- What is an ETF
- ETF Characteristics
- Advantages of ETFs
- Low fees
- Types of ETFs
- What is the difference between ETFs and index funds?
- The best ETFs to invest in
- How to invest in ETFs
- More articles related to investing in stocks
What is an ETF?
An exchange- traded fund ( FNB , or exchange – traded fund , or ETF ) is a securities investment fund whose units can be traded on a stock exchange , like stocks . At the end of 2012, the global ETF industry represented $1.92 trillion in assets under management . In 2018, this amount exceeded 5,000 billion dollars, driven by strong enthusiasm from investors.
The first theoretical model for an index fund was suggested in 1960 by Edward Renshaw and Paul Feldstein, both students at the University of Chicago. While their idea for an “Unmanaged Investment Company” garnered little support, it did start off a sequence of events in the 1960s.
Qualidex Fund, Inc., a Florida Corporation, chartered on 05/23/1967 (317247) by Richard A. Beach (BSBA Banking and Finance, University of Florida, 1957) and joined by Walton D. Dutcher Jr., filed a registration statement (2-38624) with the SEC on October 20, 1970 which became effective on July 31, 1972. “The fund organized as an open-end, diversified investment company whose investment objective is to approximate the performance of the Dow Jones Industrial Stock Average”, thereby becoming the first index fund.
In 1973, Burton Malkiel wrote A Random Walk Down Wall Street, which presented academic findings for the lay public. It was becoming well known in the popular financial press that most mutual funds were not beating the market indices. Malkiel wrote:
What we need is a no-load, minimum management-fee mutual fund that simply buys the hundreds of stocks making up the broad stock-market averages and does no trading from security to security in an attempt to catch the winners. Whenever below-average performance on the part of any mutual fund is noticed, fund spokesmen are quick to point out “You can’t buy the averages.” It’s time the public could. …there is no greater service [the New York Stock Exchange] could provide than to sponsor such a fund and run it on a nonprofit basis…. Such a fund is much needed, and if the New York Stock Exchange (which, incidentally has considered such a fund) is unwilling to do it, I hope some other institution will.
John Bogle graduated from Princeton University in 1951, where his senior thesis was titled: “The Economic Role of the Investment Company”. Bogle wrote that his inspiration for starting an index fund came from three sources, all of which confirmed his 1951 research: Paul Samuelson’s 1974 paper, “Challenge to Judgment”; Charles Ellis’ 1975 study, “The Loser’s Game”; and Al Ehrbar’s 1975 Fortune magazine article on indexing. Bogle founded The Vanguard Group in 1974; as of 2009 it was the largest mutual fund company in the United States.
Bogle started the First Index Investment Trust on December 31, 1975. At the time, it was heavily derided by competitors as being “un-American” and the fund itself was seen as “Bogle’s folly”. In the first five years of Bogle’s company, it made 17 million dollars. Fidelity Investments Chairman Edward Johnson was quoted as saying that he “[couldn’t] believe that the great mass of investors are going to be satisfied with receiving just average returns”. Bogle’s fund was later renamed the Vanguard 500 Index Fund, which tracks the Standard and Poor’s 500 Index. It started with comparatively meager assets of $11 million but crossed the $100 billion milestone in November 1999; this astonishing increase was funded by the market’s increasing willingness to invest in such a product. Bogle predicted in January 1992 that it would very likely surpass the Magellan Fund before 2001, which it did in 2000.
John McQuown and David G. Booth of Wells Fargo, and Rex Sinquefield of the American National Bank in Chicago, established the first two Standard and Poor’s Composite Index Funds in 1973. Both of these funds were established for institutional clients; individual investors were excluded. Wells Fargo started with $5 million from their own pension fund, while Illinois Bell put in $5 million of their pension funds at American National Bank. In 1971, Jeremy Grantham and Dean LeBaron at Batterymarch Financial Management “described the idea at a Harvard Business School seminar in 1971, but found no takers until 1973. Two years later, in December 1974, the firm finally attracted its first index client.”
In 1981, Booth and Sinquefield started Dimensional Fund Advisors (DFA), and McQuown joined its board of directors. DFA further developed indexed-based investment strategies. Vanguard started its first bond index fund in 1986.
Frederick L. A. Grauer at Wells Fargo harnessed McQuown and Booth’s indexing theories, which led to Wells Fargo’s pension funds managing over $69 billion in 1989 and over $565 billion in 1998. In 1996, Wells Fargo sold its indexing operation to Barclays Bank of London, which it operated under the name Barclays Global Investors (BGI). Blackrock, Inc. acquired BGI in 2009; the acquisition included BGI’s index fund management (both its institutional funds and its iShares ETF business) and its active management.
