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Exchange Traded Funds

The newer kid on the block, Exchange Traded Funds were developed as a way of offering cost-effective passive investment options. Prof Gilbert explains

Introduction to Exchange Traded Funds (ETFS)

  • Exchange Traded Funds (ETFs) were designed as a more accessible alternative to an index tracking mutual fund.
  • Prior to the first ETF being developed in 1993, the only options to replicate the ‘market’ was to either buy all the constituent stocks in the correct weights yourself, or to invest into an index tracking fund.
  • Index funds are an effective way of getting exposure that replicates the market. They don’t perfectly replicate the return on the market due to things like cash drag (the reduction in fund performance due to holding cash because of daily cash inflows and outflows) and the frequent trading results in higher transaction costs.
  • To overcome this the exchange traded fund was created.
  • An exchange traded fund is essentially a fund that invests in the underlying constituents of an index and aims to replicate the performance of that index.
  • Exchange traded fund replicate specific indices, so they come with built in diversification. As long as the underlying index is sufficiently diversified.
  • Exchange Traded Funds are traded on stock exchanges in much the same fashion as shares. This means that they can be purchased whenever the market is open and provided there are buyers or sellers available.
  • With ETFs you are buying and selling with other investors once a sponsor has created the ETF rather than with a mutual fund.
  • This reduces a lot of the transaction costs and means that ETFs are typically cheaper than an equivalent index tracking mutual fund, although in recent years mutual fund fees have gotten lower, in no small part due to the threat from ETFs.
  • The ETF market has exploded in recent decades and the range of investment options has massively expanded.
  • ETFs were originally were built around broad stock market indices like the S&P500. They now offer a lot of different options including sector ETFs, or, specific investment strategy ETFs.
  • ETFs now encompass various asset classes. These can include bond ETFs, commodity ETFs, foreign exchange ETFs, or even cryptocurrency ETFs. In 2020, there were over 7600 ETFs offered worldwide!

How do ETFs Work?

  • ETF’s buy the underlying bundle of assets. For instance, SPDR holds all 500 companies of the S&P index in the same proportion. If the companies in the S&P500 change, ETF will sell the exiting shares and buy the incoming shares. You however own a unit in the trust. If you own enough units you can redeem them for the underlying shares
  • You buy and sell ETFS on the market. ETF prices are constantly updated just like shares based on demand for the ETF. Price can move away from net asset value (NAV), that is sell at a discount or premium. Liquidity can hamper transactions.

Advantages of ETFs compared to Mutual Funds

  • Exchange traded. Intraday trading as opposed to end of day (open ended mutual funds). Pricing constantly updates compared to end of day pricing.
  • ETFs are generally cheaper. Fund management fees are typically lower, although can incur transaction fees, such as commissions.
  • There are less transactions. Buying and selling units doesn’t impact underlying asset bundle. Only need to trade when asset bundle changes. Mutual funds need to buy and sell based on cash inflows and outflows. Creates cash drag

Other Innovations

  • Active ETFs seek to outperform market via asset selection but much more expensive.
  • Exchange Traded Notes. These are unsecured debt security based. Repays initial investment at maturity based on performance of underlying index, such as, if index has performed well it pays more, and vice versa.
  • Leveraged ETFs use derivatives and/or debt to multiply returns of underlying index. It can achieve 2 or 3 times index movement both up and down!
  • Inverse ETFs offer the inverse of the underlying index i.e. if S&P500 falls ETF increases, and vice versa.

OVER TO YOU

Build an ETF portfolio that replicates your original asset allocation using locally available ETF’s. Keep it simple and invest in only one ETF for each asset class (i.e., domestic stocks, international stocks etc.).

Play around with the weights of your ETF portfolio and calculate what your expected return on your portfolio would be based on the past 1, 3 and 5 year returns for your ETF’s. The expected return of a portfolio is simply the weighted average of the returns for each ETF. Also calculate what the fees would be for your ETF portfolio.

Now try to find a local mutual fund that has a similar asset allocation to your original asset allocation. Compare the past returns with your ETF portfolio and compare the fees. In the discussion section put your findings and any observations you wish to make about your findings.

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How to Invest: Modern-Day Financial Decisions

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