Exchange Traded Funds (ETFs)

Overview

An ETF is a fund that's open-ended and trades on a stock exchange just like an individual share would, in contrast to an OEIC, which is priced once a day. Most ETFs are specially designed to track specific indices or track certain markets so that investors can gain exposure to entire industries rather than specific investments.

How they're created

ETFs rely on a creation and redemption mechanism involving "authorised participants" (normally large banks), who exchange baskets of underlying securities for new ETF shares or vice versa, which keeps an ETF's trading price closely aligned with the value of its underlying holdings throughout the day, as any gap between the two creates arbitrage opportunities that authorised participants tend to close.

Types

ETFs can use physical replication, when they actually hold the underlying security in the index, or can use synthetic replication. This is when the ETF uses a derivative, typically a swap, to deliver the index's return, but this introduces counterparty risk that a physical ETF doesn't have. 

They can also be split into passive ETFs, which just track an index, and actively managed ETFs, where a manager makes investment decisions and continually changes the ETF's security holdings.

Thematic ETFs have grown significantly in popularity as they allow investors to track a specific trend or sector rather than a singular firm or commodity, thus spreading risk effectively. For example, an investor who speculates that gold may rise in price may purchase an ETF of gold miners instead of buying gold in order to spread risk.

Examples

iShares Core S&P 500, Vanguard FTSE All-World, and SPDR Gold Shares are three of the most widely held ETFs globally. These ETFs provide investors with exposure to US equities (specifically the largest 500 firms in the USA), global diversification in a huge number of equities, and volatile commodity exposure, respectively.

Advantages

A specific advantage of passive ETFs is that they are generally low-cost relative to actively managed funds, and can offer intraday liquidity due to exchange trading. They are also highly transparent about their holdings and offer tax efficiency advantages in some jurisdictions compared to other funds.

Risks

Tracking error can occur and refers to the gap between an ETF's return and its target index return, which creates a possible loss but is usually small. Synthetic ETFs can carry counterparty risk tied to whoever is on the other side of a swap instrument. Furthermore, ETFs can struggle for liquidity in stressed markets, meaning that an ETF's trading price can briefly diverge meaningfully from the value of its underlying less liquid holdings.