An exchange traded fund (ETF) is a fund that trades on the stock market itself, meaning that investors can buy or sell its shares.
The fund aims to track an index or a commodity in a passive way, giving investors the same return they would have if they held the relevant stock or commodity.
Trading on a stock exchange means the price depends on supply and demand for the shares; this in turn means that the price can vary from that of the underlying index or commodity.
What products do they cover? Investors can buy ETFs that cover various stock markets and geographies, but some of the most popular ones – sometimes called exchange traded products (ETPs) – cover commodities. Those that seek to capture the performance of gold or silver have been growing in popularity recently.
How are they made? The issuer either owns the underlying asset or borrows it, and then sells shares in its ownership, which can be traded.
An ETF can be physically backed, where the issuer owns the physical items that are being tracked, or synthetic.
A synthetic ETF, like a synthetic index tracker, uses derivatives to replicate the performance of the underlying asset, the main benefit being a reduction in costs.
Some providers of gold ETFs therefore own no physical gold, but have an agreement in place with a counterparty – typically a large investment bank – that entitles them to receive payments equivalent to the returns of the precious metal.
How much do they cost? Like index trackers, the other main form of passive investing, the charges are low, typically around 0.5 per cent. Investors do not need to pay initial charges, for example.
The other thing to remember is that ETFs trade like shares. This means that short-term investors potentially have the opportunity to buy the shares when they are trading at a lower price than the underlying assets and sell when the price rises, taking profits.
The manager will take advantage of these differences to buy or sell the physical asset or the ETF as and when they can make a profit (this is called arbitrage).
This will help to keep the price in line with the underlying asset too.
What are the risks?
The worry with synthetic ETFs is that if the counterparty goes bust, the ETF investor stands to lose their money, and the 2008 collapse of Lehman Brothers showed that even large investment banks can collapse.
This means that many analysts recommend the holding of physical commodity ETFs rather than their synthetic counterparts; that said, the synthetic products may be more useful for covering indices with a large number of constituents that it is impossible or impractical to physically hold.
Another risk with synthetic ETFs is what is done with investors’ collateral. If the issuer of the ETF holds your money in an investment with its own risks – like other shares – then it can be at risk if that investment suffers.
This means it is very important to inform yourself about how the product works, particularly if it is synthetic.
What are the key differences between ETFs and index trackers? As with any stock, a potential problem is finding a buyer. Whereas investors can take their money out of an index tracker fund – the other key method of passive investing – whenever they want, they will need to find a buyer if they want to offload their ETFs.
Furthermore, while the prices of tracker funds are set once a day, ETFs can vary minute-by-minute, which means they are more easier to trade but that timing can be more important.