What is an ETF?

My last article was about indices and how they can be useful as a performance gauge. However, their scope of use is much broader. Quite a lot of money is invested according to an index. This approach has acquired its own name: Index investing or Passive investing.

Index itself is not tradeable. It’s just an artificially constructed price of some basket of securities. In order to trade it, you have few options. You can buy the underlying components, which is however the least common (and convenient) approach. Most people usually choose to buy a derivative, which is a tradeable instrument tracking the price of predefined index. I would mention the two most common choices, which are futures and ETFs.

Futures

Futures are usually very liquid instruments. By taking a position in future contract you enter into an agreement to purchase or sell some volume of underlying assets (based on size of the contract) at predetermined date and price. Therefore all futures contracts have a fixed expiration date, when the final settlement happens and the contract ceases to exist. The index futures we talk about have cash settlement. It means you won’t receive underlying securities constituting the index. You’ll get a difference between the settlement price and your entry price (multiplied by contract’s size) in cash.

Although futures are great for short term speculation, they’re not really suitable for long term holding. Size of these contracts is too big for most individuals, so they can’t incrementally build a position, like they’re accustomed in stocks. There is also need to roll the position forward, as the futures expire. This is annoying, costs broker fees and has negative tax implications.

Exchange Traded Funds (ETF)

ETFs are an investing hit of recent years. Even small investors can seamlessly open a position in a stock index or various commodities using an ETF. Previously, this was only possible by using big futures contracts that require a huge account. Moreover, there is nearly 2000 listed ETFs only in the US, compared to just tens of futures. This brings a great variety of funds you can choose from. There are ETFs even for quite niche sectors of the market, which you can’t trade with futures.

How typical ETF works

An ETF is basically a fund that holds some assets or performs some predefined investment strategy. Shares of this fund trade on a stock exchange like ordinary stocks. The price of these ETF shares simply tracks the net asset value of the fund, i.e. the value of all the assets (less liabilities) the fund holds. The fund charges a small fee, which is automatically deducted from the fund’s cash. But why would anyone buy ETF shares when they could buy the underlying assets directly? The main reason is time, cost savings, and simplicity. Take the SPY ETF as an example, which has a goal to replicate the S&P 500 stock index. The fund’s manager basically holds all the 500 stocks in such a ratio that corresponds to the weight of each stock in the S&P 500 index. If you would like to replicate this on your own account, it won’t be easy. First, you’d have to calculate exactly how many shares of each stock you need to buy. If you have a small account, you may find the required number of some shares to be less than one, or the rounding errors to be too significant. And even if you have a large account, calculating share allocations, and the actual process of buying 500  shares of each stock would be quite time-consuming. Not to speak of paying commission to a broker 500 times instead of once for the ETF. The expense fee a fund charges is very low. It’s just 0.1% p.a. for the SPY.

The rise of ETF definitely changed the global investment landscape. It democratised investment approach traditionally employed by mutual funds, albeit with much lower costs and greater simplicity.