underlying index goes up 1%, the ETF goes up 1%? Yes, it is. That’s for a couple of reasons potentially. One is tracking error. Just be a little bit careful. The exchange traded fund manager issues the ETF so you can buy the share on one side if you like, and that in theory is buying shares that exactly replicate an index such as the S&P 500. But, the exchange traded fund may not hold all of the shares in the index. It may just hold most of them. That means that the performance of the ETF won’t exactly replicate the performance of the underlying index. It might vary a little. That’s called tracking error and that’s a fact of life with some ETFs. The solution is to look under the bonnet. Get the fund sheet and find out what’s in there. You can do that. There’s one problem.
The next one is that some of the more sophisticated ETFs, in the commodities market for example, don’t actually physically hold the underlying asset. The fund may not physically own gold for example. It may create an artificial position like holding gold using derivatives. If that’s the case, there’s another source potentially of what I’d call tracking error. You won’t necessarily see this with a 1% uplift in the gold price mirrored by the 1% uplift in ETF.
Another issue is currency. Be careful if the underlying asset is denominated in a currency which is not the one you’re buying the ETF in on your local exchange. You’ll get a foreign currency movement between the ETF and the share you’re buying. Obviously if you line up the currency of the underlying asset and the currency of the ETF, that shouldn’t be so much of a problem. All those things can be sources of what are called tracking error.
Now, the next point: Is it true to see that all ETFs are cheap? Mostly they are, and it’s the simple ones you want. If you’re just tracking large cap US stocks, why pay a fund manager? There’s plenty of research that suggests they just don’t do very well, because all the information about those companies is well known. All investors can get a hold of it, so how do they beat the market? They tend not to. There is a great case to picking up a nice, simple, what I call plain vanilla exchange traded fund because you’ll probably get better performance or certainly no worse for less money in terms of cost.
But, those plain vanilla ETFs are being joined in the market by sexier ones that are more expensive and try and draw your money in. Now, in this video I’m not going to go through all the different types of ETF, but suffice it to say the following words spell danger to me in the ETF market or spell cost and spell complication. We don’t like cost and we don’t like complication at MoneyWeek. Inverse ETFs. As the market rises they go down, and vice versa. Sounds a bit fruity. Can be and it can also be expensive. Not for novices that one, geared ETFs. Those are the ones where the market goes up 1%, the ETF in theory goes up 2% or 3% and vice versa. You can have an inverse geared. That’s sounding pretty hairy, and be careful because the performance of those things can be pretty damn difficult to predict and you’ll probably be paying extra money for the privilege of having a slightly sexier-sounding ETF.
Finally, the strategy ETFs. The active fund management industry is trying to fight back and saying we want to make money out of ETFs. They’re too cheap. There must be a way, so they’re offering an exchange traded fund that mirrors the strategy of a great investing guru. Juries out on whether that’s a good idea or not. Fundamentally, the point of an ETF is to give you cheap, easy, straightforward access to a basic index or a basic asset. Steer clear of complication and steer clear of cost in this market.
In summary, exchange traded funds, an easy way for an investor to get access to something like an index or a commodity or a basket of shares for example, without having to go to the hassle and expense of buying positions in every single component. They’re listed on major exchanges. They can be bought through a broker like a normal share. They can be traded pretty much any time of day, and you’ll incur similar costs to trading a plain share other than that stamp duty tax that I mentioned in the UK.
When would you use them? In summary, basically we would use them where there’s no clear case for involving active fund management. That tends to be in the well known, developed markets where frankly, as a fund manager, it’s pretty difficult to get an edge.
Footnotes and Credits:
This is produced by Tim Bennett of MoneyWeek and was uploaded to their YouTube channel on May 23, 2012 under the title What is an exchange traded fund? I have created a summary and transcript to help you find the spots that interest you and make the bet use of your time.
