With the planned launch of our new ETF trading methodology fast approaching, I thought it would be timely to explain what ETF’s are and how they work.
What is an Exchange Traded Fund (ETF)?
An exchange-traded fund (ETF) is an investment fund that trades on a stock exchange just like stocks. An ETF holds assets such as shares, commodities, bonds, property and even cash. All the major asset classes are now covered by ETFs. Whilst the majority of ETFs track an index, such as a stock index or bond index, they may also track a certain sector of the market, such as energy, metals or the financial index. Some ETFs even track a specific market such as gold or silver.
What ETFs are available?
There are well over 1200 ETFs listed on the US stock market and over 30 listed on the ASX. ETFs are available over a wide range of indexes, sectors, shares, commodities, currencies and property. Whilst there are a huge number of ETFs available, liquidity in some of the lesser known and more infrequently traded ETFs is an issue, just as it is with some thinly traded stocks. For this reason, trading in the more actively traded ETFs with high daily volumes and liquidity is advisable.
What are some of the most popular ETFs?
Some of the more popular and actively traded ETFs include;
SPDR S&P500 (SPY) – tracks the S&P500 Index
Market Vector Gold Miners (GDX) – tracks a basket of global gold mining shares
Powershares Trust (QQQ) – tracks the Nasdaq 100 Index
iShares MSCI Emerging Index Fund (EEM) – tracks a basket of over 800 emerging market stocks
Financial Sector (XLF) – tracks the S&P Financial Sector Index
US Oil Fund (USO) – tracks the daily price movement of West Texas Intermediate light, sweet crude oil.
From this sample you can get an idea of the range of possibilities available for trading and investing using ETFs.
What are the real benefits for Active Investors?
There are a number of benefits associated with using ETFs in your basket of tools for trading and investing. Some of the major benefits and reasons for using ETFs include:
1. Single Transactions.
Because ETFs track an Index or certain market sector or specific commodity when you buy the ETF you are essentially buying a mini portfolio that already exists with one transaction. If, for example, you have a view on the direction of the US equity market, you can buy the SPY – the SPDR S&P500 ETF – which tracks the S&P500 Index. This is the equivalent of buying all the stocks in the Index in a ratio that fits with your position sizing rather than having to buy a futures contract or attempting to replicate the Index yourself by purchasing a basket of individual stocks from within the Index.
2. Ease of execution.
ETFs are listed and trade on stock exchanges. This means that we are able to buy and sell these ETFs through our existing stock broker or using our existing online share trading platform or broker. As we are undertaking one transaction to effectively buy a basket of shares, orders are filled much easier than if we are trying to buy a basket of stocks at specific prices. Trading ETFs on existing stock exchanges with our existing stock broker also alleviates the need to open an account with a futures broker or FX broker. If we have a view on the price of gold or oil for example, we can trade a gold or oil ETF that is listed on the stock market, rather than having to open an account with a futures broker in order to trade gold or oil futures contracts.
3. Cost-Effectiveness
Since there is only one transaction per trade, commissions are lower on an ETF as opposed to an index, which requires a basket of stocks and multiple trades. Also, there are no load fees, and managing fees tend to be lower for ETFs as opposed to regular managed funds.
4. Flexibility
Like all equities, ETFs trade during open market hours. You can buy and sell them whenever the share market is trading, just like any other listed stock.
5. Accountability
The company sponsor/creator of the ETF publishes the list of assets in the fund on a daily basis. Most managed and mutual funds tend to publish the constituents of the fund on an infrequent basis and are not known for their transparency.
6. Simplicity
ETFs are simple in structure and easy to understand. If you are looking to replicate an Index or industry sector there are ETFs available for this. If you are looking to make a specific play in a specific commodity, bond or currency there are ETFs available to do this too.
Are there any disadvantages to using ETFs?
The main disadvantages associated with using ETFs are low volumes and lack of liquidity in some of the lesser known and less actively traded ETFs. The SPY regularly trades in excess of 80,000,000 shares on a daily basis so entry and exit from this market will never be a problem. By comparison, DCNG or Seasonal Natural Gas regularly trades less than 100 shares on a daily basis, so entry and exit from this market could be a problem!
Next week we will take a look at the benefits of trading and investing using ETFs and how they can be used by investors in an actively managed portfolio.
6 Responses
Interesting.
How is the price set?
Hello,
Are you referring to SPY listed on ASX or American market ?
There is an ETF with code SPY on ASX but has very low liquidity. In fact lower average volumes than IVV stock code.
Thanks Gary a nice simple explanation. Do you know if ASX offers the UUP USdollar ETF
Hi Gil,
Gary is away at present and has asked if I would respond.
How is an ETF created and priced?
ETFs are similar in many ways to traditional mutual funds, except that shares in an ETF can be bought and sold throughout the day like just like stocks on a stock exchange. Unlike traditional mutual funds, ETFs do not sell or redeem their individual shares at net asset value (NAV). Instead, financial institutions purchase and redeem ETF shares directly from the ETF, but only in large blocks varying in size from 25,000 to 200,000 shares, called creation units. Purchases and redemptions of the creation units generally are in kind, with the institutional investor contributing or receiving a basket of securities of the same type and proportion held by the ETF, although some ETFs may require or permit a purchasing or redeeming shareholder to substitute cash for some or all of the securities in the basket of assets.
The ability to purchase and redeem creation units gives ETFs an arbitrage mechanism intended to minimize the potential deviation between the market price and the net asset value of ETF shares. Existing ETFs have transparent portfolios, so institutional investors will know exactly what portfolio assets they must assemble if they wish to purchase a creation unit, and the exchange disseminates the updated net asset value of the shares throughout the trading day.
If there is strong investor demand for an ETF, its share price will temporarily rise above its net asset value per share, giving arbitrageurs an incentive to purchase additional creation units from the ETF and sell the component ETF shares in the open market. The additional supply of ETF shares reduces the market price per share, generally eliminating the premium over net asset value. A similar process applies when there is weak demand for an ETF: its shares will trade at a discount from net asset value.
Index ETFs
Most ETFs are index funds that attempt to replicate the performance of a specific index such as the S&PASX 200 Index or the S&P500 Index in the US. An index fund seeks to track the performance of a specific index by holding in its portfolio either the contents of the index or a representative sample of the securities in that index. Some Index ETFs replicate the Index by investing 100% of their assets proportionately in the securities that underlie the index. Other index ETFs use representative sampling, investing 80% to 95% of their assets in the securities of an underlying index and investing the remaining 5% to 20% of their assets in other holdings, including futures, option and other derivatives not in the underlying index to help the ETF achieve its stated objectives.
Hi Annes,
Gary was referring to the SPY on the American markets which has significant volume and liquidity.
Hope this helps.
Sean
Hi Robin,
UUP is listed on the Arca Exchange in the US, however there is a Betashares US Dollar ETF and the code is USD.
Hope this helps.