What is an ETF?
Summary: With an exchange-traded fund (ETF), you can get a broad exposure to a basket of financial assets through a single instrument. And, with ETFs offering short-selling and leverage opportunities, you can stay competitive in both bear and low volatility environments. In this article, we look closer at three different ETF types and how you can use them in your investment strategy.
An ETF is an instrument traded like an equity which gives exposure to a broad basket of instruments such as equities or bonds. As an example, an ETF tracking the S&P 500, could invest in the 500 companies constituting the index, in similar weightings as in the index. This is known as physical replication, which means that the ETF provider owns the underlying physical assets. However, some newer ETFs also track derivative products such as VIX index derivatives or futures contracts, and some ETFs even apply leveraging and inverse payoffs of the underlying benchmark. ETFs are also an easy way to do thematic trading – read more here.
A common type of ETFs track an underlying index on a one-to-one basis, just like a direct equity position. Taking the German DAX index as an example, multiple ETFs are tracking this index – one shown in the chart below, with performance since 2019. The slight underperformance of the ETF (blue) compared to the index (purple) reflects trading costs and management fees which are charged by the ETF provider to facilitate the ETF basket. The standard measure is called the Total Expense Ratio, and it may be worth checking this number when comparing ETFs tracking the same index – as well as how well the ETF performance follow the performance of the index. See more on ETF replication here.
Whereas traditional ETFs track an underlying benchmark on a one-to-one basis, leveraged ETFs use debt and/or derivatives to give returns in a specified multiple of the daily one-to-one return, commonly two or three times. This generally makes leveraged ETFs much more volatile than a traditional ETF. One example is shown below, where the ETF is of offering 2x leveraging, i.e. enhancing profits/losses by twice the amount of the underlying index (minus fees taken by the ETF provider plus some tracking errors). The chart below illustrates how the returns for both the Euro STOXX 50 index (purple line) and the leveraged ETF (blue line) developed since 2019.
Inverse ETFs use derivatives to benefit from a value decrease in an underlying index. The inverse ETF enables you to exploit short selling without having a margin account, as you´re not shorting any instrument yourself. One example is shown below, where the French CAC 40 Index (purple) and an inverse ETF (blue) is shown. Note that tracking errors and management fees is the reason why losses in the ETF is larger than the gains in the index.
ETFs offer diversified industry exposure at low expense ratios and save you time on research and analysis. More specifically, the large variety of ETFs available in the Saxo platforms can enable you to tailor your portfolio according to your investment strategy and risk appetite, in any market environment.
However, like any investment product, trading ETFs does involve risk. This is especially true of leveraged ETFs. While they use derivative products to try and amplify your potential returns on a benchmark index, conversely they will amplify your losses if the market moves against you.
Another important risk factor to bear in mind is tracking error, which refers to how much an ETF’s returns deviate from its underlying benchmark. In some instances, a high tracking error can be a good thing, if the fund is outperforming its benchmark. But if the fund is lagging the benchmark index by a wide margin, your returns will be negatively impacted – or you may even lose money on your initial investment.
Before you start trading ETFs, please make sure you understand the underlying mechanisms – especially if you want to trade derivative-tracking ETFs. Check these articles for more on liquidity and market "surprises".
The ETF industry was launched in the US in 1993 and initially created for institutional investors demanding an alternative to equity futures which exhibit rolling costs. In the beginning the demand was low, but over the following 10 years the assets under management (AUM) of equity ETFs grew as retail investors also discovered that this new financial instrument offered broad-based access to financial markets at low costs compared to active mutual funds. Especially since the financial crisis ETFs have enjoyed rapid growth in AUM by more than 200 % since 2009 to USD 2.9 trillion in the US with around 80 % tracking equity indices [BlackRock Global ETP Landscape – Industry Highlights (May 2017), BlackRock].