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What Are ETFs?

>> Thursday, September 10, 2009

Exchange Traded Funds (ETFs) are typically an open-ended fund on a stock exchange tracking a broad-based underlying market. They are widely considered as a convenient way for individual investors to gain exposure to assets classes such as emerging markets, commodities and even hedge funds.

The vast array of ETFs across different asset classes and index styles (leverage, inverse, fundamental, thematic, actively-managed ETFs) may leave some investors bewildered. UOBAM has developed a three-step approach to evaluate ETFs that involves looking at the three different levels of an ETF.

LEVEL 1: THE INDEX

When it comes to investing in a developed country, an investor can easily pick out indices that are widely regarded as barometers of the underlying market.

However, when it comes to less readily accessible markets or asset classes, a detailed comparative analysis of the underlying index constituents and methodologies has to be conducted.

LEVEL 2: THE ETF

At the ETF level, investors need to pay attention to its legal structure and the replication methodology. The legal structure of an ETF differs across and within asset class and fund strategies.

For example, commodity ETFs are typically structured as grantor trusts or exchange traded notes (ETNs). Shares in a grantor trust represent fractional ownership in the underlying asset of the trust while ETNs combine features of a bond and an ETF. There is ongoing suspicion that such ETFs have undue influence on the price of certain commodities, and this has affected the ETF providers' ability to issue new shares for their ETFs and ETNs.

Various replication methodologies each come with its unique pros and cons.

  • Cash-based physical replication can either fully replicate the index by holding all the underlying securities or just a sample of the index. Most ETF providers sample the index because of the larger number of member constituents in the index.
  • Swap-based replication on the other hand typically minimises the tracking error. The fund holds a basket of securities that can be unrelated to the index it is tracking. The fund then enters into a swap arrangement with a counterparty where the latter delivers the performance of the index to the fund, while the fund will deliver the returns on its basket of securities. Counterparty risk can arise when either party fails to deliver on the agreement.

LEVEL 3: THE ETF PROVIDER

Due diligence on the ETF provider is carried out by monitoring its assets under management, the number of ETFs it has listed, average trading volume of its ETFs and whether it has a history of ETF closures or trading suspensions.

Investors should pay attention to the ETF providers' track record, expertise and market share of the ETF industry.

1 comments:

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