In the early 90’s ahead of the turn of the 21st century, a new form of investing known as an Exchange Traded Fund (ETF) emerged, and sparked a popular wave of participating in funds that were traded like shares of a stock with the Net Asset Value (NAV) of the fund replicated in its share price.
This method allows investors to trade ETF like they would any listed stock, via the ETF’s ticker symbol, and over the past decade ETF assets increased twelve-fold totaling $1.3 trillion according to a recent report by Investment Company Institute using data up until 2012. That trend has continued as can be seen with the subsequent growth of the ETF markets as seen in the graphic below from ETFGI.
The emergence of ETFs followed on the heels of the success of Mutual Funds, and in many ways are similar yet have a distinct difference that catered to traders and those wanting to get in and out of the market fast, and/or simplify the process, without having to worry about minimum investments, or hold-up periods such as waiting several weeks for redemptions of their investment capital, or other lock-up periods.
The Emergence of ETFs Appealed to Day Traders
In addition, the automated mechanism of ETFs allowed for the distribution of P/L to occur nearly instantly regardless of the timing of new entrants into the fund. This helped to avoid the common equalization challenges that hedge funds face when attempting to either distribute profits and losses on an asset-weighted method or equal-weighted method, and dealing with crystallization and calculating any high watermark where managers are paid incentive fees, which all can vary for respective investors in the fund depending on when then enter/exit.
Such complexities are typically automated and/or simplified in many ETFs in order for the funds to be freely traded on the stock exchange, and thus traders can participate both entering and exiting the fund literally within seconds.
The Basics of ETF investing include trading shares (Buying/Selling) of an ETF that focuses on a particular sector or set of sectors, and that utilizes an investment methodology that appeal to investors specific investment objectives including risk appetite and tolerance.
Understanding the Basics of ETF Investing
The cornerstone of considering investing in any ETF is to thoroughly review its prospectus or disclose document which typically contains all required regulatory disclosures including fees, charges, turnover ratio, investment objective and strategy, leverage, any benchmark followed or aimed to be tracked, a historical track record, and potentially a breakdown of its holdings and/or how its holding may shift or change from time to time.
The specific structure of each such prospectus may vary from one ETF to the next, however many will share comment elements such as described above including quantitative data about the fund, including qualitative information about the people and company operating the program (running the ETF day-to-day).
Further disclosures that may contain material information that investors should consider as part of the due diligence process can be typically found on the registration statement on form S-3 filed with the Securities & Exchange Commission (SEC) by the fund sponsor on behalf of the ETF, based on the Securities Act, for ETFs traded on regional exchanges within the U.S. stock markets. In addition, the SEC has provided a detailed alert on the risks of trading leveraged and inverse Exchange Traded Funds. Below is a description of basic things to consider when investing in ETFs.
Things to examine in an ETF program description may include:
- Fund Type and Date of Inception
- Fund Strategy Description
- Available detailed updated prospectus
- Total Assets Under Management (AUM)
- Historical Performance
- Leverage Applied? Inverse Fund?
- Legal Structure (trust,etc…)
- Who is the Fund Company
- Prospectus Benchmark(s)
- Gross Expense Ratio
- Net Expense Ratio
- Total Holdings and weighting of top ten holdings
Benchmark-Tied Funds, and Leveraged Exchange Traded Funds
One of the perceived advantages of ETFs, is that some have developed precise purposes, based on for example a strict mathematical formula that creates a rule or process to connect the ETF to an underlying benchmark, index, instrument or other asset class. In addition, a fund that will invest using leverage or via margin, can enhance the return which can work either favorably or un-favorably for investors.
For example, an ETF that aims to replicate exactly 3 times the performance of the Dow Jones Industrial Average (DJIA), will have a process in place so that each day that the market is operational, whatever the DJIA returns for that day, the ETF will have tripled that performance. This can be achieved in a number of ways, using a combination of investment vehicles such as Futures, or other securities, like some of the components of the Dow which consists of some 40 companies, and/or other high correlated or inversely correlated financial instruments.
So for a day where the Dow is down 3% , in the the example, the ETF described above would be down 9%, or vice-versa if the market was up for the day (the ETF would be up 9%,etc…). Comparing the actual return of an index, against the performance of an ETF (on a non-leveraged basis) will reveal any degree of tracking error, or a deviation from the ETF replicating the performance of the benchmark.
Risk of Inverse ETFs and Tracking Error in Performance Relative to Index
Conversely, inverse leverage means that rather than replicate the performance, an ETF that aims to provide negative leverage such as -1 or -2 times the underlying benchmark, will aim to return the exact opposite return, such as a negative 3% when the index is positive 3% for an ETF that uses a -1 times leverage (negative leverage), for example.
Investors should be aware that a degree of tracking error, known as the information ratio, can exist for funds that aim to track an underlying index, and this error – if any – can be very subtle yet have significant consequences over a long period of time.
For example a tracking error of only 1/100 of a percent, over the course of a hundred trading days, can amount to 1% of performance (if the error was in the same direction over that period). Therefore, understanding how much the performance of an ETF can deviate from any tracked benchmark that it aims to replicate, or that it is based on, is a prudent step as part of the due diligence phase, when researching the basics of ETF investing.
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