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Exchange-Traded Funds are open-ended mutual funds that aim to closely track the movement of stock market indexes, commodities or a basket of other assets such as bonds or stocks. This is how Exchange-Traded Funds differ from traditional mutual funds, which aim to beat the market and outperform major stock market indexes.
Exchange-Traded Funds – what are they?
Exchange-Traded Funds are investment products that allow the average investor to beat most actively managed funds over the long term. Moreover, he does not have to make any special effort at all while doing so. How do Exchange-Traded Funds work? An investor can imagine that he wants to buy ETFs, which are listed on the New York Stock Exchange, mimicking the S&P 500 index. Then the investor places an order with a brokerage house, and in a moment his brokerage account holds the purchased Exchange-Traded Funds units, sold at that time by another investor.
Investing in Exchange-Traded Funds one of the easiest and least risky, as well as effective ways to save for retirement on the stock market. In some countries this is a relatively new solution. For example, on the Warsaw Stock Exchange (one of the largest stock exchanges in Central Europe), the first Exchange-Traded funds appeared in September 2010. It was W20L, a fund based on an index of the 20 largest Warsaw companies. A few months later, 2 more appeared – on the S&P500 index, i.e. the largest US market companies, and on the DAX index, i.e. the largest German market companies. All these ETFs are managed by the Lyxor Asses Management group. It is one of the world’s largest.
However, where do these units come from? Large institutional investors play a key role in the operation of ETFs. They are a kind of intermediary between ETFs and clients and balance demand and supply in the right way, making sure that the value of Exchange-Traded funds does not follow the value of the index. They also take care of the proper liquidity of the index.
How do Exchange-Traded Funds work?
Exchange-Traded funds are a type of mutual fund that almost mirrors the state of one of the selected stock exchanges and more. So how do exchange-traded funds work? In such a way that when, for example, the DAX index falls, the value of the units of the Lyxor DAX ETFs also falls. Conversely, when the DAXz rises the ETF DAX also rises.
You can invest in Exchange-Traded funds on not only your country. You just need to open a brokerage account or an account on an international investment platform, which gives you access to several thousand Exchange-Traded funds. More than 2,000 Exchange-Traded funds are listed on the American stock exchange. You can find Exchange-Traded Funds for almost anything, such as gold, coffee, emerging markets, etc.
Track or beat the index?
Exchange-Traded funds offer diversification. When you invest in ETFs, you invest in the entire index. So a decline in a few companies should not significantly affect the value of the entire index. The next important issue is performance. It is often the case that indexes over the long term offer higher and more certain returns than open-ended mutual funds, which invest in similar companies aimed at beating the index score.
In addition, it’s worth remembering dividends and lower management fees positively affect the bottom line. Investing in Exchange-Traded funds is not limited to mimicking well-known indexes. New ones are being created for Exchange-Traded funds, for example, grouping companies from a specific industry or region.
What is an index?
Investing in Exchange-Traded funds and index funds is continuously linked to stock market indices. After all, Exchange-Traded funds are a fund that is supposed to provide the investor with a rate of return similar to that of a specific index that it tracks. An index is a measure of prices that shows the health of a specific, selected market. This can be explained using the stock market as an example.
The Warsaw Stock Exchange has the WIG20 index, which reflects the prices of the 20 largest companies listed on the Warsaw Stock Exchange. That is, it is enough for an investor to look at the index to know whether the prices of stocks from the index are rising or falling at a certain time. In addition to the WIG20, investors will find other indexes on the stock market, focusing on all companies on the exchange, small, medium or specific industries.
There are different methods of compiling an index. A company is placed in a specific index based on a number of conditions. One of the most popular criteria by which companies are selected for an index is capitalization. In the case of a capitalization-weighted index, the larger a company is, the more weight it has in the index.
Price index and income index
Investing in exchange-traded funds also involves such indexes. When investing in stocks, the profit or loss depends on 2 factors – first and foremost, how a certain company is valued and the level of dividends these companies pay. An investor must know that there are 2 types of indexes. The first are price indexes, which only show the change in the price of companies, and the second are income indexes, which, in addition to the change in the price of companies, also take into account dividends paid.
