ETFs –Simple, but not straightforward

An Exchange Traded Fund (“ETF”) is, by definition, a fund; meaning a collection of investments that trade on an exchange, meaning latest traded prices are listed on an exchange to facilitate trade between counterparties. It does not mean that it trades at its fair value, as represented by its NAV; neither does it necessarily mean that it tracks either a widely recognized index or a passive strategy.

The problem of discounts and premiums to NAV is overcome if a market is efficient; buyers and sellers will keep the price at its fair value, through supply and demand. The emphasis here is to use products that are widely traded.

The first things to check for are the size of the ETF and daily volume traded. A secondary issue in this regard, is to address the misconception that these products are cheap, as most of them have very low quoted management fees. However, this is only half the story. There is also the bid offer spread to consider, which can be quite large – especially if an instrument does not trade regularly on the secondary market and has to be created/redeemed by its market maker. The more frequent you trade, the more expensive it becomes, as costs add up.

There are also different ways of tracking, some of which are more effective than others, and some even carry very specific risks. For the sake of keeping this to one page, I will not even go into similar, but very different products such as Exchange Traded Notes (“ETNs”) etc. For instance, some ETFs would loan out the shares that they buy to track an equity index and receive compensation for it, which means that even after fees they can outperform the index they are tracking. This comes with counterparty risk though, which is not as scary as it sounds, but the tracking strategy needs to be understood properly to know what to expect.

The best way to screen for all of the above mentioned potential issues is to look at the funds tracking error, the lower it is – the better. The second critical part is to understand what the fund is actually tracking. An index can be created specifically for the purpose of creating an ETF to track it. The index would have its own prospectus, or set of rules, in the same fashion as any fund would. This mean it does not necessarily need to be static, just consistent, and smart indices that over or underweight securities based on mathematical formulas are quite common. The constituents may vary vastly over time, the only difference between these ETFs and other discretionary funds is that they follow a set of rules and thus there is no human intervention once the strategy has been finalised. This not exactly passive, in my opinion, but rather a quantified thinking process that can take very active positions compared to widely recognized exchanges.

In conclusion, not all ETFs are equal, and it is wise to make sure that you understand all the intricate details of a product and not take anything at face value. This does not mean that there is no place for them in an investment solution, on the contrary, I believe they can be used to great effect, just make sure you know/understand what you are buying.