What is an ETF?
Introduction – Why Invest in Stocks?
So why prefer stocks when there are other financial instruments? The simple answer is that stocks go up in value in the long run.
The US Stocks have consistently outperformed inflation and have generated real returns despite various drawbacks.
There has never been more money supply by the government than today, and all this money goes into assets, as a result we have "asset price inflation". This is just an economic expression for when the prices of bonds, shares, their derivatives, real estate and other capital goods increase in price as opposed to inflation of goods and services.
And right now asset price inflation is mostly in stocks. To drive home my point, stocks have increased 4x since 2009. This brings us to a financial instrument that makes it easy to invest in the broad stock market, ETFs!
What is an ETF (or exchange traded fund)?
Let’s start off with the perfect context, what is a fund?
At its core a fund is a collection point for investors’ capital.
The way it works is that thousands of investors pool their investments together in a fund, and a professional, the fund manager, invests these funds as profitably as possible while diversifying. But these investments are done according to a planned investment strategy.
It is through investment strategy that allocation of funds to various asset classes such as bonds, stocks, commodities is determined. Bear in mind that in a fund, the investor’s assets are segregated, which means that the funds are held by a depository bank, separate from the company assets. This is to protect investor’s money in case the investment company becomes insolvent.
The typical investment fund is active, which means that the fund manager is responsible for achieving returns higher than the benchmark. This active fund management is different from managing index funds.
What is an index fund?
An index fund represents the development of an index as accurately as possible. The components and their respective weight, in an index funds are exactly the same as the index itself. If you invest in an index fund, you have the advantage of knowing the exact composition since it replicates the index. For instance, the underlying composition of EURO STOXX 50 is known at any given time. The EURO STOXX 50 is the European stock index and holds 50 of the largest corporate stocks of Euro zone in a proportion determined by their free float market cap.
In an Exchange traded fund or an index fund, there is no complicated mechanism for stock picking, it’s simply a replication of an index, as opposed to active funds. And this is why managers of index funds and ETFs receive small annual fee.
What is an Exchange Traded Fund?
Exchange traded fund or an ETF, is exactly what it sounds like, a fund that’s traded on an exchange, like the stock of a company. ETFs combine the benefits of intraday trading and liquidity of stocks, with the diversification of index funds.
A simple way to understand ETF is to imagine an asset manager that buys a bunch of assets, say, 100 stocks of FTSE 100, and puts them in a fund. To be clear, FTSE 100 (total return) index tracks 100 largest stocks in the U.K. Now the asset manager, gets this fund listed on the stock exchange like a company, and issues its shares to public.
An actual example of this strategy is iShares Core FTSE 100 UCITS ETF (Dist)… An ETF that seeks to track the performance of FTSE 100 index.
The names of many ETFs might sound too long and complicated but when you break them down they make sense. For instance, iShares represents the family of exchange-traded funds managed by BlackRock, an American global investment firm, it’s the world’s largest asset manager with about $5.7 trillion asset under management.
Core FTSE 100 part represents investment style, which in this case is to track the performance of FTSE 100 index.
The last part UCITS stands for “Undertakings for Collective Investment in Transferable Securities”. In simple terms, it only means a European mutual fund. Here it represents the investment structure of the ETF.
Similarly you can break down Vanguard S&P 500 UCITS ETF. Vanguard is a huge name, it is an American investment advisor with over $4.5 trillion of assets under management. S&P 500 part is the investment style, which means that it tracks the performance of S&P 500 index.
When the underlying assets (the assets that an ETF holds) appreciate in value, the price of that ETF on the exchange also goes up
conversely, when the assets’ depreciate in value, the price of the ETF on the exchange goes down in value. ETFs go through price changes during market hours as they are bought and sold. Which is why these typically have higher liquidity and lower fees compared to mutual fund shares. This makes them an attractive investment for individual investors.