DIY Investor Magazine
| August 2017
18
ETF ACADEMY:
HOW DO ETFS WORK?
ETFs enable you to gain diversified exposure to a stock
market, sub-sector or asset class by investing in just
one cost effective and easily traded product.
ETFs operate just like mutual funds with the big
difference that they are listed on the stock market
which means that whereas traditional funds can only be
bought into or cashed out of once a day, you can trade
ETFs whenever you like during normal market hours just
like other share.
Because ETFs are index-tracking funds, there are
no expensive fund managers or analysts to pay for
which makes them much cheaper to run and own then
managed funds – yet ironically, over the medium term,
index-tracking funds beat most actively managed funds
anyway.
PHYSICAL AND SYNTHETIC ETFS
With just a single ETF purchase, an investor can
effectively track the performance of a stock market
index of hundreds or even thousands of listed
companies and they can do the same with government
and corporate bonds and with different commodities
and currencies. There are two different kinds of ETF:
•
Physical ETFs track an index by buying the
underlying assets of the index with the same weight
as in the index, in order to mirror its rise and fall.
•
Synthetic (or swap based) ETFs where the ETF
provider enters a contract with an investment
bank to provide the return of a particular index in
exchange for a fee.
To construct a Physical ETF the provider purchases all
or a selection of relevant securities from within the index
to be tracked – a FTSE 100 index tracker holds all of the
companies in the index in proportion to their weighing.
If HSBC bank made up 7% of the FTSE 100 index,
then the ETF provider would put 7% of its fund’s assets
into HSBC shares and as the value of these holdings
fluctuate, they track the index’s performance.
An ETF’s holdings and an index’s constituents may
not always match precisely and a provider may hold
a sample of the index that it believes can replicate its
performance but at a lower total cost.
Replicating an index by sampling is especially used
for large indices with hundreds or thousands of stocks,
such as the MSCI World index.
A Synthetic ETF does not directly invest in the index’s
constituents; instead, the provider enters into a
contractual agreement with an investment bank, with
the latter promising to pay them the daily return from the
index being tracked, plus any dividends due, in return
for a fee.
A synthetic ETF can therefore track an index very
precisely since the investment bank has agreed to pay
the exact return to the provider; they can be particularly
useful for accurately tracking less liquid markets,
where it may not be easy to implement a cost-effective
physical ETF.
A potential downside is the introduction of counterparty
risk which is explored elsewhere.
ETF providers work in conjunction with specialist firms
known as Authorised Participants to ensure that whether
physical or synthetic, you can freely trade your chosen
ETFs during market hours.
CHEAPER TO RUN AND OWN THEN MANAGED FUNDS
