The advantages of exchange-traded funds

Major benefits of ETFs include low costs, transparency and liquidity.

This is the 10th and final article in a series by Henry Cobbe, head of research at Elston Consulting, exploring the world of index investing. Henry is author of How to Invest With Exchange-Traded Funds.

Indexes: the DNA of an ETF

An exchange-traded fund (ETF) is an index-tracking investment fund that aims to perform exactly in line with a specific index, usually noted in the fund’s name. The index it tracks defines an ETF’s “DNA”.

An index is a collective measure of performance for a defined group of securities, with criteria for inclusion and weighting within that group defined by a systematic set of rules. Indices can represent a basket of equities such as the FTSE 100 index (the “Footsie”), or a basket of bonds such as the FTSE Actuaries UK Conventional Gilts All Stocks index (the “gilts” index). Indices can be used as benchmarks to represent the performance of an asset class or exposure. ETFs aim to track these benchmark indices by holding the same securities in the same weights as the index.

While ETFs can be an equity fund or bond fund (among others), based on the type of index they track, the shares in those ETFs trade on a market exchange just like an equity.

ETFs combine the diversification advantages of a collective investment scheme with the accessibility advantages of a share, but with a management fee substantially lower than traditional active funds. These features make ETFs easy to buy, easy to switch and easy to own, revolutionising the investment process, as well as reducing investment costs.

Indices enable transparency

ETFs are regulated collective investment schemes (often known as UCITS schemes) that can be traded on a recognised exchange, such as the London Stock Exchange.

The manager of a traditional active fund aims to outperform an index such as the FTSE 100 by overweighting or underweighting particular securities in that index or by holding non-index securities. In contrast, an ETF aims to deliver the same returns as the index by holding in the fund the same securities as the index and in the same proportion.

If the index represents a basket of securities weighted by their respective size, it is a “market-capitalisation-weighted index”: this is the traditional index approach.

If the index represents a basket of securities weighted by a criterion other than their respective size, it is an “alternatively-weighted” index. For example, an equal-weighted index means all the securities in an index are given an equal weight.

Example of cap-weight and alt-weight indices and ETFs

Source: Elston, for illustration only

ETFs track indices, and indices have rules. Index rules are publicly available and set out how an index selects and weights securities and how frequently that process is refreshed. Indices, therefore, represent a range of investment ideas and strategies and are codified using a rules-based approach. This makes ETFs’ investment approach transparent, systematic and predictable, even if the performance of securities in the index is not.

Furthermore, ETFs publish their full holdings every day, so investors can be sure of what they own. This makes the investment risk of ETFs transparent.

The investment risk-return profile of an ETF is directly linked to the risk-return profile of the index it tracks. Hence, ETFs tracking emerging-market equity indices are more volatile than those tracking developed-market indices, which in turn are more volatile than those tracking shorter-duration bond indices.

ETFs vs traditional funds

An ETF is different to other types of investment funds in the following ways:

• A traditional active fundhas shares or units that are not traded on an exchange and typically has an objective to outperform a particular benchmark index.
• An index-tracking fund has shares or units that are not traded on an exchange and typically has an objective to track the performance of a particular benchmark index.
• An investment trust has shares that are traded on an exchange and typically has an objective to outperform a particular benchmark index.
• An exchange-traded fund has shares that are traded on an exchange and it typically has an objective to track a particular benchmark index.

The primary advantage of ETFs is the additional liquidity that a “secondary market” creates in the shares of that ETF. This means that investors are able to buy or sell existing shares of ETFs via a recognised exchange. However, it is important to note that ultimately the liquidity of any ETF is only as good as its underlying assets.

Traditional mutual funds can be traded once a day and investors transact with the fund issuer, who must buy or sell the same amount of underlying securities. Fund issuers have the right to “gate” funds and refuse to process redemptions to protect the interests of the broader unit-holders of the fund. If this happens, there is no secondary market for shares or units in the fund. Recent examples of “gating” include UK property funds after the Brexit vote.

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By contrast, ETFs can be traded throughout the day and investors generally transact with each other via the exchange. If necessary, the fund issuer must create (or redeem) more units to meet demand and then buy (or sell) the same amount of underlying securities.

While the liquidity of the fund is ultimately only as good as the underlying assets, there is additional liquidity in the secondary market for shares in the fund that can be bought or sold among investors. For example, there have been circumstances when some markets have closed, and the underlying shares aren’t traded, the ETF continues to trade, albeit at a premium or discount to net asset value (NAV).

As regards to fees, whereas funds have different fee scales for different types of investors based on share classes, the fees on ETFs are the same for all investors, meaning that the smallest investors benefit from the economies of scale that the largest investors bring.

While the active/passive (we prefer the terms non-index/index) debate grabs the headlines, it is this targeted access to specific asset classes, fee fairness and secondary market liquidity that makes ETFs appealing to investors of any size.

Ways to use ETFs

We see three key applications for ETFs in portfolio construction: core, blended and pure.

Using ETFs for a core portfolio means creating and managing a core asset allocation constructed using ETFs, with satellite active fund holdings in an attempt to capture some manager alpha at a fund level. This helps the investor to reduce, in part, the overall costs without forsaking their hope of higher expected returns from “true active” non-index fund holdings for each exposure.

Using ETFs for a blended portfolio means creating and managing an asset allocation constructed using ETFs for efficient markets, or markets where portfolio managers may lack sufficient research or experience; and active funds for asset-class exposures where the manager has high conviction in their ability to deliver alpha from active fund or security selection. For example, a UK portfolio manager with high conviction in UK stockpicking may prefer to access US equity exposure using an ETF that tracks the S&P 500 rather than attempting to pick stocks in the US.

The use of ETFs for a pure ETF portfolio means creating and managing an asset allocation constructed using ETFs entirely. For example, a portfolio manager looking to substantially reduce overall client costs without compromising on diversification is able to design a portfolio using ETFs for each asset class and risk exposure.

Who uses ETFs and why?

ETFs are used by investors large and small to build and manage their portfolios. As well as providing low-cost, diversified and transparent access to a market or asset class, the major benefit of ETFs is in the liquidity. ETFs invest only in liquid securities that are index-eligible. At the same time, the ETF can itself be bought or sold between market participants, meaning that investors can adapt their portfolio in a timely basis, if required.

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ETFs are designed to be tradeable on a secondary market via an exchange, and can be bought and sold between market participants on the same day without the fund manager’s involvement. This means that if investors want to alter their risk posture to respond to changing events, they can do so instantly and effectively if required.

ETFs have therefore grown in popularity as a core part of the toolkit for portfolio and risk management.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.