What are ETFs

So what are ETFs? 

ETFs or exchange traded funds are investment vehicles that pool money collected from multiple investors to invest in diverse securities, like stocks, bonds, and other instruments. Most ETFs aim to replicate an index and are classified as passively managed. Passive ETFs' primary objective is to match the performances of the index rather than outperform it. This approach typically leads to lower expense ratios compared to actively managed ETFs and mutual funds.

ETFs are typically diversified across countries, sectors or industries, which helps investors spread risk and gain exposure to a broad market. This diversification is one of the key advantages of investing in ETFs. However, there are also ETFs that focus exclusively on specific trends, themes, sectors, or industries, allowing investors to capitalize on specific market movements.  

An ETF is governed by a set of rules -called an investment mandate- that dictates which investments the fund manager can make. This mandate can be based on geography, asset classes or instruments, sectors, currencies, or any combination of strategies. Once defined, the ETF manager invests the fund's money in assets that adhere to the guidelines of the mandate. 

The different types of ETFs

There are several types of ETFs, including: 

• Passive ETFs: A passive ETF mirrors the exact composition of the index it seeks to replicate. Its primary goal is to provide investors with the same returns as the benchmark.
  
  
• Active ETFs aim to outperform a specific index and their composition can deviate from the index. These ETFs seek opportunities for higher returns, which leads to more frequent trading and adjustments in their positions and weights.
  
  
• Stock ETFs invest in equity securities or stocks. there are several types of equity ETFs including, index ETFs, growth ETFs, value ETFs, large-cap, mid-cap, small cap ETFs and international ETFs. 
  
  
• Bond ETF invest in bonds. This is further broken down in several categories including government bond ETFs, corporate bond, ETFs, high yield bond ETFs and international bond ETFs
  
  
• Commodity ETFs invest in commodities such as oil, gold or coffee.
  
  
• Sector and Industry ETFs invest exclusively in a specific sector or industry such as financials or healthcare.
  
  
• Thematic ETFs invest in a specific trend or theme such as artificial intelligence or renewable energy.
  
  
• Leveraged ETFs use borrowed funds or leverage to gain exposure to larger positions than they would with their own capital. A 2X leveraged ETF is designed to deliver a return that is double the daily performance of the index it tracks.
  
  
• Inverse ETFs are designed to move in the opposite direction of the index they track. When the index rises, the ETF goes down and vice versa.

ETFs can be either distributing or accumulating funds. A distributing fund will distribute dividends received from the investee companies back to the fund’s shareholders usually on a quarterly basis. While accumulating funds will reinvest dividends back into the fund, leading to a higher value per share versus a comparable distributing fund. The tax treatment of these funds may differ so it is important to understand the tax system of your country of residence. 

How are ETFs funds priced and traded? 

The price of an ETF fluctuates throughout the day. It is influenced by its net asset value (NAV), but is also significantly affected by supply and demand dynamic. The NAV represents the total value of all individual holdings in the fund minus its liabilities, while the market price is the price at which ETF shares can be bought or sold on the exchange. 

The NAV of an ETF and its price may differ for several reasons, including supply and demand, trading hours, arbitrage opportunities, and overall market sentiment. Generally, this difference is not significant for most ETFs, but it can be more pronounced for leveraged ETFs, inverse ETFs, international ETFs and small-cap ETFs.   

ETFs are traded throughout the day, much like stocks, allowing investors to buy and sell shares intraday. This means that investors don’t have to wait for the market to close to know the price of their transactions, unlike mutual funds.

The cost of investing in ETFs

Fees matter because they eat away at a fund’s performance and the higher the fees, the greater the impact on the fund’s performance over time. Investing in ETFs involves various fees. Although ETF fees are generally lower than those of mutual funds, it's still important to check the costs, as not all ETFs charge the same fees. Some funds, particularly actively managed ETFs and thematic ETFs, may have fees that are more comparable to mutual fund fees.

1. Sales commissions: Sales commissions are one-off charges levied at the time of purchase and sale of shares of an ETF. Some brokers charge it, others don't. 
   
   
2. Ongoing costs: This cost represents the annual fee for managing the ETF and includes operational costs, administrative expenses, and management fees. The ongoing cost is expressed as a percentage of the fund’s net asset value. It is deducted from the ETF’s assets and is reflected in its net asset value. The fee that an investor pays is a percentage of his/her investment in the fund.
   
   
3. Performance fee: A performance fee is charged by a manager for achieving specific performance targets, typically exceeding a benchmark index. Some actively managed ETFs and thematic ETFs may impose a performance fee.
   
   
4. Custody fee: Some financial institutions charge investors a fee for the safekeeping of their assets which includes protecting them from loss, theft or misuse. 

To learn more about ETFs, please refer to our 2nd chapter which provides a comprehensive overview of the advantages and disadvantages of investing in ETFs.