Key benefits of ETFs

A look into the world of exchange-traded funds (ETFs) and their unique structure, which holds securities on behalf of the fund’s investors. 

There are many great investment tools available for investors to reach their objectives. Choice is wonderful, but understanding the various options is important. 

For millions of people, the right option is exchange-traded funds (ETFs). From humble beginnings in the 1990s, ETFs have become a veritable juggernaut in the world of investments. The ETF is a transformational vehicle, and its crucial benefits have won over both individuals and institutions alike.

We’ve all heard the adage, “Don’t put all your eggs in one basket.” In an investment context, this advice speaks to the importance of being properly diversified. Diversification can enhance risk-adjusted returns over time, protecting a portfolio against a sharp drop in one holding or asset class. 

ETFs can offer compelling benefits in terms of diversification. From an asset allocation standpoint, owning ETFs can complement and augment the other building blocks of an investor’s portfolio – whether that’s cash or cash equivalents, individual securities (equities or fixed income), or alternative investments (such as private equity, hedge funds, and real estate). 

Meanwhile, ETFs allow for diversification because they offer investors access to a wide range of stocks and bonds. There are ETFs that aim to track broad market indices (such as the Nasdaq 100®); strategies that complete parts of a portfolio, such as value, growth, or income; and there are funds that focus on specific countries or sectors. Each investor can buy the mix of ETFs that helps to meet their unique needs and objectives. 

Individual and institutional investors can also choose from passive and active ETFs. Passive ETFs buy and hold a basket of securities, which are typically representative of an index, sector, or country. Unlike a traditional active mutual fund, a passive ETF doesn’t have portfolio managers who aim to buy certain securities (and avoid others) in a quest for outperformance. These ETFs often have ultra-low fees, as the fund provider doesn’t need to maintain expensive teams of analysts and portfolio managers. 

While passive funds still dominate the ETF market, investors now have increasing access to actively managed ETFs. These function in the same way as traditional (i.e. passive) ETFs but have professional managers at the helm buying and selling in a bid to outperform an index or other benchmark. Active ETFs tend to come with higher fees, but they also have the potential of outperforming their benchmark.

Two features that have made ETFs so popular are their low fees and their ease of access. Take cost, for starters. Compared with mutual funds, exchange-traded funds tend to have lower total expense ratios (TERs).Fees for passive strategies can go as low as single-digit basis points; and active strategies, or those with more niche allocations, typically charge slightly higher fees. 

ETFs are also easy to access. Anyone with a trading account  can buy and sell ETFs. Indeed, with online trading, this can literally be done with the click of a few buttons. What’s more, the management fees associated with owning an ETF tend to be very inexpensive. To use a simplified example, an investor who buys €10,000 of an ETF with a 0.1% management expense ratio would pay €10 to the fund provider each year. Trading costs (which are paid to an investor’s broker) are a separate cost. 

ETFs are accessible in another way, too: there’s no minimum purchase. This makes them ideal for individuals who are just starting to build a portfolio. Mutual funds, on the other hand, typically require a minimum investment.

Another advantage of ETFs is that you can buy and sell them throughout the trading day. So, while we don’t recommend attempting to time the market, you can respond to market changes as they happen. Intra-day trading is also crucial because it allows investors to buy and sell a holding instantaneously. This allows you, for instance, to quickly raise funds if you spot another investment opportunity. You don’t have to wait for the close of trading to know the price you’ll receive, either. 

Intra-day trading is available for all ETFs, including those that trade less frequently. For those ETFs which can have more price fluctuations, it’s best practice to use a limit order or wait until after the market has been open for an hour or so.

Price matters. Whether you’re buying a sweater, a car, or an ETF, you want to feel confident that you won’t pay more than something is currently worth or sell for less than you could get. The good news is that ETFs have two mechanisms that contribute to the price efficiency. 