Read also: Investing in ETFs
The aforementioned WIG20 is a price index and WIG20TR is an income index. This is worth knowing, because when an investor checks out a passive fund, he or she should make sure that it seeks to replicate the income index, not the price index. An investor may wonder whether the differences between the performance of the price index and the income index, will be significant. Of course, everything depends on the market. The index of the 500 largest U.S. companies over 100 years, earned 10.3 percent on average per year, with dividends corresponding to 41 percent of earnings.
What is replication?
An exchange-traded fund is designed to provide an investor with the return of a selected index. It can do this in two ways. The first method is physical replication. Under it, full replication is distinguished. Then the fund buys into the portfolio all the companies in the index, in the same proportions as they are in the index. If the composition of the index changes, the fund will either buy or sell shares in such a way that the composition of the portfolio agrees.
When investing in exchange-traded funds, there is also physical replication, whereby the manager does not buy all the companies in the index, but only the most important, most liquid ones with the greatest impact on the change in the index. It also happens that the manager selects the best sample of stocks whose behavior is similar to that of the index.
The above-mentioned methods are used with broad stock and bond indices, when the index includes up to several thousand securities – some of which are characterized by low liquidity. For this reason, it does not make sense to buy all of them for the portfolio, but only the most important ones.
When it comes to investing in exchange-traded funds, another method of replication is synthetic. In this situation, the fund’s portfolio may contain quite different securities from those in the index. For this method of replication, a swap contract is usually used. This involves the fund having a contract with an investment bank to provide the return on a specific index. If the fund’s assets have a higher rate of return than the index, the investment bank will make money, and if less, it will be forced to pay extra to the fund’s assets.
As for the synthetic replication method, this also uses futures contracts for a specific asset class. This is the case when it is not possible to replicate in a physical way. This is especially true for the commodities market. An exchange-traded fund will not hold, for example, bags of coffee, so it replicates the behavior of an index, or the price of an asset, through synthetic replication. Information on the method of replication can be found in the fund’s documents.
Creation and redemption of indexes Exchange-Traded funds
The procedure for creating and redeeming Exchange-Traded funds units, in brief, is as follows:
- Each day, Exchange-Traded funds publish a basket of stocks it wants to hold in its portfolio. If an Exchange-Traded fund mimics the S&P 500 index, these will be the common stocks that are included in the index in such weights as they appear in the index. This basket is called the creation basket,
- If there is an advantage in demand, i.e. more traders want to buy units of a particular Exchange-Traded funds than to sell, then the units may be in short supply and their price detached from the imitated index. And in this situation, institutional investors enter the game, who buy a suitable basket of shares in the market, deliver this basket to Exchange-Traded funds, and in return receive from Exchange-Traded funds units of the same value as the delivered basket of shares.
Units obtained from ETFs are then sold by institutional investors in the market, and that’s how they go to customers who place purchase orders. Transactions between these investors and Exchange-Traded funds, are usually carried out in large blocks.
- If supply prevails, that is, more investors want to sell units of a particular Exchange-Traded fund than buy them, there are too many units on the market, so they have to be redeemed. In this case, too, institutional investors come into play, buying back Exchange-Traded funds units from sellers, and then delivering them to the Exchange-Traded funds themselves and exchanging them there for a basket of shares. They then sell the received shares on the market and the cycle closes.
Breakdown of exchange-traded funds
Since the financial industry is highly creative, new investment products are constantly being developed to give investors the chance to earn higher returns. The divisions of Exchange-Traded funds can be made in various ways, and the most important ones will be listed and described later.
Traditional Exchange-Traded Funds
The basis of an investment portfolio are products for broadly diversified indexes. This type of product includes Exchange-Traded Funds, replicating indexes, having in their composition several hundred or even several thousand companies from many different industries and continents. Products that are global in nature include not only stock ETFs, but also products that are based on the bond market.
The most popular Exchange-Traded Funds replicate indices for developed markets, developing markets, as well as global indices. In addition to these funds, there are products that cover both markets. As a result, all an investor needs to do is invest in one ETF and own several thousand stocks or bonds, and get a share in the growth of the global economy.
