Now that the vanilla-flavored index fund of the investment portfolio is familiar, it’s time to look at another popular fund option, the ETF.
Why is ETF good? Like an index fund, an ETF can be invested with monthly savings. It’s perfect for us passively refueling fund units of power. Compared to index funds, the range of ETFs is wider and they can catch the most bizarre investments.
On the other hand, there is a wide variety of ETFs, some of which may be very complex. So don’t lose your nerves, even if the full content of this post doesn’t open right away. Rather, take this post as a voyage of exploration into the mystical world of ETFs, sometimes a little difficult to understand.
Anyway. If you ever have to mingle in a bouncy investment event, and want to name-drop important-sounding investment instruments, you might as well talk about these ethics. Disguised as an authoritative investment guru in seconds.
But before that, you should probably read through this post. So, what does that secret book series consist of?
What the heck is an ETF?
ETF stands for Exchange-traded fund. Exchange-trade means stock exchange trading and a fund of funds. An ETF is thus a fund that is sold and bought on a stock exchange like shares. The listed fund, so to speak.
But aren’t those other funds being bought there on the stock exchange? Basically yes. However, differences can be found;
First, ordinary funds (such as index funds) are listed, that is, purchased, on a stock exchange through a management company. ETFs and shares are bought and sold directly by investors to each other.
Second, when you buy a fund unit on the stock exchange, the purchase order is executed with a delay of a couple of days. The purchase and sale of ETFs and shares take place in real-time.
Third, for traditional funds, the value (and thus the price of the fund unit) is calculated once a day. For ETFs and shares, a price is quoted (i.e. determined) every second during the opening hours of the stock exchange.
ETFs, like other funds, include shares and securities of various companies. ETFs can even invest in commodities, fixed-income funds, government bonds, or real estate, but most ETFs invest in stocks
How are stocks, index funds, and ETFs priced on the stock exchange?
The price of shares is determined by their demand and supply, i.e. buyers and sellers determine the share price. If investors rush to an individual stock, its price will go up. If investors decide to dump a particular stock, its price will go down. Pretty simple.
The price of the index fund corresponds exactly to the value of the shares held by the fund. That is, the value of an index fund depends on how people buy and sell the same shares that the fund owns. But if investors rushed crazy to buy portfolios full of an index fund, it doesn’t directly mean that the price of the index fund would rise to the ceiling, but that the value of the shares it owned would rise.
Determining the price of an ETF is something between a stock and a fund. Because it is bought and sold in the same way as shares in individual listed companies, its price is determined by supply and demand. But because an ETF is also a fund, its holdings have a value defined on the stock exchange, just like index funds. Thus, an ETF has a market guarantee, which means that the issuer (ie the entity that created the ETF) determines the price range between which the ETF can be bought and sold.
Because of this, a particularly popular ETF may be expensive, even if the shares it owns are not. At the same time, an ETF may also be underpriced, ie cheaper than the value of its holdings. Because the ETF is priced every second, its value may vary throughout the day. This enables the trading of ETFs, ie their active buying and selling.
Nevertheless, the long-term investor does not have to worry too much about the price volatility of the ETF itself, because, as with index funds, it is best to rely on the long-term appreciation.
Active and passive ETFs
Just like regular funds, ETFs can be divided into active and passive funds.
The majority of ETFs are passive funds that follow a pre-defined benchmark. Passive ETFs are called index mutual funds (NOTE! So not the same thing as an index fund). I always prefer passive funds.
Active ETFs have a portfolio manager who selects the appropriate instruments for the fund. Active ETFs are usually those that do not invest directly inequities, but in real estate or commodities, for example.
Physical and synthetic ETFs
An index mutual fund that invests in the same stocks as a benchmark index is called a physical ETF. A physical ETF therefore invests in the same way as an index fund.
Example: An ETF is worth 100 million and invests in a US index. If amazon.com accounts for 3% of the US index, 3% of the ETF, or 3 million, is also invested in amazon.com. Eezy.
In addition to physical ETFs, there are synthetic ETFs that, while striving for index returns, do so in a slightly different way. Synthetic ETFs do not invest in equities (at least in full) according to the index, but in a derivative that promises an index return. A derivative is an investment instrument whose value is based on, for example, the value of an index. They need a separate post!
Both physical and synthetic ETFs aim to provide the same, index-linked returns. The difference is that a synthetic ETF is often cheaper because it is cheaper to maintain derivative contracts than equities. The downside of a synthetic ETF is that it is perceived to be more risky and its content often unclear.
Yield and growth ETFs
Finally (bear with me), ETFs can still be divided into yield-based and growth-based.
A return-sharing ETF pays a return (such as dividends) into the accounts of the fund unit-holders. Depending on the ETF, income is distributed on a monthly, quarterly, semi-annual or annual basis. In Finland, capital gains tax is paid on income shares.
A growth ETF invests the return back in the shares held by the fund, in the same way as an index fund. In this case, the income does not have to be taxed because it is not repatriated.
For a long-term investor, a growth-contribution ETF is recommended because it allows yields to rise in interest rates without a tax brake. In my opinion, this is just a no-brainer, because why would we let the taxpayer slow down the growth of our capital.
So which ETF should you invest in?
Okay, after this whole litany, your love for ETFs may not be tangible. I understand. But, however, ETFs are being hailed as a great alternative to a monthly saver. Although they cannot be caught with just as little money as index funds (the minimum monthly investment is probably € 50), the threshold is significantly lower than for direct stock purchases, where it is not advisable to invest less than € 500 at a time due to trading costs.
As with all investment instruments, costs should be taken into account when choosing an ETF. There are currently no completely cost-free ETFs. I think this is precisely because ETFs are traded in real time on the stock exchange, unlike completely zero-cost index funds.
Comparing and selecting ETFs is more cumbersome than even whitening an index fund due to its wide range. Therefore, it is a good idea to look at what the professionals recommend and get to know them through their recommendations.
And even if you don’t go out of this seat to invest in ETFs, it’s good to see them in terms of its name-drop.