Exchange Traded Funds (ETFs) are a type of mutual fund that are listed and traded on an exchange. For example, in London, ETFs are traded on the London Stock Exchange (LSE), which has set up a special subset of the exchange for ETFs. ETFs represent a natural evolution of mutual funds, combining the benefits of traditional funds with the ease and efficiency of owning and trading stocks, making these vehicles more liquid and easier to trade than the traditional open-ended fund. This liquidity is provided by market makers to trade (buy and sell) the ETF each trading day.
ETFs typically track the performance of an index and trade very close to their net asset value. Some ETFs are more liquid or easier to trade than others depending on the index they track. Some of their distinguishing features include:
They track the performance of a variety of fixed income and equity indices, as well as a range of sector and theme specific indices and industry baskets. Some also track actively managed indices.
The details of the fund's holdings are transparent, making it easy to calculate the net asset value.
They feature continuous real-time prices so investors can trade at any time.
Depending on the market, index or sector being tracked, they generally feature low bid-offer spreads, e.g. B. only 0.1% or 0.2% for example an ETF tracking the FTSE 100.
They have low expense ratios and there are no initial or exit fees. Instead, the investor pays his stockbroker normal trading commissions. An annual management fee is deducted from the fund, typically 0.5% or less.
Unlike other stocks, there is no stamp duty on purchases in the UK.
ETFs can be used by retail and institutional investors for a variety of investment strategies, including building core satellite portfolios, asset allocation, and hedging.
In Europe they are usually structured as UCITS III compliant funds.
ETFs typically track stock or bond market indices. To achieve their investment goals, ETF providers can use either physical or synthetic replication. The risks of the latter have been the subject of intense regulatory scrutiny by regulators around the world.
ETF Replication methods:
Full replication (Physical)
Full replication is an approach where the fund attempts to mirror the index by holding shares in exactly the same proportions as the index itself. This type of replication reaches its limits with very broadly diversified indices, such as the MSCI World with over 1,600 stocks. The ETF providers replicate such indices using what is known as “sampling”.
Sampling selects investments that are representative of the index. Overall, the "tracking error" or deviation from the index is expected to be relatively small. However, the trading size required for shares should be less than for full replication as the fund does not need to replicate every single constituent of an index. This should reduce transaction costs and therefore help ensure that such costs do not affect overall performance.
The alternative is the synthetic replica. This involves the ETF providers entering into a swap agreement with single or multiple counterparties. The provider agrees to pay the return of a predefined basket of securities to the swap provider in exchange for the index return.
Synthetic replication generally reduces costs and tracking error but increases counterparty risk. Most providers disclose the composition of the collateral taken on a daily basis on their websites.
Which is better?
In summary, the main benefit of physical replication is its simplicity. However, this comes at a cost, resulting in a larger tracking error and a higher total expense ratio (TER). The main benefit of synthetic replication tends to be lower tracking error and cost, but at the cost of counterparty risk.
When investing in an ETF, it's important to understand tracking error when tracking an underlying index or sector. However, a high tracking fund only refers to the deviation from the tracking index and should therefore be accompanied by a higher performance than the underlying.
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