A basket of ETFs
Last week I wrote in BusinessDesk that an Exchange Traded Fund might be one (good) way of gaining investment exposure to the world of chipmakers such as Nvidia, AI start-ups etc. I’ve since had a lot of incoming inquiries mainly along the lines of “…what is an Exchange Traded Fund?” Good questions indeed, so back to basics for the next few paragraphs.
An Exchange Traded Fund (ETF) is a type of pooled investment security that operates much like any managed fund. Typically, ETFs will be structured to follow or track a particular index, a sector such as US financials, commodities, or other assets. They’re not a particularly new concept, they’ve been around for 30 years but have proliferated in the past 10 or so. The first ETF was the SPDR S&P500 ETF, which was established by State Street Global Advisers in 1993 to track the US’s S&P500 Index. The Spyder, as the ETF has become affectionately known has a market capitalization of US$400bn and remains an actively traded ETF today.
There are US$107 trillion of listed shares across all the share markets in the world. ETFs control less than 10% of these shares with some 80% of that controlled by the three largest providers: BlackRock, Vanguard and State Street. You will likely be aware of the drive by these and other groups to collectively ‘pool’ the votes and rights of the underlying shares they own (on behalf of single stock investors) and vote them in a manner they deem worthy of affecting change. Mainly towards various green and/or ESG or SR initiatives. There are almost as many ETFs listed in the USA as there are single stocks (3,000 vs 4,000 as a ballpark). From my check of the NZX we have a lot fewer ETFs, we have 34 versus the 50 stocks that make up the benchmark S&P/NZX 50 Gross Index.
ETFs can even be structured to track specific investment strategies. An ETF can own hundreds or thousands of stocks across various industries, or it could focus on just one particular industry or sector. For example, banking-focused ETFs would contain shares of various banks across the industry. Some funds focus on securities in one geography while others may invest across many. As the acronym ETF suggests, and unlike the funds managed and offered by the likes of Milford Asset Management or Fisher Funds here in NZ, ETFs can be purchased or sold on a stock exchange the same way that regular shares can. They’re typically cheap in terms of ongoing fund and administration costs, certainly nearly always cheaper than actively managed funds. Because there are multiple assets within an ETF, they can be a popular choice for diversification as I mentioned last week when discussing Nvidia.
You can imagine with a total universe of ETFs exceeding US$10 trillion in value that there’d be lots of them and lots of different types – and there is. Here is a brief description of some of the ETFs available on the market today.
First, there are passive ETFs that are structured / indeed automated to try to replicate the performance of a broader index be it either a diversified index such as the S&P500 or a more specific targeted sector, such as US financials. There are active ETFs that comprise a basket of pre-selected securities such as shares of mining companies. These ETFs don’t typically target an index of securities, but rather have portfolio managers making decisions about which securities to include in the portfolio. These funds sometimes have benefits over passive ETFs but can be more expensive to manage.
Within the subsets of active and passive ETFs their underlying investments usually comprise shares, bonds and in the case of shares, sector groupings thereof. Share ETFs comprise a basket of stocks to track a single industry or sector. For example, a share ETF might track the shares of auto companies. The aim is to provide diversified exposure to a single industry, one that includes high performers and new entrants with potential for growth. Another example is the technology sector, which has witnessed an influx of funds in recent years as investors have sought to gain exposure to the potentially complex and confusing sector. Bond ETFs provide regular income to investors and would likely include investments in government and local authority bonds and corporate bonds. As can be the case with the underlying investment these ETFs can trade at a premium or discount from the actual ETF value.
I could go on as there are so many more types of ETFs, from commodity ETFs to currency ETFs to leveraged ETFs. But I think you get the gist.
The fans of ETFs will promote their trading flexibility, source of portfolio diversification and risk management, lower costs, and in some cases tax benefits. Those that don’t like them so much will cite trading fees, operating expenses, liquidity or lack thereof, tracking error or return drift from the target benchmark, hidden risks etc. To my mind, both can be true at the same time.
The largest risk though is that the ETF doesn’t actually do what you want it to. By way of example, at Hobson Wealth, we have recently been trying to get exposure to the AI space (outside of single securities) and in doing so have found that a number of the ETFs do not actually reflect or capture what we actually want to invest in or have other issues such as poor liquidity or concentration risk.
There you have it – a quick overview of the growing and bespoke world of ETFs. They have their places in investment portfolios but as with every type of investment, you need to be very thoughtful about what the underlying investments and exposures look like looks like and whether you’re truly getting the exposures you know, understand and want.