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What can I do with my money? |
Exchange Traded Funds (ETFs)
What is an Exchange Traded Funds (ETFs)
An ETF is a financial product that can be traded on the stock exchange. What makes an ETFs unique is that it typically tracks a financial index such as the Dow Jones index, Standard and Poor (S&P 500), FTSE 100 etc. These indices track the performance of the largest companies in the world.
How does an ETF work?
An ETF can be created to:
Passively tracking an index
Most ETFs on the stock market passively replicate financial indices. Take for example the S&P 500 which tracks the largest 500 companies that are listed on the New York Stock Exchange (NYSE). These 500 companies vary in size, size being measured by market capitalisation. Market capitalisation refers to the total market value of shares of a given company.
Imagine that the 3 companies listed in the S&P
Company A is worth £5 million and contributes 5% to the value of the S&P index
Company B is worth £3 million and contributes 3% to the value of the S&P index
Company C is worth £1 million and contributes 1% to the value of the S&P index
These differences in capitalization will be reflected in the S&P 500 Index meaning Company A is weighted more than company B or C. When an asset manager (also called an Investment fund provider) is creating an ETF that tracks the S&P, they also take these weighting into account.
If an asset manager has a pool of investors money worth £10million. In order to replicate the S&P index, the asset manager will allocate £500,000 (5% of £10million) to Company A, £300,000 (3% of £10million) to B and £100,000 (1% of £10million) to C. This allows the ETF to fully replicate the behaviour of the S&P index. If S&P removes company C from its index and replaces it with Company F, the ETF will withdraw from Company C and will instead allocate £100,000 to F.
When you buy an ETF, you are not buying the stocks in the ETFs you are buying the share of the fund which contains these stocks.
ETFs can also be created via synthetic means where no physical stock is purchased but contractual agreements are made with banks to in order to benefit from the performance of a stock. Synthetic ETFs are rarer and you can read more here.
Follow a specific strategy (see Mutual Fund)
Asset Managers can also create an ETF by following a specific theme. In that case, they research and select companies that are in line with a given theme. Themes can be sector specific like Robotics, commodities, regionally specific such as Asia or Latin America or solutions centric such as Heathcare Innovation, Ageing Population and more.
Benefits of ETFS
Term, How long should I hold ETFs for?
As with funds and stock, you can hold these assets for as long as you like and you can also trade them easily via your brokerage account.
How can I invest in an ETF?
An ETF is a financial product that can be traded on the stock exchange. What makes an ETFs unique is that it typically tracks a financial index such as the Dow Jones index, Standard and Poor (S&P 500), FTSE 100 etc. These indices track the performance of the largest companies in the world.
How does an ETF work?
An ETF can be created to:
- Passively tracking an index
- Follow a specific strategy (like mutual funds)
Passively tracking an index
Most ETFs on the stock market passively replicate financial indices. Take for example the S&P 500 which tracks the largest 500 companies that are listed on the New York Stock Exchange (NYSE). These 500 companies vary in size, size being measured by market capitalisation. Market capitalisation refers to the total market value of shares of a given company.
Imagine that the 3 companies listed in the S&P
Company A is worth £5 million and contributes 5% to the value of the S&P index
Company B is worth £3 million and contributes 3% to the value of the S&P index
Company C is worth £1 million and contributes 1% to the value of the S&P index
These differences in capitalization will be reflected in the S&P 500 Index meaning Company A is weighted more than company B or C. When an asset manager (also called an Investment fund provider) is creating an ETF that tracks the S&P, they also take these weighting into account.
If an asset manager has a pool of investors money worth £10million. In order to replicate the S&P index, the asset manager will allocate £500,000 (5% of £10million) to Company A, £300,000 (3% of £10million) to B and £100,000 (1% of £10million) to C. This allows the ETF to fully replicate the behaviour of the S&P index. If S&P removes company C from its index and replaces it with Company F, the ETF will withdraw from Company C and will instead allocate £100,000 to F.
When you buy an ETF, you are not buying the stocks in the ETFs you are buying the share of the fund which contains these stocks.
ETFs can also be created via synthetic means where no physical stock is purchased but contractual agreements are made with banks to in order to benefit from the performance of a stock. Synthetic ETFs are rarer and you can read more here.
Follow a specific strategy (see Mutual Fund)
Asset Managers can also create an ETF by following a specific theme. In that case, they research and select companies that are in line with a given theme. Themes can be sector specific like Robotics, commodities, regionally specific such as Asia or Latin America or solutions centric such as Heathcare Innovation, Ageing Population and more.
Benefits of ETFS
- They can be traded like a stock
- They are diversified
- In the case index replicating funds, the costs are lower
- ETFs involve minimal human involvement because the asset manager simply has to copy existing indexes. The asset manager does not have to research companies individually to asses if it is the right fit for their fund. Research requires specialist skills and incurs costs. Costs are also lower as asset managers are likely to have deals with banks who can provide these stocks at a lower cost. The Vanguard S&P 500 ETF has a charge of 0.07%. This is comparable to a mutual fund like the TB Discovery Growth which charges 2.10%.
Term, How long should I hold ETFs for?
As with funds and stock, you can hold these assets for as long as you like and you can also trade them easily via your brokerage account.
How can I invest in an ETF?
- Do it yourself: You can invest in an ETF much like you would a fund. Just do some research online or via your brokerage account (see examples below) on what you would like to invest in e.g. Technology ETF, Gold ETF, Real estate ETF.
- Robo Advisor Use a Robo Advisors such as nutmeg or etfmatic, where they outline how they use ETFs to build your portfolio.
- IG Share Dealing
- Hargreaves Lansdown
- Freetrade
- Interactive Investor Share & Fund Account
- Degiro Share Dealing
- Vanguard Investor
- Revolut
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Disclaimer
The content on WealthSquats are my own thoughts. Consult certified financial experts to get information that is suitable to you.
The content on WealthSquats are my own thoughts. Consult certified financial experts to get information that is suitable to you.
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