What is an Exchange-Traded Fund (ETF)? Definition from Digimagg

An exchange-traded fund (ETF) is a pooled investment that trades like a stock. ETFs can mirror various assets, including commodities or diversified securities portfolios. They can also follow specific investment approaches, catering to income generation, speculation, risk hedging, or portfolio diversification. The SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index, was the first ETF launched.

Understanding the mechanics of ETFs

ETFs must be registered with the Securities and Exchange Commission (SEC). In the United States, most ETFs operate as open-ended funds and adhere to the regulations outlined in the Investment Company Act of 1940, as amended by subsequent rules. Open-end funds do not restrict the number of investors participating in the fund.

For instance, Vanguard's Consumer Staples ETF (VDC) tracks the MSCI US Investable Market Consumer Staples 25/50 Index and requires a minimum investment of $1.00. The fund holds shares of all 104 companies listed on the index, including well-known consumer goods companies like Procter & Gamble, Costco, Coca-Cola, Walmart, and PepsiCo.

Investors purchasing $1.00 worth of VDC essentially own shares representing holdings in all 104 companies, but there is no direct ownership transfer of the companies themselves. Unlike mutual funds, ETF share prices fluctuate throughout the trading day, whereas mutual funds are priced once daily after market close.

Types of ETFs

• Passive ETF: These ETFs aim to replicate the performance of a broader index, such as the S&P 500 or a specific sector or trend.
• Actively Managed ETF: Unlike passive ETFs, these do not track an index but are managed by portfolio managers who make decisions on securities selection. They can offer benefits over passive ETFs but may come with higher costs.
• Bond ETF: Designed to provide regular income to investors based on the performance of underlying bonds, which can include government, corporate, and municipal bonds. Unlike individual bonds, bond ETFs do not have a maturity date.
• Stock ETF: These ETFs consist of a basket of stocks that track a single industry or sector, providing diversified exposure to sectors like automotive or foreign stocks. They typically have lower fees compared to stock mutual funds.
• Industry or Sector ETF: Focuses on specific sectors or industries, like technology or energy. For example, Blackrock's iShares U.S. Technology ETF (IYW) tracks the performance of technology sector companies.
• Commodity ETF: Invests in commodities such as crude oil or gold, providing portfolio diversification and hedging against market downturns without physically owning the commodity.
• Currency ETF: Tracks currency pairs and can be used for speculation or as a hedge against currency fluctuations. They offer exposure to forex markets and can be used by importers/exporters to manage currency risks.
• Bitcoin ETF: These ETFs track the price movements of bitcoin either through physical bitcoin holdings or bitcoin futures contracts, providing exposure to cryptocurrency markets.
• Inverse ETF: These ETFs aim to profit from declines in stock prices by shorting stocks through derivatives. They are structured as exchange-traded notes (ETNs) rather than traditional ETFs.
• Leveraged ETF: These ETFs seek to amplify returns on underlying investments, such as 2× or 3× the daily return of an index. They use derivatives and debt to achieve leveraged returns, magnifying both gains and losses.

Pros and cons of ETFs

Purchasing ETFs

ETFs are traded through both online brokers and traditional broker-dealers. Various resources provide lists of reputable brokers in the ETF industry. Individuals can also purchase ETFs within their retirement accounts. Alternatively, robo-advisors like Betterment and Wealthfront offer another avenue for ETF investments.

An ETF's expense ratio covers its operational and management costs, typically low because they track an index.

ETFs are accessible on numerous online investing platforms, retirement account provider sites, and apps like Robinhood. Many of these platforms offer commission-free trading, eliminating fees for buying or selling ETFs.

Once a brokerage account is established and funded, investors can browse ETF options and execute transactions. Utilizing ETF screening tools can help narrow down choices based on criteria such as trading volume, expense ratio, historical performance, holdings, and commission fees.

