In the early 1990s, the first Exchange-Traded Fund (ETF) was created. Fast forward just under 30 years and these products comprise a significant part of the investment landscape, holding over $4 trillion of assets. 1
What is an ETF?
An Exchange-Traded Fund is a security that trades just like a stock on a recognized public market (hence the term “exchange traded”). Unlike a stock, which represents the ownership of just one company, an ETF tracks the value of a basket of underlying assets. These assets can be stocks, bonds or even commodities. As a general rule, the ETF’s price will mirror that of the assets it owns. For example, an ETF tied to the S&P 500 will rise and fall based on the performance of that particular index.
Why investors buy ETFs
The popularity of ETFs can largely be explained by what they provide investors: exposure to numerous asset classes at reasonably low fees. There are ETFs tied to virtually all major sectors of the market, as well as those that track the index of an entire country. This means you can buy an ETF representing bank stocks in the United States, or an ETF based on how the Brazilian stock market performs. Compared to mutual funds, the fees on ETFs tend to be lower. This is because most ETFs are managed passively. In other words, an ETF may own a basket of securities, but there is no manager making day to day decisions on what to buy and what to sell to achieve outperformance.
Understanding premiums and discounts
An ETF aims to have the price of the units match the value of the assets held by the fund (minus any liabilities). This characteristic gives investors confidence that the ETF they are buying is a true representation of the sector or index in which they seek exposure. So, if you’re bullish on the German stock market, for instance, you want to be pretty sure that when it goes up, an ETF based on it will go up as well.
For the most part, ETFs tend to move basically in sync with their underlying assets. However, there are cases when the price of the ETF on the exchange deviates from the value of what the ETF owns. This can happen in two ways:
- Premium: The current market price of the ETF is above the net asset value of the fund’s underlying assets.
- Discount: The current price of the ETF is below the net asset value of the fund’s underlying assets.
The details are a bit complex, but in essence most ETFs have large investment firms that help keep the price of the ETF roughly in line with the net asset value of the fund itself. These firms can profit when the fund is trading at a discount or premium, and their activities ultimately move the price of the fund back to where it ought to be. That said, the possibility that an ETF may trade at a discount is something investors need to be aware of. Especially in adverse market conditions, there is always the chance that the ETF you own may not be trading at what it`s really worth.
It’s a safe bet that ETFs are here to stay. Especially for DIY investors, they allow easy access to more markets and sectors than ever before. Just remember that the devil is in the details, and it’s important to fully understand the particulars of any given ETF before buying it. For example, some ETFs are known as “synthetic.” Rather than owning, say, actual shares, they may instead own other complex financial products that seek to replicate the performance of the shares. This adds an extra layer of risk for investors.
As is often the case in life, simplicity is a good virtue to be found in an ETF. The more complex one is, the more likely you should consider taking a pass.
This article was prepared by the author in his personal capacity. The information and views expressed in this article are those of the author alone and should not be attributed to Foresters Financial. The information provided in this article is for information purposes only and do not constitute professional advice to be relied upon. Please consult an investment professional before engaging in any transactions. Whilst reasonable effort is made to make the information accurate, Foresters Financial shall accept no responsibility for its accuracy, reliability or validity.
416375 CAN/US/UK (05/18)