An Exchange Traded Fund or ETF is generally a passive type of fund that is readily traded on stock changes.
As typically it is a passive type of fund, an ETF will track a specified index such as the FTSE 250. It will essentially look to mirror the performance of it.
Although, ETFs are not exclusive to tracking stock indexes, they can track multiple assets including commodities and currencies. For example, Exchange Traded Commodities (ETCs) are a variant that can track the price of gold.
They can also give you access to areas of the market where you wouldn’t normally be able to gain access to – for example investing in stocks directly in emerging markets such as Brazil. ETFs can also provide an income depending on what they are investing in – but this includes dividends on shares and interest on bonds.
However, you you will often hear about a rather complicated sounded warning with regards to ETFs and their structures. In order to mirror the performance of something they will take one of two approaches – we’ll take a look at them now.
It’all about the baskets and who owns them…
Think of ETFs as baskets. When an ETF tries to mirror a stock index such as the FTSE 100 as its benchmark, it will buy a basket full of shares in the FTSE 100. It owns or holds them. The synthetic approach means it doesn’t actually own the basket of the assets it is investing in:
- Physical ETFs: If an ETF is passively tracking the FTSE 100, it will physically buy the shares on of FTSE 100 companies in line with their weighting on the FTSE 100. This is a total replication of the index or benchmark the ETF is looking to mirror.
- Synthetic ETFs: These are the more risky type of ETF. They do not physically own the assets they are tracking. They can be used when certain types of investment are illiquid (can’t be bought or sold easily) or hard to access. Generally, they strike an agreement and will pay a counterparty (such as an investment bank) to pay the return of the index being traded in exchange for a supply of money. When you hear use of ‘swaps’ or ‘derivatives’ – run!
Stick to physical ETFs – a half-way house between a fund and share
Some Online Platforms rule out providing Synethetic ETFs because of their risk. We agree. For the average investor, they are adding an unnecessary layer of risk as the ETF doesn’t own the basket of assets (imagine if the actual owner of the assets goes bust…).
It is easy to spot the physical ETFs, some will have it in the name of their title such as ‘Physical Gold’, the investment approach is confirmed in the Key Investor Information Document (KIID) and an Online Platform will say the ‘Replication Method’ in the key statistics of an ETF.
Some of the benefits of ETFs are they are cheaper to invest in and can be readily traded when you want with a live price. In many ways, ETFs are like a half-way house between a share and a fund.