Everything You Need To Know

June 11, 2014

What is an ETF?

Think you know how an ETF works? Here we run through building an ETF, the different types and what to be aware of when investing.

Exchange traded funds are revolutionising investing. Their ability to access almost any market, low costs and intraday tradability lend themselves easily to both institutional and retail investors.

It is for these reasons and their ability to be used by all investors that have seen the sector grow to a global market with assets over £1.33 trillion ($2.2 trillion).

However, understanding exactly how an ETF is built … and what advantages and disadvantages it has compared to competing products … is not always clear. This article tries to provide that clarity.

  1. Lower Costs
    ETFs generally have lower costs than other investment products for two reasons: a.) Most ETFs are not actively managed, and tracking an index is cheaper and easier than staffing a team of overpaid city bankers; b.) The ETF structure (outlined below) is more efficient than the traditional fund structure.
  2. Buying & Selling Flexibility
    ETFs can be bought and sold at current market prices at any time during the trading day. This is unlike mutual funds and unit trusts, which can only be traded at the end of the trading day.
  3. Market Exposure & Access
    Because ETFs can be built with the use of a swap, they are often the only products that are able to access more obscure or less liquid markets.
  4. Transparency
    Because ETFs can be built with the use of a swap, they are often the only products that are able to access more obscure or less liquid markets.
  5. Taxation
    In the UK, ETFs can be safeguarded against capital gains tax by placing them in an Individual Savings Account (ISA) or a self-invested personal pension. Because UK-domiciled ETFs would be liable for corporation tax on non-UK dividends, most ETFs (which hold non-UK companies and are sold to UK investors) are issued in Ireland or Luxembourg.

An exchange-traded what?
An ETF is an investment fund used (in most cases) to passively track an index. Unlike traditional index trackers, ETFs – as the name suggests – are traded on stock exchanges like shares.

But there are several stages an ETF has to go through before it can come into being.

How are they created? The building blocks
An ETF can come into being because an investor or fund manager wants to get the returns of a specific underlying index without having to buy all the stock individually - for example, the FTSE 100. It would be difficult for an individual to buy and manage all 100 stocks in the FTSE 100, so an ETF really offers them the ability to get the same exposure in a single, cost-effective transaction.

The ETF can be largely built on anything: an index, commodities, individual stocks, bonds, etc. For the purposes of this article, we'll stick with the FTSE 100 example.

Creation And Redemption
REDEMPTION PROCESS The key to understanding how ETFs work is to understand something called the "creation/redemption" process.

For an ETF to secure the returns of the desired underlying – such as the FTSE 100 – each ETF share needs to be backed by the actual shares in the underlying companies, or a representative component.

How do they do that? There is a special class of institutional investors called Authorised Participants who contract with ETF issuers to "create" shares of that ETF.

Let's imagine than an Authorised Participant (AP) wants to create 50,000 shares of a new ETF linked to the FTSE 100. Each day, the ETF issuer will send the AP a list of the securities it wants to hold; in this case, let's say it's all 100 stocks in the index.

The AP will then go into the market and buy all 100 stocks in the exact proportion the ETF wants to hold them. It will then turn this "block" of shares into the issuer, along sometimes with a cash component, in exchange for block sizes of 50,000 shares upwards.

It can then trade those shares to investors like you and me, on the secondary market, just like a share of stock.

The beauty of this system is that, any time there is demand for an ETF, the AP can create new shares to meet it. And any time demand dries up, the AP can run the process in reverse (called "redeeming shares) and remove shares from the market. This keeps the ETF trading in line with its fair market value --- a feature that has made ETFs an incredibly popular tool for trading exposures on the market.

In addition, this process saves money compared to the traditional mutual fund structure, as (among other reasons) the ETF can largely outsource the need to buy and sell securities to the AP process.

 

 

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