Unlike actively managed investment funds, ETFs follow the market and do not add value by seeking to achieve higher returns or to limit losses when prices fall.

Generally speaking, an ETF represents a portfolio of securities (such as shares or bonds) and is intended to match the return of a specific market index. ETFs can be viewed as building blocks to help you create the investment portfolio that you desire. Whether you want to invest in European equities or bonds, or in something less run-of-the-mill such as emerging markets, clean energy or commodities, there are ETFs that will meet your requirements. One of the benefits when compared with investment funds is that ETFs are more cost effective. A variety of constructions are available, coupled with varying levels of risk. For instance, contracts with other parties may expose you not only to market risk, but also to counterparty risk.

How can ETFs aid your investment strategy?
ETFs offer you direct exposure to a basket of securities, ensuring that your portfolio risk is diversified broadly. Rather than buying shares in a specific company, you buy a basket of shares representing a certain market, sector or region. Doing so is less risky than investing only in specific shares or companies. An ETF can be used as a building block to help create a total portfolio, whether based on a single market (eg the Dutch AEX index) or forming part of a more complex investment strategy encompassing several regions (such as European and Asian equity markets).

As an ETF represents all the securities in a particular index, investing in it requires just a single transaction and is therefore much more cost effective than purchasing all the shares individually. ETFs have a much lower total expense ratio (TER) than traditional actively managed funds. The TER is the ratio of the total amount paid to cover the fund’s costs (fund management, trustees, licence issuing and operating expenses) to the fund’s assets. ETFs attempt to match the performance of an index. This means that they can operate with a much lower cost structure than actively managed funds, which charge more in return for the chance – but not the certainty – of beating the market. Furthermore, actively managed funds usually buy and sell more frequently than index trackers, which means that higher transaction costs are to be expected.

The average TER for bond ETFs is 0.19%, while the average TER for equity ETFs is 0.50%. This means that ETFs are amongst the most cost effective funds in the market. By way of comparison: the average TER on an actively managed equity fund in Europe is 1.71%, while the figure for a bond fund is 1.03%. The average index tracker fund has a TER of 0.91%.*

ETFs have a variety of structures, so it is important to understand the differences between them before you invest. That way you can find the fund best suited to your own investment purposes.

The two main types of ETFs are cash-based ETFs and swap-based ETFs.

A cash-based ETF generally buys all of the securities in the associated index and holds them as fund assets. However, in some cases the ETF is not expected to buy all of the securities in the index,for instance if the liquidity of the index is not particularly high. In such cases, an ‘optimisation’ process is applied, which means that some, rather than all, of the securities are purchased in order to track the performance of the index. For instance, in the case of MSCI World, the iShares ETF holds roughly 700 securities, whereas the index itself is comprised of more than 1800.

A swap-based ETF uses total-return index swaps to replicate the performance of an index. A swap is an agreement between two parties under which one party makes a payment based on a certain percentage – either fixed or variable – while the other party makes payments based on the return made on an underlying asset, comprised of both the income that the asset generates and any capital gain. In the case of an ETF, this means that the fund holds a basket of securities required by the swap counterparty. The basket need not be limited to securities from the index. The performance of this basket is then “swapped” with the swap counterparty for the performance of the index. Essentially, this means that if you buy a swap-based ETF, you are in effect buying into the performance of the index rather than the specific securities that make up the index.

In some cases swap-based ETFs can be a better investment from a tax perspective. They can also be a good way of gaining exposure to markets that cannot be accessed through cash-based funds, for instance commodities. However, swap-based funds are generally regarded as being a somewhat higher-risk investment than the cash-based equivalent.

Nevertheless, swap-based ETFs are investment funds, so the issuing party is not at risk. However, the fund is exposed to counter party risks, as they may buy derivatives, lend securities and conclude swap agreements for the fund. The counterparty risk is the risk for each party that enters into a contractual agreement that the other party will not fulfil its obligations. In the case of UCITS-compliant* swap-based funds, the maximum counterparty risk is 10% of the fund’s net asset value.  

A number of other exchange-tradable products are also available, such as Exchange Traded Notes (ETNs). ETNs are debt instruments. They are not investment funds but do share some of the same characteristics, since both are generally linked to the return of an index and are traded on the exchange. There are several different types of ETN, such as exchange-traded certificates and exchange-traded commodities. The latter are linked to physical commodities or commodity indices. Some ETNs are supported by physical assets, while others are supported by an issuer or a guarantor.

Since ETNs are notes, ETN investors have direct counterparty exposure to the issuer of the note or a third party who guarantees the performance of the security. The ETN structure allows for greater flexibility in the issuing of products (i.e. as regards individual commodities and securities).

 

* The European Union’s UCITS directives establish a common supervisory regime for undertakings for collective investment in transferable securities. Funds structured in a way that complies with the directives can be marketed throughout the European Union.

NB. Although ETFs allow you to spread the risk across a larger number of companies, sectors or countries, they do not completely eliminate market risk. It therefore remains possible that you may lose all or part of your invested capital if the price of the associated equities falls.