Every piece of advice for retail investors, beginners or seasoned ones, sooner or later mentions ETF: Exchange Traded Funds. They are considered to be suitable investments for beginners. As the ETF market got huge in the last decades, the number of available ETFs and their different flavors expanded drastically. The challenge is finding the best ETF that fits our personal strategy and is cost-effective.
However, where there is light, there is also a shadow: ETF is not a “quality label.” If we are not careful, we run the risk of buying completely inappropriate complicated constructs under the name ETF.
This article will shed some light on what ETFs are, how they work, and how we pick the most suitable ones for our portfolios.
What ETFs are
ETFs are securities that contain a basket of other securities. They can be constructed to hold almost everything: stocks, commodities, bonds, REITs, etc. The thereby created baskets of securities can be used to track all kinds of indices (by region, by sector, by market cap, and many more) and strategies.
ETFs are somewhat similar to Mutual Funds- except that ETFs are traded on exchanges- hence the “E” in ETF. Prices thus change continuously, unlike mutual funds, where the issuers determine the price in a given rhythm (usually daily).
A common misconception is that ETFs are all passively following stock indices: in reality, ETFs can be actively or passively managed. A passively managed ETF automatically tracks a fixed automated ruleset. Active ETFs are managed by portfolio managers following a specific strategy.
ETFs represent a considerable part of today’s financial markets. In 2022, according to Fidelity (a creator and vendor of many ETFs), around 3000 ETFs were traded on US exchanges, representing assets estimated at 6.64 trillion US Dollars in valuation.
What ETFs are suitable for
Because ETFs contain other securities, they are a handy tool for diversification. Additionally, they allow us, retail investors, to invest in assets that are out of our reach (like commodities or many bonds). Also, they are the only way to get real diversification for smaller portfolios and may be cost-effective because we don’t have to pay x times transaction fees, but only once (for buying the ETF). Read our three part mini-series bout creating a strategy and implementing it with ETF, especially the last part: From perfect strategy to better investing.
How ETFs work
As we already found out, ETFs are traded on stock exchanges. We can buy and sell them on the Secondary Market, like stocks. However, unlike stocks, the number of available units of an ETF is not constant. If more significant numbers of ETF shares are demanded (or supplied), new ETF shares can be created and redeemed continuously. This usually applies only to substantial sums of money and thus to institutional or very wealthy retail investors.
In this case, so-called “authorized participants” (in general large investment banks) buy the underlying securities of an ETF share and deliver them to the ETF issuer. In return, they receive ETF units (for the same value), thus increasing the total number of ETF units available. Vice versa, existing ETF units can be redeemed. This creation and destruction of ETF units increase/decrease the market capitalization of ETFs (which is not affected by buying/selling on the secondary markets).
Physical or synthetic replication: How ETFs are constructed
When trying to replicate the performance of an index, ETFs have different ways to achieve that. Physically replicating ETF buy the securities by the fractions they are represented in the replicated index. If an ETF, for example, physically replicates the Dow Jones Industrial Average Index, the 30 different stocks with the exact weights are bought.
On the other hand, synthetic replication models the performance of the underlying asset(s) without directly investing in them. Instead, derivatives are used that, in sum, are predicted to have the same returns as the tracked index.
Via synthetic replication, the behavior of hardly-accessible assets like low-liquidity securities or commodities without the problems with direct investments.
Pros and Cons of ETFs
We already mentioned the advantages that ETFs bring us, retail investors. We’ll highlight the ones that are the most important from our perspective.
ETF holding costs
Their buying and selling costs are very low compared to buying securities individually: for every transaction, we would have to pay broker fees, commissions, and a bid/ask spread. With an ETF, we can buy a basket of securities in a single transaction.
Accessibility
ETFs allow us to invest in securities and asset classes that are out of reach for many retail investors. This is not only true for government bonds, foreign currencies, and commodities. Also, for stocks that are too expensive for us retail investors: at the time of writing, Warren Buffet’s company Berkshire Hathaway Inc. stocks trade at over $460,000!
Diversification
This accessibility allows retail investors to increase the diversification of their portfolios. With a single ETF, we can not only own thousand of different stocks at once- which is good because we thus can diversify in the asset class of stocks.
But also, the diversification amongst different asset classes is now feasible for retail investors without a net worth of millions!
To sum it up, Accessibility & Diversification allows us to implement more sophisticated strategies, resulting in more robust portfolios.
Tradeability
Exchange Traded Funds can be bought and sold throughout trading time during the day (given that the ETF has enough liquidity). This is not the case for Mutual Funds.
Costs of Owning ETFs
As with everything, the good things about ETFs come at a price. This is true literally: holding ETFs costs money while owning stocks costs nothing (after we bought them).
Tracking Errors
ETFs do not track their targets perfectly. This has many possible reasons: the management fees that reduce performance, the price jumps in illiquid assets, model errors of synthetic replicated ETFs and more.
Marketing Claims
ETF, as such, is not a “quality label.” Almost every strategy trading any security can be wrapped into an ETF. Meanwhile, we can buy leveraged ETFs: by using derivatives, the returns of an index are leveraged 2 or even 3x. Also, inverse ETFs are on the market that is advertised to move inversely to the underlying. But the devil is in the details! Due to how those ETFs are constructed, they are usually only suitable for short-term investments. If we want to buy such instruments, we need to know how those ETFs work and how they react to the behavior of their underlying. Otherwise, a very rude awakening might be before us!
How to select the best ETF suitable for you
Here are some criteria we must consider when choosing an ETF to cover a specific part of our portfolio. Some of them we can read from their names, some have to be researched by the issuer’s investment documentation or ETF search websites, and some are dependent on our broker.
Check if the ETF is available with your broker
Most essential (but usually the last step in the selection process): the ETF must be tradable via our broker and your exchange. The best ETF in the world will only help us if we can buy or sell it. Not all ETFs are listed on all exchanges, especially the smaller ones. Fortunately, the check is relatively straightforward: we have to search for the ETF or the issuing company on our broker’s website/app.
Costs of ETF ownership
As ETFs are usually very cheap, the issuing institutions still have operating costs, which must be covered. So they subtract a fee regularly. The so-called Total Expense Ratio (TER) quantifies how much we will pay yearly. Lower TER is better; suitable ETFs should be under 1%.
Use an ETF screening website (google will give you some starting points) to search for the specific categories you want to cover with ETF, and then list them by TER.
Distributing vs. accumulating ETF
ETFs can distribute dividends to the owners of the ETF or accumulate them and invest them further. Accumulating ETFs tend to have better price performance. On the other hand, distributing ETFs gives us a nice passive income (creating a taxable event for each distribution). Usually, this property is reflected in the designation of an ETF: acc or accumulating and dist for distributing.
Underlying currency of the ETF
Ideally, we want an ETF to be in the same currency where we pay your daily bread. To avoid additional currency risks to your ETF’s performance, we should look for ETFs with the same currency as our portfolios. Many ETF providers issue their funds in different currency “flavors,” so we should check before buying one blindly.
Final Words
As retail investors, we have to know what we invest in. This is also true for ETFs, which have the reputation of being beginner friendly. This article covered the basics of ETFs, how they work, and what criteria we have to look at to select suitable ones for us.
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