What are ETFs? Exchanged Traded Funds Easily Explained
1.- What are ETFs?
ETF is the acronym forExchange Traded Fund. The Exchange Traded Funds or in Spanish,listed investment funds, are financial assets that evolve like a stock index and therefore replicate it. Compared to other stock index products, ETFs have avery little Tracking Error, that is, a very small discrepancy with the index. The Tracking Error is mainly due to transaction costs in the purchase and sale of each of the securities that make up the index.
ETFs are, like stocks,negotiable daily in the marketand they are listed on the secondary market, which allows us to know their value at all times. These first two characteristics make them quite different from investment funds, which can only be bought and sold at the end of the day once their liquidation value has been calculated at the end of the Stock Market session.
ETFs are passively managed investment products, since they only seek to copy the behavior of the index. That is why in the ETFs there is no figure of the fund manager doing Stock Picking, that is, choosing the values of the fund individually trying to beat the index. The adjustments usually take place in a computer system, which trades automatically and saves costs, so theCommissions are usually much lower, since there is no need to pay the figure of the manager or managers.
The only drawback that ETFs have compared to investment funds in Spain is that in traditional investment funds you can transfer money from one fund to another without paying taxes on the profits obtained until the final sale of the shares in the fund. background. With ETFs this is not possible, you cannot transfer the money from one to another, since you have to sell and buy to transfer the money to other ETFs, which means that you have to pay taxes on the profits from the sale, thus decreasing the Heritage.
2.- ETF replication methods
The creation of an ETF can be carried out in different ways or methods of replication of the index. There are basically two methods:physicalandsynthetic.
2.1.- Physical replication
In physical replication, the managing company of theETFs in effect buy the financial assets that are included in the index.
Sometimes it is not always possible to make a full physical replica of all the securities in the index, either because the index contains many securities and would cause high costs, or because the markets for some securities are not sufficiently liquid. In these cases full physical replication reaches its limits and analytical tools and mathematical optimization procedures are used to define the subset of index components that will achieve similar performance to the original values represented in the index. This is calledoptimized or sampled physical replication(Sampling).
2.2.- Synthetic replication
On the other hand, in synthetic replication oralso called SWAP, the ETF manager makes aexchange (swap) with a counterparty, which is usually an investment bank. To do this, the manager can create astock portfolioat his will, for example of large European companies, and undertakes to exchange with the counterparty the performance of that portfolio, which he has created, in exchange for the performance of the index in question. This agreement for the financial exchange of returns is called a swap contract and it is a very simple method since it is simply based on contracts.
If the synthetic method is compared with physical replication, there is generallya drawback to the synthetic method:Counterparty credit risk. Counterparty credit risk is the risk that the counterparty, with which an exchange agreement has been reached, goes bankrupt during the life of the contract and therefore the return exchange cannot be exercised. The physical replication method does not have this risk since in this method the shares are actually purchased.
3.- Types of ETFs
ETFs open the door to anew world of investment opportunities, since they allow us to access a wide range of assets, which in many cases are difficult for individuals to access. There are many types of ETFsaccording to the nature of the underlying assetsof the indices that represent:
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Equity ETFs: the behavior of the ETFs is linked to the behavior of the stock market index that it represents.
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Fixed Income ETFs: those that copy the indices of debt financial assets that represent baskets of bonds or public or private obligations.
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Index ETFs by Capitalization: They are the ones that copy indices that represent groups of values based on their market capitalization.
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currency ETFs: copy indices of short-term government debt assets with maximum credit rating.
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national ETFs,regionaleitherglobal.
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sector ETFs: those that refer to indices of different business sectors, such as the banking sector, technology sector, textile sector, etc.
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Commodity ETFs: replicate indices of groups of companies that work with oil, gold or wheat, among others.
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Factor ETFs: refer to indices that represent companies that meet a characteristic or factor, such as quality factor or value factor.
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Special mention deservesInverse ETFs(called Short-ETFs in English), theleveraged ETFs(called Leverage ETFs in English) andInverse Leveraged ETFseitherultra leveraged.
AInverse ETF behaves opposite to the index. If for example we take theIBEX 35as an index and it falls 2%, this would mean that your Inverse ETF would rise by 2% at that very moment. Conversely, if the IBEX 35 rises 2%, your Inverse ETF would logically fall 2%.
Example of the price of an inverse ETF
ALeveraged or leveraged ETF participates in a proportionate way of the profits or losses of the index. If, for example, we have an ETF indexed to the IBEX 35 with leverage of 2 and the IBEX 35 rises 2%, that means that my ETF rises 4%. Conversely, if the IBEX 35 falls 2%, my ETF also falls 4%. We benefit proportionally if the index rises and we lose proportionally if the index falls.
Ultra-leveraged ETFs are a mix of the latter two.
Equity ETFs are made up of shares of listed companies. These companies in which the ETF invests, as usual, distribute dividends to their shareholders. There are two types of ETF depending on the treatment received by thedividendsthey receive from the companies in which they invest:
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Accumulation ETFs and
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Distribution ETFs
ETFs ofaccumulationmeans that the backgroundreinvest dividends, collected by the fund companies,back in the ETFincreasing its price. Instead the ETFsof distribution, as its name indicates, yesdistribute dividends to investors.
4.- Advantages of ETFs
Diversification
The biggest advantage of ETFs is theirdiversificationor rather hisdistribution of money in multiple sectors, countries or financial assets. This reduces the overall investment risk.
Liquidity and transparency
The second advantage is the listing, which makes these funds very liquid and transparent. Being listed investment funds and beingtradable on the secondary market, they can be bought and sold or, in other words, you can enter and leave the ETF at any time, making them very liquid financial products. At the same time, they are very transparent products since thanks to the quote it is possiblesee at any time not only its valuation but also the basket of securities that make up the ETF.
Low costs
Another advantage is the low costs. As I mentioned before, ETFs are passively managed and unlike other financial products such as investment funds.no need to pay manageror active managers of the fund. The manager of an ETFs has to reproduce the index only once and only re-act when the assets of the index are modified. If we continue with our example of the IBEX 35, when a company leaves the IBEX 35 and consequently one of the companies in the IBEX Medium rises to the IBEX 35, only then does the ETF manager have to act by selling the shares of the company that has left the IBEX 35 and buying the shares of the company that has promoted.