ETFS (EXCHANGE TRADED FUNDS)

ETFs, which stands for Exchange Traded Funds, represent a fund that is traded on the stock exchange by replicating the performance of an index that invests in shares, bonds, or other assets. The aim of ETFs is, therefore to allow traders to invest in shares, bonds or assets by pooling their money and getting interest on the investment. ETFs entered the financial market in the early 1990s, showing – since then – an increasing appeal to investors. In reality, ETFs (or passive funds) had already been talked about since the 1960s, when the founder of Vanguard, John Bogle, launched an unmanaged fund – called First Index Investment Trust – in which market trends were replicated. At the time, his idea was radically rejected, while today, ETFs are among the products most appreciated by traders. The low commissions affect many investors with little capital, so much so that in 2021 the European market recorded a total of assets managed in Exchange Traded Funds exceeding trillion euros.

The initial issue of the ETFs is carried out by the manager, or a promoter who has the task of drawing up a list of securities that will create the basket of shares of the fund. Not only that, but the manager also has the task of defining the investment objectives. The list of securities created by the manager is then turned over to the APs, an acronym for Authorized Participants. The APs are institutions authorized to interact with the promoters of ETFs to package the requested product. The assembled product is then sent back to the manager, who, after approval, returns it to the AP to be sold both on the stock exchange and on market makers. The ETF has direct access to the primary market, where newly issued securities or instruments are traded and can be bought or resold by traders.

There are two types of Exchange Traded Fund, which differ according to the index replication method. These are: the Physical ETF and the Synthetic ETF. The first, the Physical ETF, also called “Physically Replicated ETF”, has the uniqueness of buying and replicating all or part of the securities contained in the index. This is why it is divided into two other sub-categories: fully physically replicated and partially physically replicated ETFs. In this type of Exchange Traded Fund, the composition automatically adapts when the index changes: when new securities enter or exit. Like most investment funds, physically replicated ETFs have autonomous assets, therefore separate from the assets of the company acting as manager. This is a very important feature because it outlines the condition of being “not attacked” in the event of bank or fund company insolvency. How synthetic replication ETFs works is different. The underlying objective is always to replicate the reference index but through an other procedure. Instead of buying the fund’s securities, Swap contracts are signed with a counterparty (generally a bank). The Swap contract is a financial transaction that exchanges cash flows between two counterparties with the commitment to carry out the reverse transaction at a future date. Similarly, a synthetically replicated ETF stipulates that:

• The bank will pay the return realized by the index-tracking securities to the fund;
• The fund pays the bank a commission.

Unlike physically replicated ETFs, Synthetically replicated ETFs present a counterparty risk (bank insolvency).

What are the indices on which it is possible to invest by relying on ETFs? Here are the main ones:

• Shares indices: they can represent a market or a specific geographic area;
• Bond indices: government bonds or securities of private companies;
• Stock indices by sector (e.g., technology sector) or emerging markets;
• Commodity indices (ETC, detailed in the next paragraph);
• Indices of private equity or real estate companies.

Another key distinction to understand when discussing the Exchange Traded Fund is the difference between ETFs, ETCs and ETNs. The three investment instruments have similar characteristics, such as the replication of the index’s performance to which they refer to or the absence of entry, exit, and performance fees, but differ in some specific features. As already widely stated, ETFs aim to fully replicate the index’s performance with which it is associated. Ultimately it is a mutual fund that operates by fully replicating an index. The ETNs (Exchange Traded Notes) are financial instruments similar to bonds. The issuer invests directly in the underlying (provided it is not a commodity) or in derivative contracts to replicate its performance. Therefore, the issuer of an ETN invests in the underlying (for example, a currency), exposing themselves directly to its performance. As you can understand, since ETNs are very similar to a bond, whoever underwrites them is exposed to the issuer risk, as they become a creditor of the issuing body. The ETCs (Exchange Traded Commodities) are financial instruments similar to the ETN but invest directly in one or more commodities, such as gold, oil, gas, zinc, soy, sugar, and more. In essence, the performance of ETCs goes hand in hand with changes in the raw material or commodity indices taken as a reference.

Anyone who wants to start investing in ETFs must have a thorough understanding of the benefits and risks of Exchange Traded Funds. We analyze them below.

Advantages of ETFs

The first advantage that attracts many traders is certainly the cost element. The costs of ETFs are less compared to other financial instruments. This is possible thanks to the very structure of ETFs, which allows managers to optimize trading costs, thus limiting general management costs. As already mentioned in the previous paragraphs, another benefit of Exchange Traded Funds is linked to eliminating the issuer risk. As ETFs are funds for which the unit holders own the assets, they do not risk the insolvency of those who manage and administer the fund. It should also not be forgotten that ETFs could be transparent investment tools. The target of replication of the reference benchmark makes their nature easier to learn and the possibility of trading them in real-time, as if they were shares. This flexibility makes them suitable for both intraday trading and investments with more extended time horizon, a feature much appreciated by traders. The last benefit, certainly not to be underestimated in terms of investment, is transparency. The replication of a reference index, well-known by the investor, allows you to be fully aware of the degree of risk and return they are exposed to—likewise, their valuation in real-time guarantees traders to monitor the instrument’s performance at any time.

Risks of ETFs

Like any investment, ETFs also have risks together with the benefits. The first and most obvious is the structural risk. When an ETF tracks an equity index, it collects the related risks, just as it invests in bonds or a currency (currency risk). A second important risk is related to the liability of ETF management. Being passively invested in the index that these instruments replicate, they do not allow the investor to have much room for maneuver in the event of bearish movements. On the contrary, this happens in funds, where managers have more functional space to deviate from the index used as a reference and lower exposures in the most critical sectors.

On the FXORO platform is possible to trade online CFDs on Exchange Traded Funds. This activity allows for more accurate risk management, thanks to diversification, and enables you to focus on targeted sectors. This type of investment is based on trading in CFDs with underlying ETF-type funds. It provides for an upward and downward exchange, with the possibility of choosing from over 5,000 ETFs available. It is also important to underline that by choosing to trade in CFDs with ETFs, the investor does not buy or sell their shares in an ETF, but expresses a valuation on the underlying price of the ETF.