Exchange Traded Fund - ETF

Exchange-Traded Fund (ETF) is very common in the States and the UK. It simply a basket of securities that tracks an index, assets, commodity (sometimes also known as Exchange-Traded Commodities), sectors or fixed income instruments but trades like a stock on an exchange. Therefore, its price changes on daily basis. The fact that ETF is not a mutual fund, it does not have net asset value (NAV) calculated everyday. In simple term, think ETFs as mutual funds that trade like a stock.

Therefore, most of the advantages are related to its trading features compared to mutual funds. They are becoming popular especially among institutional investors with access to big capital. They usually make large bets on sectors, countries, regions and even currencies. To them,ETFs are one of the efficient hedge tools against their individual holdings on stocks, bonds and commodities. What is more, a few years back, they started to introduce ETFs for retirements and pension schemes which are conservatively managed.

Barclays Global Investor and State Street Corp. are the biggest managers with the total ETF assets is about $440 billion. According to Bloomberg, State Street manages the biggest exchange-traded fund, $66 billion S&P 500 SPDR (Spider) whilst Barclays manages $46 billion iShares MSCI EAFE and $26 billion iShares MSCI EM, the second and third largest respectively as of Feb 29, 2008.

The Benefits


Diversification: The biggest selling point, in my views, is the diversification element that ETFs could offer. There are hundreds of ETFs available in the market and they covered almost everything; indexes, large caps, small caps, regional, country, global market, specific sector, currencies or even commodities. Recently, you can also find ETFs focus on asset classes such as fixed income.

Nevertheless, investors must not over-diversify their portfolio. The ratio of allocation also plays a greater role in determining the performance of chosen ETFs. The basic allocation for one ETF perhaps by allocating 80% stocks and 20% bonds, depending on your investment style. Out of 80%, you may want to divide them into large cap, small cap, sectors or even regional. And for bonds, perhaps split them into 5 year bonds, 10 year bonds or government bonds.

Low expense ratio: Since ETFs are not mutual funds, ETFs do not bear costs like management fees, operational fees or auditor fees. Therefore, the total cost of ETFs is a far less. In screening ETFs, one should look for low Total Expense Ratio or TER. Basically, it means the total fund costs divided by the total fund assets.Most of the time, the attractive TER should be less than 0.5%. SPDR has 11 basis point expense ratios, which is inarguably the lowest so far.

On the other hand, ETFs are traded via brokerage firms like a normal stock. Therefore, the exposure on commission charges and other brokerage related charges are inevitable. 

Investors should consider a low-cost brokerage to maximize returns.