There have been few financial innovations which have had as dramatic an impact on the global investment landscapes as have Exchange Traded Funds (ETFs). When the first ETF came to market some 20 years ago, few expected that today there would be over 1,500 ETFs worth some $1.1 trillion trading in the US alone.

ETFs are funds which trade on exchanges and are designed to track the return of a particular index or portfolio. They are typically low cost and passively managed and will post returns very close to the underlying index the fund tracks. ETFs have become popular primarily because so few high cost, actively-managed fund managers can outperform their respective index. Unlike open-ended mutual funds which have prices calculated only at day’s end, ETFs – like stocks – trade throughout the day, offering investors efficient liquidity terms.

ETFs can also be shorted, a way to bet on a market going lower and even leveraged using margin accounts.

Generally passive management is a key ETF attribute and implies a fund management company which makes minor and periodic adjustments to ensure the fund tracks its index. ETFs normally track a benchmark without necessarily trying to outperform and thus experience minimal costs.

The S&P500 ETF (SPY), one of the world’s most active, is a widely watched and frequently traded basket of 500 of the largest companies in the US. An investor could attain exposure to these 500 stocks by either buying them directly (an extremely expensive undertaking when one factors the commissions associated with buying each individual stock) or can buy the SPY which already owns these 500 stocks. So for example, if the S&P500 on any given day is up 1.5 per cent, the SPY ETF which tracks the index will also be up very close to 1.5 per cent.

ETFs come in many varieties, some representing particular industries, others a basket of commodities or a country equity or bond index, a currency, etc. ETFs have become so popular primarily because they’re efficient to trade, tax-efficient and quite transparent.

Although the process of investing in ETFs is normally quite straightforward, investors do need to consider some risks. Many ETFs such as SPDR Gold (GLD) or the PowerShares Nasdaq 100 (QQQ) are ETFs which hold with a custodian, or in vaults, actual stocks certificates or gold bars. In the case of the GLD, each share is worth approximately a 10th of an ounce of gold. However, there are some ETFs which don’t actually hold securities or commodities, but instead could use complex derivatives such as total return swaps, futures and options to replicate the index’s performance.

A derivative is a security that derives its value from the value of something else. The problem with derivatives is that should the counter­party to those derivatives declare bankruptcy, the ETFs value could be significantly impaired. It’s also quite common for commodity, foreign exchange inverse and leveraged ETFs to use derivatives.

Inverse ETFs such as ProShares Short S&P 500 (SH) are designed to move in the inverse direction as the S&P500 index. Should the S&P500 be down two per cent, the SH ETF will rally two per cent. There are also some ETFs which utilise two or three times leverage to magnify returns. The ProShares Ultra MSCI Japan (EZJ) ETF is two times leveraged and designed to replicate the movement in the MSCI Japan Index. Should this index rally two per cent in any given day, EZJ will rally a magnified four per cent.

Leveraged ETFs aim to replicate the movement of a single day, as measured from one net asset value (NAV) calculation to the next. Because of compounding issues, returns over a longer period could deviate significantly from the underlying index. This is called tracking error, which occurs often when investing in leveraged ETFs. Leveraged ETFs should be predominantly short-term trading vehicles.

Like closed-ended funds, ETFs also trade at a discount or premium to NAV and care should be taken to not purchase securities at a significant premium. Although many ETFs are very active and liquid, some aren’t and could have quite wide trading spreads.

Besides ETFs, there are exchange traded notes (ETNs). The attractiveness of ETNs is they have minimal tracking error because the issuer promises to track the underlying index. It’s important to appreciate that ETN are credit securities and pose issuer credit risk.

ETFs and ETNs offer investors invaluable opportunities to invest in investment vehicles, which only years ago were out of reach for most investors. With sound diversification attributes, ETFs can help you attain your investment goals.

This article is the objective and independent opinion of the author. Any opinions expressed here should not be interpreted as investment advice, nor should they be considered as an offer to sell or buy an investment.

Joseph Portelli is the managing director and chief investment officer at FMG Funds (Malta). He also is a lecturer at the University of Malta and Institute of Investment Analysis.

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