What is an ETF?
An ETF (Exchange Traded Fund) is an investment fund that aims to replicate the performance of a particular market or underlying strategy. The most popular ETFs are those based on indices, but there are also many based on other asset classes, such as currencies and commodities.
An ETF is treated in the regulated markets like a stock, but it has the same diversification and professional management benefits of a fund, even for a limited amount of investment. With a single transaction, you can, for example, divide the risk among all the companies that make up the S&P 500. Obtaining the same level of diversification by buying all the individual stocks would be extremely complex and costly. For this reason, ETFs are also suitable for the needs of private investors.
ETFs make it possible to replicate the performance of an index at extremely low costs. On average, the management fees of a traditional mutual fund are around 1.5%/2.5%, those of an ETF around 0.20%/0.40%.
With the well-known and well-documented failure of approximately 90% of actively managed funds to beat their benchmark, strategies for replicating a market’s liabilities through ETFs have become very popular in recent years. And, as a result, the ETF market has experienced exponential growth.
Main differences between Funds and ETFs
Behind a mutual fund, there is a manager or a team of managers who decide the investment strategy. In an ETF, on the other hand, since it is generally index-linked, there is no active management behind it: it is therefore an eminently passive instrument, which means that its costs can be extremely low.
Apart from their costs, the differences between ETFs and funds mainly concern the way they are traded. If an investor wants to buy an ETF, the transaction is carried out on the stock exchange, at the current market price of the ETF. On the contrary, if you want to buy units of a fund, the transaction is done at NAV and at its daily closing value.
Thus, potentially, an ETF can be bought and sold intraday, something impossible to do with a fund. Its liquidity is ensured by the presence of one or more specialists who undertake to offer price in accordance with supply and demand prices on a continuous basis and are subject to obligations in terms of minimum quantity and maximum spreads applicable.
Other typical transactions can be made on an ETF like any liquid listed instrument, such as placing a stop loss, take profit, sell short, or leverage.
How to invest: ETFs, basic terminology
NAV = value of underlying net assets / number of outstanding shares of the ETF. Equivalent to the unit NAV of each share.
TER (total expense ratio) = total annual fee paid by the ETF’s underwriters based on the management and operating costs incurred by the issuing company. It is expressed as a percentage of the fund’s value.
Tracking difference = difference between the performance of the ETF and the performance of the benchmark (if the annual performance of an ETF is 6.5% and that of its benchmark is 8%, the Tracking difference is -1.5%).
ETFs are an excellent low-cost instrument for building efficient diversified portfolios tailored to each user’s profile.
