Exchange Traded Funds (ETF) are a type of investment fund that you can invest your money into. ETFs are listed on the stock exchange and can be bought and sold like shares. When you invest in an ETF you buy units in the fund, the price of these units rise and fall in value daily, usually in line with the assets in the fund.
The aim of an ETF is to track an index, you can read more about indices here. An index is like the S&P500 in the FTSE 100 in London, or the DAX in Frankfurt – just to name a few. An index, like the S&P 500, tracks the top performing companies in the sector it’s tracking.
An ETF that tracks the S&P500 index will invest a share in each of the 500 companies that make up the S&P500 index. By investing in an ETF, you gain exposure to all 500 companies. This means your investment will typically perform as well as the top 500 companies in the S&P500. It also means that because your investment is diversified you will on average lose less money if the stock prices of these 500 companies fall in value.
There are multiple ETFs run by different fund managers that track the same index. The reason their performance varies is because different fund managers will have different weightings in the companies they invest in. A weighting means the percentage you invest into each company. Often fund managers will have more or less confidence in the companies and therefore have higher or lower weightings in each of these companies.
ETFs can be actively or passively managed. Typically, an actively managed ETF will aim to outperform the index it is tracking. This can be done by either regularly adjusting the weighting in each company, by ‘shorting’ the market (a technique used to make money when the stock market goes down) or by using leverage (margin loans) to increase performance and in turn the risk.
ETFs can be subject to a tracking error or active risk, which means they may perform better or worse than the index they are tracking. If the performance varies from the performance of the index it is called a tracking error. Tracking errors are a result of the following:
Fees and taxes deducted from the assets in the fund.
The fund either under or over performing in comparison to the index it is tracking.
ETFs can track many different asset classes such as the below and therefore vary in risk. However, with the exposure to multiple assets or investments in a particular asset class they are deemed less risky than other types of investments and are generally lower in cost than other types of managed funds.
ETFs that track international shares carry currency risk if they are not hedged back to your country’s dollar. ETFs that invest in fixed interest assets, like bonds, can also be hedged against interest rate changes to minimise interest rate risk.
What are inverse ETFs?
An inverse ETF is generally an actively managed ETF which is designed to profit when the market goes down, and lose value when markets go up - like ‘shorting’ the market. This reverse relationship is why they are called “inverse”.
What is a 'Leveraged ETF'?
Leveraged ETFs are available for most indexes, such as the Nasdaq 100 and the Dow Jones Industrial Average.
Leverage is a form of margin that is used by a fund manager to increase an investment into an asset within the fund, the aim is to also increase the return on investment, however this does not always happen. Leveraged ETFs are therefore high risk and high cost.
The risk is increased if the investor investing into a leveraged ETF also uses leverage such as a margin loan to invest more into this type of ETF.
Margin loans are deemed higher risk than standard leveraged ETFs as they are subject to interest payments and potential margin calls should the position of the ETF begin to lose money.
Leveraged ETFs use financial derivatives (typically futures contracts)which are contracts between two or more parties that dictate the price and date in the future to sell an asset within the ETF (this is how the ETF is leveraged and gets its name). The price in a futures contract is linked to the expected price of the asset in the future.
As a simple example, depending on the type of futures contract, if the price of the asset goes down and your contract is for a higher price then you make money, however if the price of the asset goes up and your contract is for a lower price then you lose money.
The profit or loss of the position fluctuates in the account as the price of the futures contract moves. If the loss gets too big, the broker will ask the trader to deposit more money to cover the loss. This is called maintenance margin which is the minimum amount of equity that must be maintained in a margin account.
Leveraged ETFs aim to keep a constant amount of leverage during the investment time frame. Many leveraged ETFs have expense ratios (percentage of expenses in comparison to the assets in the fund) of 1% or more of the funds being traded.