This type includes the Smart Beta ETF, also known as a factor fund. In most cases, indexes are based on market capitalization. The larger the company is, the larger its share in the index. When it comes to Smart Beta products, it’s different. Exchange-Traded funds replicate an index that is a modification of the original index.
The modified index consists of companies selected, based on specific parameters, the so-called factors. These may be companies, paying the highest dividends, which have better analytical indicators.
Inverse Exchange-Traded funds
The next type of exchange-traded funds are inverse exchange-traded funds. They are designed to give a chance to earn I falls. In simple terms, if a certain index falls 10 percent, the investor, investing in such ETFs, is expected to earn 10 percent, and the opposite for increases. Unfortunately, it is very difficult to forecast declines, and playing the declines if you are not a professional investor is unlikely to end well. These are also products that you need to understand well, since they are based on futures contracts.
Read also: Investing in CFDs
Leverage Exchange-Traded funds
Leverage ETFs are also available. The idea here is that if a given index rises, for example, by 10 percent, Exchange-Traded funds with double leverage will give the investor twice as much to earn. But if there are declines, he will also lose twice as much. There are Exchange-Traded Funds even with quadruple leverage. It’s also worth knowing that with leverage, a compounding percentage works, so profits as well as losses can be significant in just a short period of time. These types of ETFs are another tool, designed for speculation to experienced and informed investors. Before investing, an investor should thoroughly familiarize himself with the principle of such a product.
What is the difference between Exchange-Traded funds and a classic mutual fund?
Exchange-Traded funds are also an investment fund, but a specific one. Exchange-Traded funds means listed on the stock exchange. Units of Exchange-Traded funds are listed on various markets in a similar way on stocks and other financial instruments. A few differences between these instruments:
- In order to purchase units of any ETFs, an investor must have an investment account. In contrast, units of a traditional fund can usually be purchased by depositing money directly into the fund’s account – a person does not need to have an investment account,
- Units of Exchange-Traded funds can be bought or sold at any time during the ongoing trading session. Their price changes from minute to minute, to the rhythm of changes in the value of the index mimicked by a specific Exchange-Traded funds. In this case, there is so-called intraday pricing and practically instantaneous possibility of buying and selling the specified Exchange-Traded funds. In principle, at the time of placing the order, the investor knows the price at which he will purchase units of Exchange-Traded funds. The case is different for classic mutual funds. In this case, the valuation is usually made once a day – at the prices of shares from the close of a specific trading session. That is, when placing an order on a particular day, the investor does not fully know what the value of the fund units he buys will be,
- Although Exchange-Traded Funds are listed on the stock exchange, the feature of a specific ETF does not depend directly on the relationship of demand and supply, as is the case with ordinary shares, but on the value of the index mimicked by the ETF. This is due to the specific mechanism of creation and redemption of Exchange-Traded funds units.
How much can you earn from exchange-traded funds and is it safe?
This question cannot be answered unequivocally. Exchange-Traded funds, like any investment fund, lose as well as gain. So the potential profit really depends on exactly which exchange-traded fund the investor puts the money in and how long the investment is. To outline how much can be earned on exchange-traded funds, one can show how much the ones listed on the Polish stock exchange have grown by, since its inception, i.e. over 10 years. The Exchange-Traded fundsSP500 earned the most, as much as 97.2%. It is interesting to note that the proof of the S&P index alone earned only 51.5% during this period.
Read also: Day trading and swing trading
This may be very tempting, however, is it safe? It is important to remember that Exchange-Traded Funds are financial instruments that are listed on the stock market, and like all other investment products, they record profits, of course, but also declines. At any time, the index on which the investor’s chosen Exchange-Traded funds are based may begin to fall, and with it the ETFs will begin to fall. Then the investor loses his money for a while, or permanently if he decides to sell his Exchange
Trading under the influence of emotion
However, this does not mean that investing in Exchange-Traded funds is a bad idea. It’s a financial product that will work well as a long-term investment, such as for retirement. The design of Exchange-Traded funds is simple and logical, and the costs associated with investing are small. They are certainly lower than those of traditional mutual funds. In addition, due to the fact that ETFs are listed just like stocks. Exchange-Traded funds trade during every trading session.