Firstly, each ETF has one or more designated Authorised Participant (AP). These are typically brokerage firms, banks or other trading companies. APs may deal both in an ETF, as well as that ETF’s underlying assets – creating and redeeming units of a fund in the process. 

If the market price of an ETF is trading at a discount to its net asset value (NAV)*, an AP can deliver units of the ETF to the fund’s provider, taking the ETF’s basket of securities in return. On the flip side, if an ETF is trading at a premium to its NAV, an AP can profit by doing the reverse: buying securities and delivering them to the fund provider in exchange for ETF units. This kind of arbitrage is profitable for the AP and brings the market price of a fund in line with its value. 

A second layer of price efficiency in ETFs arises from the actions of market makers. These are trading firms designated to provide liquidity when required. These firms post bid-and-ask quotes throughout the trading day, giving prospective buyers and sellers the ability to trade in an ETF. As with APs, market makers can help arbitrage away any significant premium or discount in an ETF, relative to its underlying NAV–buying if an ETF is trading at a discount and selling if it’s trading at a premium.

A final but still crucial benefit of ETFs is their transparency. In other words, investors know what they’re buying and selling. ETFs differ in the amount of transparency they provide, but in both cases, there is sufficient disclosure for someone to make an informed decision. 

Fully transparent ETFs publish their complete list of holdings daily. That means the market knows at the end of each trading day which securities an ETF owns – and exactly how many.

In certain regions, such as the US, there are semi-transparent ETFs that shield some level of detail to protect their investment process. To facilitate transparency, these funds publish what is known as an indicative NAV. Usually updated every 15 seconds throughout the trading day, an indicative NAV tells the market what a fund’s underlying holdings are worth. Semi-transparent ETFs also publish a proxy basket for market makers. While not a fund’s actual portfolio holdings, this basket is designed to be sufficiently representative so as to encourage trading firms to keep providing liquidity to the market.

Returns matter for investors, but what really matters are after-tax returns. Fortunately, the way ETFs are designed can help minimise the impact of overall taxes on investors holding the ETF. They can have ‘in kind’ transactions for their underlying securities, which avoid the realisation of capital gains. This leads to lower capital gains taxes impact for those who hold an ETF in their portfolio. So, while investors may still realise their own capital gains when the price at which they sell the shares is higher than the price at which they purchased them, trading activity within the ETF will likely have minimal or no tax implications.

Historically, most ETFs have been passive. But that’s starting to change, with more and more active ETFs coming to market. The growth in active ETFs is largely the result of traditional fund managers realising that the ETF is a great wrapper and investment vehicle for a broad range of strategies. The result is that investors have more choice than ever before.

Active versus passive ETFs

Passive ETFs are designed to track a particular index or sector – and, hence, don’t aim to “beat the market.” Rather, they tend to own a basket of securities (based, for example, on market capitalisation). The buying, selling, and rebalancing process for these strategies is based on a specific set of rules outlined in the product’s methodology.

While they can be rebalanced occasionally if, say, an index is altered, they don’t engage in buying or selling for the purpose of generating excess returns.

Active ETFs, by contrast, are designed with the goal of outperforming a benchmark index or sector. Helmed by professional fund managers, these ETFs may employ a proprietary mix of quantitative and qualitative investment strategies to inform buy and sell decisions. Ideally, an active ETF will deliver ‘alpha’ to investors, that is, a risk-adjusted return that beats a given benchmark.

Why investors might choose either an active or passive ETF

Both styles of ETFs have merits. Passive ETFs might be the right choice for investors who want index-like returns and low fees. Meanwhile, investors may gravitate toward active ETFs if they have a desire to outperform the market — and a belief that their ETF is led by professional managers with the ability to do so.

The scope of ETFs has broadened considerably in recent years. Investors can still access a wide range of passive vehicles, but now have the choice of adding active ETFs to their portfolios. To help ensure you own the ETF that best fits your objectives, understanding the nuances behind the different products is a must.