What are ETFs and how do they work?

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An ETF, an abbreviation for "Exchange Traded Fund", is a type of investment fund that is traded on the stock exchange – just like a share. The characteristics of ETFs are:

  • They closely track the benchmark index;
  • They offer the opportunity to diversify portfolios without major difficulties;
  • They have low administrative costs;
  • They are often chosen for creating a fund savings plan;
  • They are mainly selected for medium- or long-term investments, but also for trading – including Intraday.
  • They are funds preferred by those looking to take a bearish position in the benchmark index.

How ETFs work

The peculiarity of this type of fund is that it replicates the index to which it relates (such as Ftse 100 or the London Metal Exchange Index). So, when you buy an ETF, you invest in a complete market index and begin what is known as “passive management”. In practice, you position yourself in the target market in real time with a single purchase. The ETF has characteristics of both a fund and a stock. This allows investors to take advantage of both diversification and a reduction in the typical risk of the funds, but also to have information and flexibility typical of the stocks (which are traded in real time). The performance therefore corresponds to that of the reference index, the composition and weighting of which are precisely replicated.

The euro is the constant trading currency, while the currency related to the index can vary. In this case, the ETF’s return may deviate from the benchmark after a possible devaluation or revaluation of one of the two values. The market price, based on the primary price, is always adjusted to the net asset value (NAV) on the basis of the so-called creation/redemption process. Onone hand, this system enables the official value of the ETF to be constantly adjusted to the price on the stock exchange. Authorised participants, on the other hand, can structure and redeem shares by exchanging ETFs on all of the securities that make up the benchmark index.

The mechanism of creation and redemption of in-kind contributions requires authorised participants to work with the securities contained in the reference index, i.e. to create new shares and then request a refund. As a result, the liquidity of the ETF and that of the underlying market are closely related. In the trading book, the spread and countervalue conditions of the offers at hand are the same as they would be if working directly with the securities that make up the ETF. However, in order to ensure maximum liquidity, it is necessary that a specialised trader is present for each ETF, who is obliged to display bids and offers for a quantity and a maximum spread set by the German Stock Exchange without interruption.

Why invest in ETFs?

As already mentioned, investing in an ETF means positioning yourself in a market index, which by definition contains a large number of securities that should be added to the portfolio. And this brings some benefits, such as reducing risk. In addition, there’s a reduction in administrative costs with ETFs. In fact, this type of fund has a reduced annual total expense ratio (TER) and is automatically correlated with the holding period, but without entry, exit and performance fees. The commissions, charged by the respective bank or advisor for buying and selling, are the only variables that the saver needs to consider. The dividends received by the ETF can, however, regularly be distributed to investors in proportion to the shares held in their assets (as well as the proceeds from their reinvestment) or activated in the assets of the ETF. In any case, the investor remains the only beneficiary.

Even if the issuing company goes bankrupt or becomes insolvent, ETFs won’t be at risk. In fact, depending on the type and structure, ETFs are “Undertakings for Collective Investment in Securities” (UCITS) or investment funds. The distinguishing feature of UCITS is that they are segregated from the assets of the companies involved in the management of ETFs. Certainly, however, ETFs are exposed to the fact that stocks, bonds and other instruments in which their assets are invested can change in value.

Related topics

In this article, we’ve touched on many other financial concepts that you can find useful in deepening your knowledge. MoneyController has a glossary and several articles from the Financial Forum that can help you in this regard:

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