The exchange-traded fund has the same composition as the stock market index it tracks. It therefore varies upwards or downwards like the index it reproduces. There are funds that reflect the stock market indices of all countries, all financial sectors or all management styles.
Most exchange-traded funds are similar to actively managed funds except that they are not managed by financial analysts who try to buy securities that have very good growth potential. Promoters of exchange-traded funds consider that financial analysts are not capable, over a long period, of beating stock market indices. They therefore consider that it is useless to pay for their services and that it is better to buy a fund that directly reproduces a stock market index (or any other predetermined index).
Since exchange-traded funds do not use financial analysts, their administration fees (entry, management, exit) are minimal (0.1 % to 0.9 % per year) compared to the fees of investment (1 % to 5 % per year).
However, formally, an ETF can be an active fund or a passive fund. To date, there are far more passive ETFs than active funds in the United States or globally. Like any investment fund, ETFs can be actively or passively managed, but those in passive management, or index funds , still represent the majority of ETFs.
When new shares of an ETF are created due to increased demand, it is called ETF inflows. When ETF shares are converted into constituent securities, it is referred to as ETF exits.
Summary, let’s see the main characteristics of ETFs
- Great diversification: ETFs can contain many different financial assets. They normally cover a certain sector or a country.
- Low fees: its costs are lower than mutual funds because they do not need a fund director to actively manage them
- High liquidity: they are bought and sold at any time
- Transparency: you can know its price at all times, and decide the purchase and sale price. With mutual funds you do not know the price you are going to sell or buy them
- Tracking error ratio: it tells you how well the ETF tracks the index performance
- Great variety: you can invest in any type of financial asset, since the amount of ETFs available is huge
- Currencies: ETFs are quoted in any currency, so you have exposure to currency exchange
These characteristics make them a great way to invest.
Advantages of ETFs
ETFs are one of my favorite investment tools. Let me tell you their biggest advantages.
Because the composition of a target index is a known quantity, relative to actively managed funds, it costs less to run an index fund. Typically expense ratios of an index fund range from 0.10% for U.S. Large Company Indexes to 0.70% for Emerging Market Indexes. The expense ratio of the average large cap actively managed mutual fund as of 2015 is 1.15%. If a mutual fund produces 10% return before expenses, taking account of the expense ratio difference would result in an after expense return of 9.9% for the large cap index fund versus 8.85% for the actively managed large cap fund.
This is its best quality. ETFs have very low management costs. Their expense ratio is much lower than the typical mutual funds your bank offers you.
This is because they belong to passive investment. ETFs, like index funds, do not require a manager to do financial analysis of individual companies and find the ones that will perform best.
Mutual fund managers carry out active management. This requires work, and they charge for it. So the mutual funds expenses are higher.
An ETF just copies an index, and this allows them to lower their fees.
In addition, mutual funds obtain lower returns than the reference index in the long term.
You would be surprised how much mutual funds charge on annual fees. Go to any investment platform website, and compare mutual funds fees with ETFs fees. You will be shocked!
ETFs are very similar to stocks, they are listed on the stock exchanges. This makes them highly liquid.
The liquidity of a financial asset is the volume of transactions that asset has on a daily basis, and it is a very important factor. When you want to buy an asset, you need someone to sell it to you, and vice versa. If you invest in assets that lack liquidity, you will most likely have trouble buying or selling it.
That is why a great advantage of ETFs is that in general they tend to have great liquidity, there is always supply and demand.
Types of ETFs
There are several types of ETFs, some follow indices , stocks, commodities, etc. We can also distinguish ETFs with a “capitalization” or dividend distribution policy. ETFs can also be distinguished by the type of replication used: physical replication (securities are physically purchased), or synthetic.
Funds with physical replication
This type of ETF replicates the performance of an index, the CAC 40 or the Dow Jones for example, via investments made directly in the companies that make up the target indices. Each security is therefore given the same proportion as in the index . For the manager, this physical replication approach involves constantly adjusting the values of the assets under management according to their position in the target index, in order to replicate the evolution of the index as precisely as possible.
Synthetic Replication Funds
This type of ETF works with a more complex mechanism: it invests in a basket of various assets, called the collateral , but reproduces the performance of a specific stock market index via a performance swap contract or total return swap , entered into with a counterpart. Most often, the collateral is the bank that owns the management company of the ETF. Thus, even if the ETF does not hold the same assets as the index it is supposed to replicate, the performance swap allows it to track the performance of the latter.
The performance of the sample (the collateral) thus constituted is compared with that achieved by the target index . The collateral is generally invested in very liquid securities (international large capitalisations, Treasury bonds, etc.) in order to facilitate its management. This type of ETF therefore does not necessarily invest in stocks associated with the underlying index.
