What is ETF?

2018-12-10 08:26
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ETF is an open-end fund traded on Exchange with variable fund units. It allows investors to participate in a particular market indirectly. Buying an ETF, investors can receive a return similar with the specific index, even though the investors haven’t held any shares of the index.

The introduction of global ETF market

Over the past decade, the passive investment financial products developed rapidly, especially ETFs, which offer couple of choices to investors in terms of asset classes and strategies. The growth of ETF is significant in terms of both number and asset under management (AUM). The number of global ETFs has exceeded 5,900 with an AUM of 3.6 trillion US dollars at the end of March 2018, which is much higher than the 2007 level of 0.6 trillion US dollars.

The development trends of ETF

Since the first ETF was introduced in Canada in 1990, ETF products entered the US, Asia and European Exchanges in 1993, 1999 and 2000 respectively. In 2000, ETFs were no longer limited to track with stock indices, but also track with other non-stock indices.

Recently, the development of ETFs has surpassed the basic categories of assets. The US ETF options market grew rapidly over the past five years. According to JP Morgan’s research, there are about one-third of the US ETFs are composed with options, but they are mainly contributed by several renowned ETFs. The volume of US ETF options has been higher than the sum of all stock options, implying that investors prefer using ETF option as a hedging tool in the portfolio. In the past two years, ESG has become a hot issue. ESG stands for Environmental, Social and Governance Criteria. It is a set of standards for a company’s operations that socially conscious investors use to screen potential investments. ESG has been infiltrated into the ETF investment, and it provides a mechanism to capture corporate profits and to manage corporate reputation and operational risk at the same time.

Moreover, the ETF fee rate is decreasing continuously. All the weighted asset management fee of ETF showed different degrees of decline in US, Europe and Asia. And it results from two main reasons, which are the high demand on low fee ETF products and the fee reduction in ETF due to the high competitions in this market.

Characteristics of ETF

As an investment product that combines stocks and funds, ETF has four main characteristics. Firstly, ETFs are established in the form of mutual funds and unit trust funds, but the fund units are allowed to trade on the Exchange like the way stock does. Secondly, ETF fund managers can adopt different strategies, include comprehensive simulation strategies, representative sampling strategies, and synthetic simulation strategies, to achieve their goals in tracking the index. Thirdly, the ETF mainly tracks with the index of spot market, including the price index and the total return index. If the ETF tracks with the total return index, the dividends and interest received by the fund will be reinvested in the index portfolio based on their weighting. In addition, there are ETFs that track with futures indices. Fourthly, there may be a spread between ETF trading price and the fund’s net asset value. The bid and ask price will depend on the market supply and demand. Therefore, it is not necessary that the ETF trading price is equal to the net asset value, and the difference between them will offer arbitrage opportunities for investor.

Advantages and major risks of ETF

The rapid development of ETFs is due to their own advantages. Firstly, ETFs are easy to buy and sell, which can avoid the trouble of individual in selecting stocks. Also, ETF includes a basket of stocks, it provides a diversified portfolio to investors, and which can lower the concentration risk of buying one single stock. Secondly, the operation of ETFs is simple and transparent. ETFs are closely track with the indices and they allow investors to get access to the composition funds daily. Also, Investors can obtain the real-time trading information of the fund easily. Thirdly, the transaction costs of ETFs are low since the cost of indexed investment is generally lower than the one of actively managed funds.

 

At present, there are many types of ETFs and investment strategies, resulting in higher investment risks. The main risk of the ETFs comes from the price change of the tracking index. The decline in tracking index may led to a decline in the ETF’s net value. Unlike the actively managed funds, ETFs would replicate the performance of the tracking index, the fund managers will not deploy a defensive plan for the bearish market, so investors may lose most of their investment when the index falls. Secondly, the performance of ETFs and related indices may be inconsistent, resulting in tracking error. The risk of tracking error may depends on the tracking strategy that used by the ETF. The physical asset ETF is relatively simple while the synthetic ETF that formed by having a derivative contract is relatively complicated and risky. Therefore, the synthetic ETFs that listed on the Hong Kong Stock Exchange will be marked with an “X” at the beginning to make synthetic ETF products easier to be identified.

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