This gives investors many opportunities to close, open or invest at any time. Importantly, Exchange-Traded Funds are properly diversified. By deciding to buy Exchange-Traded funds, an investor buys many companies at once in the right proportions, something that on its own could fail to do and would certainly be very difficult.
Advantages of Exchange-Traded funds
Investing in Exchange-Traded funds undoubtedly has many advantages. What are the benefits, associated with Exchange-Traded funds?
- Passive management. Exchange-Traded funds are designed to reflect the behavior of a specific stock market index – stocks, bonds or commodities. This is known as passive management, where the manager’s job is to replicate the index as closely as possible, and to faithfully mimic its changes. In comparison, in the case of FIO and FIZ funds, managers implement their own strategies in such a way as to outperform a benchmark, such as a stock market index. This results in the fact that they can also achieve lower returns than the benchmark set,
- Low costs, associated with investing in Exchange-Traded Funds. The manager of Exchange-Traded funds incurs exchange costs, administrative and licensing fees, as well as custody of assets with the depositary. To cover these costs, an Exchange-Traded funds management fee is charged. Due to the passive management method, this fee is quite a bit lower than the fee charged for managing FIO or FIZ funds. As for ETFs listed on the Warsaw Stock Exchange, the fees range from 0.15 to 0.6 percent per year, compared to stock FIOs, where they range from 0.2 to 0.4 percent. When it comes to long-term investing, management costs can significantly reduce the profitability of an investment,
- Listed on the stock market. Titles of Exchange-Traded funds are listed on the stock exchange in a continuous trading system and can be traded on the same basis as stocks. Therefore, the person purchasing Exchange-Traded Funds, incurs costs when either buying or selling units. The level of fees is determined by the brokerage house with which the investor trades,
- Current pricing. Due to the exchange listing, Exchange-Traded Funds are valued by the market on a daily basis during the hours of the trading session. Investors who hold units of the funds or intend to purchase them can do so at any time. This type of advantage is lacking in CIF funds, which are priced at most once a day, and the execution of purchase or repurchase orders, usually takes place over several days,
- Liquidity of trading, which is supported by the activities of market makers. Liquidity of funds on the exchange is provided by market makers. In order to ensure the purchase or sale of exchange-traded funds by investors, they must carry out established activities. They are obliged to do so on the basis of a contract with the exchange with regard to the application of the maximum spread (the difference between the price limits of buy and sell orders), the minimum size of orders placed, as well as the time of the market maker’s presence in the sheet, which exceeds 90 percent of the duration of the session.
Risks associated with exchange-traded funds
What are the risks involved in investing in Exchange-Traded funds?
- Currency risk – when it comes to investing in exchange-traded funds based on foreign indices, such as the DAX, currency fluctuations affect the profitability of the investment. It can work favorably for investments when the zloty weakens, or reduce the rate of return when the zloty strengthens. Even if the prices of foreign indices increase and the zloty strengthens, the investment may result in a loss (read also: How to invest in currencies online),
- Market risk – Exchange-Traded Funds are based on indexes, so their prices can fluctuate significantly. Bad price movements of the underlying indexes directly affect the prices of Exchange-Traded funds. This risk is quite a bit lower than when buying individual companies, due to the diversification of the underlying index portfolio,
- Issuer risk – this is the risk of removal of an Exchange-Traded fund from the stock exchange is that the fund’s titles cease to be listed on the stock exchange. In such a case, however, investors usually do not lose their capital, as the issuer repurchases the titles from them and pays out the funds due. The worst-case scenario is when the repurchase value is lower than the purchase value, investors may be forced to realize a loss that was previously only a capital loss.
Exchange-Traded funds at first glance do not seem to be very complicated, but the more a person knows, the more questions he has. Therefore, before she starts investing in Exchange-Traded funds, she should acquire the necessary knowledge that will make investing much easier for her. If she then builds a passive investment portfolio, she will have to spend little time to make profits.
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However, it’s worth knowing that Exchange-Traded Funds are just a tool and not every fund of this type is good. Only the combination of various components, such as fees, taxes, etc. into a single whole, as well as self-discipline will make success almost certain.