What are ETFs and how do they work? A complete guide

Understanding what ETFs are and how they work is essential for investing in a diversified way with low costs and low risk.

ETF is short for exchange-traded funds, a security that aims to replicate stock, bond, or commodity indices. These are among the most innovative and successful financial products of recent decades, born in the 90s in the United States.

This guide delves into detail about what ETFs are and how they work, their characteristics, risks, advantages, and potential earnings.

In simple words:

• an ETF is a basket of securities, the shares of which are sold on the stock exchange just like shares;
• ETFs allow you to diversify your portfolio in a convenient way;
• ETFs are passively managed (though sometimes they can be actively managed) and replicate the performance of a market without trying to beat it.

What are ETFs

Exchange Traded Funds (ETFs) are investment funds that faithfully replicate the performance of stocks, bonds, raw materials, cryptocurrencies, and other asset classes.

It is the same asset management companies (SGR) that issue these instruments that establish the reference underlying, indicating its characteristics in the information prospectus.

With ETFs, investors can follow the performance of specific market indices, the value of which is determined by the sum of the securities that compose them. This offers the possibility of following indices such as the Dow Jones, the DAX, or the S&P500. An ETF on the MSCI World index has the same portfolio and therefore the same daily result as this index.

There are also ETFs related to indicators such as the Cboe volatility index or virtual currencies.

In other words, investing in ETFs allows you to participate in these markets with small sums, without having to purchase each security individually.

How do ETFs work

ETFs aim to replicate indices and make them "investable". Thanks to the wide range of indices available, you can choose from a variety of ETFs that match your investment objectives. You can invest long or short-term, in different asset categories, regions, countries, sectors, or strategies.

How is an ETF named

An ETF takes the name from the index it tracks and provides information on the provider, regulation, currency, and share class.

For example, "iShares" is the name of one of the ETF issuers. “ACC” indicates that the ETF reinvests income (accumulation), while “D”, “Dist” or “Dis” indicates that the ETF distributes income. The acronym "UCITS" indicates that the ETF complies with European directives for the protection of private investors, monitored by national supervisory authorities. These directives guarantee safety and transparency standards.

The underlying benchmark of the ETFs

It is possible to use ETFs to invest in numerous indices of different types and nature, including:

• Bond indices, which can be government bonds or bonds of private companies in the euro area and beyond;
• Stock indices representative of single markets and entire geographical areas, you can decide to invest in the Italian or English index;
• Emerging market stock indices;
• Sectoral stock indices: this includes the various sectors that have companies listed on the stock exchange and range from the technology sector to energy services;
• Raw material indices: through the so-called ETC (Exchange Traded Commodities) it will also be possible to invest in gold or silver, safe haven assets suitable for lateral market moments;
• Stock indices style;
• Indices of real estate and private equity companies.

The possibilities with ETFs are almost endless and allow you to invest in any financial instrument.

The global supply of ETFs is also continuously increasing thanks to the low management costs and the lower uncertainty on returns compared to normal mutual funds.

What are cryptocurrencies ETF

In addition to those seen in the previous paragraph, the underlying of the ETFs can also be a cryptocurrency.

The first cryptocurrency ETF was Bitcoin ETF, launched on October 26, 2021, by ProShares and listed on the NYSE, the New York Stock Exchange, under the name BITO.

Cryptocurrency ETFs are an alternative to direct investment in cryptocurrencies and are suitable for investors who are not familiar with the use of blockchain technology.

Through an ETF that replicates the value of the underlying digital tokens, the investor can participate in the crypto market with an instrument traded exactly like ordinary shares, albeit with greater volatility.

The characteristics of ETFs

Before investing in an ETF it is important to understand what characteristics to take into consideration:

• the underlying replication strategy, which can be physical or synthetic (for the less experienced it is better to choose the first);
• the liquidity of the fund;
• the reference currency;
• the company that manages the fund;
• the cost. ETFs are less expensive than traditional funds in terms of management costs which are generally in the order of 0.10% per year on the invested capital compared to a cost that often approaches 1% in the case of traditional funds: a decisive element especially in an era of low returns in which management costs can transform already meager profits into losses.
• the yield (with the distinction between accumulation ETFs and distribution ETFs).

How much do ETFs yield

We have seen that the yield of an ETF is very similar or identical to the performance of the underlying index or basket (the benchmark), minus management costs.

First of all, a distinction must be made between accumulation ETF and distribution ETF. In the first case, the dividends collected by the fund manager are reinvested in the same product, while in the second case, the managers distribute the proceeds with the periodicity established in the information prospectus. It is therefore clear that the return can vary based on the method of redistribution of performance.

To establish how much ETF yield is then necessary to refer to the NAV (net asset value). The NAV represents the difference between the value of the assets and liabilities of the fund (including commissions collected by the management company), compared to the total shares in circulation. It is calculated only once during the day, at the close of the market. For this reason, it may differ from the price of the ETF.

In simple words, the NAV offers the investor a daily snapshot of the value of the investment and is useful for quantifying the portfolio’s return in the event of the sale or redemption of shares.

The advantages of ETFs

ETFs are decidedly advantageous tools taking into account that:

• They have independent equity from the issuer.
• They have no entry or exit commissions but only management fees (not linked to performance) which are generally very low (0.1-1.5%).
• They can pay dividends.
• They are extremely liquid and can be traded in real-time like stocks.
• With some intermediaries it is possible to short ETFs, i.e. betting on their decline by using CFDs.

The disadvantages of ETFs

Unfortunately, there are not only advantages: as with all financial instruments there are also cons and, remember, in the world of investments there is always a risk.

The main problem, in fact, lies precisely in the risk linked to this tool. Through diversification, you can try to reduce risks, but not eliminate them completely. The underlying may not perform as we anticipated and lead to significant losses.

ETFs can only be subscribed to via the secondary market, which means it is impossible to create your own basket, but the constraint to invest in a basket that has already been created and which cannot be changed.
Companies with problematic balance sheets and considered less valid may also be included in these baskets.

Original article published on Money.it Italy 2023-06-19 09:41:00. Original title: Cosa sono gli ETF e come funzionano? La guida