ETF knowledge centre

What are ETFs?

Like a traditional mutual fund, an exchange-traded fund (ETF) offers the opportunity to invest in a portfolio of securities, such as stocks or bonds.

As with a mutual fund, each share of an ETF represents an undivided interest in the underlying assets. ETFs and mutual funds also offer professional management, so you don't have to keep track of every security your fund owns. However, ETFs are different in that they can be traded throughout the day on an exchange at a market-determined price.

Most ETFs use an indexing approach. They're built so that their value can be expected to move in line with the indices they seek to track. For example, a 2% rise or fall in an index should result in approximately a 2% rise or fall for an ETF that tracks that index (before fees and expenses).

How ETFs work

ETFs are traded throughout the day on exchanges at market-determined prices, just like individual securities.

In contrast, mutual fund shares are bought and sold directly through the fund company at the fund's net asset value (NAV) at the end of each trading day.

Although they trade like individual securities, ETFs – like mutual funds – are open-ended investments. That means new shares can be created and existing shares redeemed daily, based on investor demand. Closed-end funds and individual securities, on the other hand, generally issue a fixed number of shares.

The ETF creation/redemption process

While any investor can purchase or redeem mutual fund shares directly with the fund company or distributor, only authorised participants can interact directly with the ETF provider to create or redeem ETF shares. Also, while mutual fund investors generally exchange cash for mutual fund shares, the authorised participant can typically exchange the underlying securities for ETF shares. The ETF shares that authorised participants create are then traded by investors on an exchange.

What are the benefits of ETFs?

ETFs offer several potential benefits, including low costs, liquidity, diversification and more.

Low costs

ETFs generally have lower ongoing charges figures/total expense ratios (OCFs/TERs) than mutual funds, and index-based ETFs generally cost less than actively managed funds and ETFs. Lower costs mean more of a fund's returns go to the investor. When trading ETFs, however, investors incur transaction costs such as broker commissions. So investors should always weigh the full costs of investing.

Liquidity

ETFs are traded on stock exchanges, so they can be bought and sold any time the exchange is open, even if the underlying market is closed. For example, a European investor can buy a Japanese equity ETF during European trading hours when the Japanese market is closed.

Diversification

An ETF that tracks an index might contain hundreds or thousands of securities – more than many actively managed funds and far more than a typical portfolio of individual securities. Broad diversification can help offset the risks associated with any one security or market segment.

Transparency

ETFs provide full transparency on constituents, performance versus the benchmark and costs on a regular basis.

How are ETFs regulated?

The vast majority of Europe-domiciled ETFs are organised and regulated as registered investment companies under the Undertakings for Collective Investments in Transferable Securities (UCITS) directive¹.

This is the same regulatory regime that governs the UCITS mutual funds domiciled within the European Union.

While all investing involves risk, this framework provides various degrees of investor protection. These include ensuring underlying investments are liquid, portfolios are diversified, and assets are ring-fenced and held by a custodian.

¹European Council Directive of 13 July 2009 (2009/65/EC) on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities and any amendment thereto.

What is the history of ETFs?

The world's first ETF was created in Canada in 1990, transforming the investment landscape and offering the advantages of pooled investing and trading flexibility.

In their early days, ETFs were used primarily by institutional investors to execute sophisticated trading strategies. However, it wasn't long before individual investors and financial advisers embraced ETFs.

Since their introduction, ETFs have grown to become one of the most popular products in the global investment industry. Today, global ETF assets total more than USD 7.3 trillion, invested in more than 7,500 ETFs and ETPs¹.

ETF Milestones

¹Source: ETFGI as at 30 November 2020.
²Source: ETFGI as at 31 December 2009.

Note: ETF assets and product data include exchange-traded funds and exchange-traded products (ETPs).

How do ETFs compare with mutual funds?

ETFs and mutual funds serve the same general purpose.

They provide exposure to particular markets or market segments. So it's not surprising that they share more similarities than differences.

Similarities between ETFs and mutual funds

Diversification

By pooling money from many investors, ETFs and mutual funds have greater buying power, enabling them to buy many different securities in large quantities. This results in greater diversification than an investor can achieve buying individual shares and bonds. ETFs, like mutual funds, can also provide diversified exposure to many segments of the market.

Regulation

The vast majority of Europe-domiciled ETFs are organised and regulated as registered investment companies under the Undertakings for Collective Investments in Transferable Securities (UCITS) directive¹. This is the same regulatory regime that governs the UCITS mutual funds domiciled within the European Union.

¹ European Council Directive of 13 July 2009 (2009/65/EC) on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities and any amendment thereto.

Transparency

Compared with actively managed funds, index ETFs and index mutual funds are extremely transparent. Investors generally know what the holdings are and in what proportion based upon the target index, particularly when a full replication strategy is used to track the index.

Differences between ETFs and mutual funds

Trading flexibility

Orders to buy or sell ETF shares are executed throughout the trading day at market-determined prices that change continually. ETFs can also be traded at the day’s calculated net asset value. By contrast, mutual fund shares may only be purchased or redeemed at their NAV, which is struck once a day. Typically this is the end-of-day price in the relevant market.

Costs

Both ETFs and mutual funds charge a total expense ratio (TER) (also known as the ongoing charges figure, or OCF) which essentially covers ongoing operating costs. But because ETFs trade on exchanges, they also have unique costs not associated with mutual funds, such as broker commissions and bid-ask spreads.

How can ETFs be used?

ETFs can be used to implement a variety of short and long-term investment strategies.

Some of the uses for ETFs are strategic – for example, asset allocation – while others are tactical. Whether it makes sense to use ETFs in a particular strategy depends on a number of factors, including the amount invested, holding period, trading costs, appetite for risk and more.

Here are some of the most common ways investors put ETFs to work in their portfolios:

Core allocation

Fast, precise and cost-effective access to a broad variety of assets and sub-asset classes.

Portfolio completion

Complete portfolio diversification by minimising benchmark risk with pure exposure to specific areas of the market such as factor or styles.

Active and passive combinations

Combine index ETFs and low-cost actively managed funds for diversification and the opportunity for outperformance.

Liquidity management

Invest short term in the market while refining a longer-term investment view.

Transition management

Quickly gain market exposure while searching for a new investment manager.

Rebalancing

Manage portfolio risk/beta tilts in between rebalancing cycles.

Tactical adjustments

Over- or underweight certain asset classes, regions or countries.

Overlay management (sometimes known asliquidity sleeve)

Use a portfolio of ETFs to provide similar exposure to the strategic asset allocation but with additional liquidity.

What are the costs of ETFs?

Like mutual funds, ETFs charge total expense ratios to cover ongoing operating expenses.

But they also have some costs that aren't associated with mutual funds.

Operating expenses

ETFs charge fees to cover ongoing operating expenses, such as advisory services, administration and recordkeeping, among other things. These fees are expressed as a percentage of fund assets and are commonly known as the total expense ratio (TER) or the ongoing charges figure (OCF).

ETFs tend to have lower TERs/OCFs than mutual funds. This is largely because most mutual funds are actively managed and charge higher TERs/OCFs than their index counterparts. As the vast majority of ETFs are index funds their TERs/OCFs, on average, are lower than traditional mutual funds.

Bid-ask spread

When buying or selling ETF shares on an exchange, there is a difference between the price a dealer is willing to pay for an ETF share (the bid) and the somewhat higher price the dealer will accept to sell that ETF share (the ask). As a result, an investor will typically buy ETF shares for slightly over market price and sell for slightly less.

Bid-ask spreads are typically lower for ETFs that are heavily traded or that own securities that are highly liquid.