Commonly used ETFs

• SPDR S&P 500 (SPY): The oldest and most well-known ETF tracking the S&P 500 Index.
• iShares Russell 2000 (IWM): An ETF that follows the Russell 2000 small-cap index.
• Invesco QQQ (QQQ) (often referred to as "cubes"): Tracks the Nasdaq 100 Index, which includes many technology stocks.
• SPDR Dow Jones Industrial Average (DIA) (known as "diamonds"): Represents the 30 stocks of the Dow Jones Industrial Average.
• Sector ETFs: ETFs that focus on specific industries such as oil (OIH), energy (XLE), financial services (XLF), real estate investment trusts (IYR), and biotechnology (BBH).
• Commodity ETFs: ETFs that mirror commodity markets including gold (GLD), silver (SLV), crude oil (USO), and natural gas (UNG).
• Country ETFs: Funds that track major stock indexes in foreign countries but are traded in the U.S. and denominated in U.S. dollars. Examples include China (MCHI), Brazil (EWZ), Japan (EWJ), and Israel (EIS). Others cover broad foreign markets such as emerging market economies (EEM) and developed market economies (EFA).

Dividends and taxation in ETFs

ETFs provide investors with the opportunity to profit from stock price fluctuations and also benefit from dividends distributed by companies. Dividends represent a portion of earnings companies pay out to shareholders. ETF shareholders receive dividends and may also receive residual value if the fund is liquidated.

Compared to mutual funds, ETFs are more tax-efficient because they trade on exchanges, minimizing the need for frequent share redemptions or issuances by the ETF sponsor. This reduces potential tax liabilities for investors. In contrast, mutual funds typically incur tax liabilities when shares are redeemed, which is borne by the fund's shareholders.

Creation and redemption mechanism in ETFs

ETF shares are regulated through creation and redemption processes facilitated by authorized participants (APs), specialized investors. When an ETF needs to issue new shares, APs purchase stocks from the index the ETF tracks (e.g., S&P 500) and exchange them for new ETF shares of equivalent value. This transaction, known as creation, allows APs to profit by selling ETF shares in the market.

Conversely, in redemption, APs sell ETF shares back to the sponsor in exchange for individual stock shares, which they can then sell on the open market. The frequency of creation and redemption depends on market demand and whether the ETF's market price differs from its net asset value (NAV), which represents its asset value per share.

ETFs in the United Kingdom

The U.K. ETF market is prominent in Europe, hosted primarily on the London Stock Exchange (LSE). These ETFs offer exposure across various asset classes such as equities, fixed income, commodities, currencies, real estate, and alternative investments.

Investing in ETFs within the U.K. provides advantages like inclusion in Individual Savings Accounts (ISAs), offering tax-efficient savings up to £20,000 annually without income or capital gains tax. Additionally, U.K. ETF transactions are exempt from stamp duty, a tax on ordinary share transactions.

While U.K. investors can purchase shares of U.S.-listed companies, regulations prohibit direct investment in U.S.-listed ETFs. However, U.K.-based ETFs with the 'UCITS' designation can track U.S. markets, indicating full U.K. regulatory compliance.

For exposure to U.K. equities, UCITS ETFs tracking the FTSE 100 index are available. An example is the HSBC FTSE UCITS ETF (HUKX) listed on the LSE, boasting an ongoing charge of 0.07% and a dividend yield of 3.62% as of January 2024.

The first Exchange-Traded Fund (ETF)

The SPDR S&P 500 ETF (SPY), launched by State Street Global Advisors on January 22, 1993, is widely regarded as the first ETF. However, precursor securities called Index Participation Units tracking the Toronto 35 Index appeared on the Toronto Stock Exchange in 1990.

Differences between ETFs and index funds

While both ETFs and index funds track indices, ETFs are traded throughout the day like individual stocks and are generally more cost-effective and liquid compared to index mutual funds. Index mutual funds, in contrast, are traded once daily at market close through a broker.

ETFs and diversity

ETFs typically offer diversification benefits compared to individual stock investments. However, some ETFs may be more concentrated, either in terms of the number of holdings or the weightings of those holdings. For instance, a fund heavily invested in a few positions may provide less diversification than a fund with a broader distribution of assets across its portfolio.