An investment product that has been proliferating among investors worldwide, in recent years, is a vehicle known as an Exchange Traded Fund. This is an investment vehicle which is constructed like an open-ended collective investment scheme but which trades like an individual security on a stock exchange. Most ETFs track an equity index, but a growing number provide access to other asset classes, including fixed income, money markets, commodities, currencies and alternative investments.

An ETF trades at approximately the same price as the net asset value of its underlying assets over the course of the trading day. Most ETFs track an index such as the Standard & Poor's 500, the Dollar Index or the MSCI Emerging Markets Index. ETFs may be attractive as investments mainly due to their low cost and equity like features which provide investors with much needed transaction flexibility.

The 'Spiders' ETF

ETFs have been available in the United States since 1993, with the launch of the S&P 500 Depositary Receipts (known as SPDRs or "Spiders") by State Street Global Advisors while in Europe they entered the market in 1999. By 2000, ETFs had just $74 billion in assets. But by the end of 2009, there were more than 2,600 funds globally, with over $1,000 billion in assets under management. By 2011, Morgan Stanley forecasts the sector will have $2 trillion under its belt. Another gauge of their growing popularity is the fact that, over the past year or so, the daily turnover in US-based ETFs was on average around 33 per cent of the total US equity daily turnover.

BlackRock Inc. became the biggest seller of ETFs after its December 2009 purchase of Barclays plc's iShares unit. IShares manages about $489 billion of ETF assets, giving it a 51 per cent share of the US market. State Street, based in Boston, is the second biggest seller of ETFs, with about $161 billion in such assets, while Vanguard ranks third, with $92 billion of ETF assets.

Structured like funds but trade like shares

ETFs have characteristics similar to those of both shares and open ended collective investment schemes. Like shares, ETFs are listed on the major stock exchanges in each region. Like open-end funds, ETFs are available on a wide range of both broad and narrowly-focused indexes. ETFs are popular among institutional investors in making rapid and large bets on sectors such as oil, gold, waste-management and semiconductors. They also use ETFs to hedge their bets on shares, bonds, commodities and other securities. For individual investors, ETFs offer a wider selection of indexes than collective investment schemes.

This has given retail investors an easy way of getting exposure to assets they might previously have been able to access only in a more costly, or roundabout, fashion. Those who foresaw gold's surge to a record high, for example, have been able to buy an ETF that tracks the metal's price instead of having to buy shares in a mining company and taking a bet on the management competence.

Given that ETFs trade on an exchange, each purchase and sale transaction is subject to a brokerage commission. However, most ETFs have a lower total expense ratio than comparable, traditional collective investment schemes. This is mainly because ETFs are not actively managed and have lower marketing, distribution and accounting related expense. Moreover, because of the way it is structured, an ETF does not have to invest cash contributions or fund cash redemptions and as such does not have to maintain a cash reserve for redemptions.

Investors in ETFs pay average annual expenses of $25 for every $10,000 of assets, compared with $91 for actively managed US equity funds, according to Morningstar Inc., a Chicago based independent research company. Perhaps the most important benefit of an ETF however, is the equity-like features it offers. Since ETFs trade on the market, investors can carry out the same types of trades that they can with an equity. For instance, investors can sell short, use a limit order, use a stop-loss order, buy on margin and invest as much or as little money as they wish (there is no minimum investment requirement).

ETFs also enjoy continuous real-time pricing, which means that they can be bought and sold on a stock exchange throughout the trading day. This allows investors to react to adverse or beneficial market conditions on an intraday basis.

This equity-like liquidity also allows investors to trade many ETFs in the pre-market and/or after hours with reasonably tight spreads. In contrast, an investor in an open-ended collective investment scheme can only purchase or sell at the fund's net asset value (NAV) which is determined at the end of the day.

Continuous trading is also beneficial when investors want to switch from one ETF to another. With collective investment schemes, unless they are on the same funds platform, you cannot sell one and buy another, without waiting for the settlement to take place, which typically take a number of days. With ETFs, the buy and sell orders can go in together. Even where the funds are on one platform, you will have to deal blindly, as you do not know what the closing price will be.

Leveraged and inverse ETFs

Following the turbulent events in the marketplace over the past year, some providers have introduced the concept of levered ETFs which use investments in derivatives to seek a return that corresponds to a multiple of, or the inverse (opposite) of, the daily performance of the index. Leveraged index ETFs are often marketed as bull or bear fund. A leveraged bull ETF fund might for example attempt to achieve daily returns that are two or three times more pronounced than the Dow Jones Industrial Average or the S&P 500. A leveraged inverse bear ETF fund on the other hand may attempt to achieve returns that are -2x or -3x the daily index return, meaning that it will gain double or triple the "loss" of the market.

Although the first ETFs were designed to track broad market stock indexes, since that time, ETFs have been developed to track industrial sectors, investment styles, fixed income, global investments, commodities and currencies. ETFs are now available to replicate just about any index available. All that is required is that there is enough investor interest to make the product profitable. An investor who wants to buy ETFs has a myriad of options to choose from. What is important is that the investor evaluates the different options available to ensure that the right ETF is chosen for the purpose of his/her investment.

Beware of the risks

An investment in an ETF is subject to similar risks as an investment in a portfolio of shares, where the general level of equity prices within the portfolio may decline, affecting the value of each ETF share. In addition, the overall depth and liquidity of the secondary market may also fluctuate. An exchange-traded, sector-focused fund may be adversely affected by the specific performance of its targeted benchmark. International investments may involve the risk of capital loss as a result of unfavourable fluctuations in currency values, differences in generally accepted accounting principles, or economic and political instability in other nations.

Although ETFs are designed to provide investment results that generally correspond to the price and yield performance of their respective underlying indexes, they may not be able to exactly replicate the performance of the indexes because of trust expenses and other factors. ETF investors are typically subject to expense fees charged by the issuer, and transactions are subject to standard brokerage equity-trading commissions.

This article has been prepared by the Research & Analysis Unit of BoV Wealth Management.

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