Benefits of Exchange Traded Funds
Part of the enthusiasm around ETFs is explained by the lower administration fees applied to these products, unlike more traditional investments, on individual securities or mutual funds. According to the managers, part of the investors would have pivoted in favor of ETFs because of the very high side on the long-term returns of the fees in question .
In addition to this element, the possibility of buying them like a share, as well as the protection of subscribers by the same rules as those that exist for SICAVs or mutual funds have also contributed to the success of these products internationally.
Advantage of actively managed funds
Management by experienced financial analysts who try to choose the securities with the best growth potential and thus seek to beat the stock market indices which reflect the growth of all the securities of a country or a particular sector (biotechnology, pharmaceuticals, etc.). ), some experts consider that these analysts do not add value .
My favorites are the Equity Index ETFs, since they track stock indexes like the S&P 500, which has yielded a 9% annual return over its 150-year history.
What is the difference between ETFs and index funds?
I imagine you are wondering: If ETFs and index funds copy market indices, what is the difference between an ETF and an index fund?
Well, although they are very similar products, they have two important differences.
The first difference is in the price. ETFs are listed on stock exchanges, their prices change throughout the trading session. In contrast, index funds are not listed on the stock markets. Their price is established once a day, and the same price applies to buy and sell.
ETFs have the advantage that you decide the time and the price at which to sell. When you want to close your position in a index fund, you give the sell order, and the value you get will be the day the order is executed (it usually takes one or two days).
In ETFs there is always a small difference between the buy and sell price. This is known as a spread. This is the same thing that happens when you buy shares.
The second important difference is related to dividends.
If the dividends are distributed they will be taxed. When you get paid dividends you must pay taxes, so it is better that the dividends are reinvested in order to delay the payment of taxes.
Delaying the payment of taxes makes your capital grow faster thanks to compound interest.
Both ETFs and mutual funds can distribute the dividends or reinvest them, but in my experience I have seen more ETFs distributing the dividends than reinvesting them. That’s why when you invest in an ETF, you should check its dividend strategy.
The best ETFs to invest
Surely you are thinking now: Gonzalo, what are the best ETFs to invest?
When you are going to invest in an ETF, the most important data you have to review are the annual fees and the average returns obtained in recent years.
The strategy that I recommend is to invest in ETFs with low commissions and high yield. The best ETFs in my opinion are:
- S&P 500: follows the United States economy, and has achieved a 9% annual return for 150 years
- MSCI World: global ETF formed by more than 1600 companies from 23 countries, with a 10% annual return in the past decade
I recommend that you buy these ETFs from a high-level issuer, such as iShares and Vanguard. They are international fund managers with a long track record, provide you with quality services and currently manage trillions (yes, with t) of dollars.
Both Vanguard and iShares give you access to any ETF you can think of. Their fees are much lower than other companies, such as Fidelity. For example, my Vanguard S&P 500 ETF I pay 0.07% on annual commission, almost free! 🙂
How to invest in ETFs
Investing in ETFs is very simple, since nowadays most brokers and investment platforms offer them.
It is important to invest with a broker that charges low fees, has an easy-to-use platform and is regulated.
You can confirm if a platform is regulated checking the Financial Conduct Authority register.
I invest my money through two easy to use and fully regulated platforms:
- DEGIRO: broker with very low fees and a great platform. This is ma favourite broker, since they allow you to access companies and ETFs all around the world with low costs.
- Hargreas Lansdown: they are the biggest investment platform in United Kingdom. They offer a large range of mutual funds and index funds. Their fees are higher than DEGIRO but they allow you to invest through ISAs and Pension Plans, which is tax efficient since you don’t pay taxes on your capital gains.
If you are thinking of your retirement plan.
- Robo advisors: they design an investment portfolio adjusted to the investor profile. Your money is managed by professional investors at a very low cost. My favourite robo advisor in UK is Nutmeg
An ETF is not a risk-free product, beyond price variations, it may have errors in tracking the indices it tracks or liquidity problems, linked to a lack of volume on the market.
For several years, ETFs have been regularly accused of being vectors of systemic risk . While the latter are often praised for their transparency and simplicity and thereby benefit from growing popularity, linked in particular to the expansion of the range, fears relate in particular to their impact in the event of a financial crisis .
Depending on the type of investment you want to make, it will be better for you to open an account on one platform or another. For example, I have my pension plan with Hargreaves Lansdown, and my stocks and ETFs with DEGIRO.
We are nearing the end, I hope by now you have learned that investing in ETFs is one of the best investment strategies.
That’s all on ETFs, thank you very much for reading the entire post, I hope you liked it!
If you have any questions or need more information, use the comments section, I would love to help you 🙂