Exchange Traded Funds (ETFs) are an investment solution structured similar to a mutual fund that are listed on the stock market. These ETFs are attractive to investors due to their low cost, tax efficiency and stock like features. ETFs are able to invest in various asset classes such as stocks, bonds, currencies, commodities and more. One of the most popular ETFs is the SPDR S&P 500 ETF (SPY) that tracks the S&P 500 index.
ETF Construction
ETFs have many similarities to stocks as they’re bought and sold the same way on an exchange. As an EF is a basket of stocks, they offer much more diversification than purchasing an individual stock. This is one of the unique advantages of ETFs which makes them so popular. Why expose yourself to additional risk when buying a single stock when you can purchase an entire market sector, index or foreign market?
An ETF sponsor would work together with an authorized participant, usually a large institutional investor to set up purchases and redeeming provisions. The authorized participant would borrow shares and place those shares in trust. Often these type of shares borrowed mimic an underlying asset, such as the S&P 500 for example. By placing the shares in trust, this forms creation units. The units are limited and can be considered a legal claim on the shares held in trust. Once these units are in hand of the authorized participant, they’re sold in the public market similar to stocks.
Types of ETFs
Since the inception of the first exchange traded funds, the S&P 500 SPDR, in 1993, the number of ETFs and their values have grown dramatically, to over $50 trillion. There are many types of ETFs and below we’ll discuss the most common one’s you might run into.
- Index Exchange Traded Funds – Index ETFs are constructed to track the performance of an index. This could include ETFs that tracks the overall market such as the S&P 500 or ETFs that track a section of the market such only small cap or large cap companies. Index ETFs aim to perform at the same level as the underlying index that it’s tracking. You might run into slight discrepancies as index ETFs are not able to produce a return exactly as 100% of the underlying index due to tracking error, discussed below.
- Commodity Exchange Traded Funds – Commodity based ETFs invest in physical commodities such as gold, oil, agricultural goods and so on. To gain exposure to these commodities, you may either do so through a physical commodity ETF or a Equity Commodity ETF.
- Physical commodity Exchange Traded Funds – such as, SPDR Gold Trust, own the underlying commodity. Investors who buy these type of ETFs have an ownership stake in the underlying asset or commodity.
- Equity Commodity Exchange Traded Funds – Equity Commodity ETFs – Equity commodity ETFs invest in companies that offer exposure to the underlying asset. For example, the Market Vectors Gold Miners ETF (GDX) and the Market Vectors Junior Gold Miners (GDXJ) would provide you exposure to companies who are involved in mining gold.
- Inverse Exchange Traded Funds – are popular with hedge funds who engage in short term arbitrage opportunities. With inverse ETFs, you’re betting that the underlying asset or index would go down. Inverse ETFs are very attractive to professional portfolio managers as they can be used to hedge a specific sector or asset class. Keep in mind there are different strengths of inverse ETFs. You may run into a 1x ETF which seeks 100% of the inverse performance of the index or asset. There are also 2x or 3x inverse or leveraged ETFs. The latter are more volatile.
- Actively Managed ETFs – These types of ETFs are managed professionally by a portfolio manager who decides what securities to buy and sell. The goal of these types of ETFs is to perform better than a benchmark index.
- Industry Exchange Traded Funds – Sector specific ETFs invest a particular sector such as energy, REIT, Health Care. For example, Vanguard Energy ETF (VDE) invests in companies that are involved in exploring and producing energy products such as oil, natural gas, and coal. Vanguard Health Care ETF (VHT) would invest in companies that cater to medical or healthcare products and services.
- Foreign Market Exchange Traded Funds – Foreign or International ETFs invest in growing economies around the world. For example, the iShares MSCI Brazil Index Fund (EWZ) invests in companies in Brazil. In 2019, the ETF produced a return of almost 125% as Brazil was experiencing an economic boom. Foreign ETFs are a great way to diversify your portfolio further.
Tracking Error
Tracking error is known as the difference between the portfolio return and the return of the benchmark. For example, you invested in S&P 500 ETF which replicates the S&P 500 Index, both in composition and in returns. If the ETF returned 10.5% a year but the benchmark returned 10%, then the tracking error is 0.5%.
When you’re investing an ETF, keep in mind the tracking error, especially if the ETF is mimicking an underlying index. You would like to see a low tracking error as the ETF is closely following its benchmark. High tracking errors indicates the opposite.
A higher tracking error would mean that the portfolio manager took on great and possible unnecessary risk. In active ETFs, tracking error would indicate a manager’s level of skill and a reflection of how well they performed above the benchmark. The higher the return above the benchmark, the greater the level of skill of the portfolio manager.
Factors that can affect the tracking error include:
- The number of common securities the portfolio and the benchmark have.
- Differences in timing, investment style, market capitalization.
- The equal weighting of securities relative to the benchmark.
- Management and portfolio fees.
- Volatility of the benchmark.
- Portfolio’s Beta.
ETFs vs. Mutual Funds
