Types of Exchange Traded Funds (ETFs) – explained

The below article is for informational purposes only and does not constitute a product recommendation, or taxation or financial advice and should not be relied upon as such. Please check with your adviser or accountant to obtain the correct advice for your situation.

It has taken exchange-traded funds (ETFs) less than 25 years since they were first introduced to become a firm favourite of investors around the world. In 2018, the assets managed by ETFs globally were estimated at US$6.18 trillion, largely on the back of the trend towards passive, indexed funds that has taken place since the 1990s. Initially promoted as a cheaper alternative than mutual funds, ETFs offer investors access to low-cost portfolio diversification as well as tax advantages in some regions.

The ETF sector has grown from offering products with a passive exposure to index investing to being widely considered a good starting point for investors to gain low-cost exposure to a broad range of investment opportunities.

The growth in popularity of ETFs has come alongside an explosion in the range of ETF products offered by fund managers as they seek to satisfy investor demand. With an ever-expanding range of ETFs to choose from, investors need to understand how they differ, and the roles they can play as part of a diversified investment strategy.

This article explores the various types of ETFs available to investors, how they differ, and the roles they play in building an investment portfolio.

The rise of passive index tracking ETFs

While index tracking funds date back to the 1970s in the US, these were not considered appropriate for retail investors, who were largely content to invest directly or through mutual funds. The first listed ETF in the US was launched in 1993, with other major markets following in the late 1990s and early 2000s. And the resulting products appealed to the investing public as an alternative to mutual funds, which at the time were often expensive, complicated and illiquid, with large minimum investment amounts a clear barrier to entry.

ETFs are designed to follow a specific index - which may include companies, bonds or commodities - according to established rules. For example, a FTSE 100 index would track the 100 largest companies by value on the London Stock Exchange. This means that investors must be comfortable with the fact that an ETF will only track the market rather than try to outperform it, which is what you would expect from an actively managed fund.

Why are there now both active and passive ETFs?

ETFs diversify an investment across a range of underlying holdings thus spreading the risk. And they are also traded on the stock market, meaning they can be traded online at a live market price throughout the day, just like regular shares. But while the broad trend has been towards passive rather than active management over the past decade, many investors see active ETFs as a good compromise between some of the attributes of ETFs and more traditionally managed products like some mutual funds.

Unlike index tracking passive funds, which seek to deliver returns in line with the underlying index’s performance, actively managed funds seek to outperform a benchmark index by taking an active role in electing when to buy and sell stocks based on the fund manager's research and expertise. As with actively managed mutual funds, active ETFs involve a fund manager making the investment decisions.

While fund managers are actively trying to beat the market in order to optimise returns, active ETF investors must take into account that they will be paying for the service of a fund manager and so their admin fees will be higher than an index tracking fund. Additionally, active fund managers don’t always succeed in outperforming their target benchmark, and investors need to assess how this impacts the risk-adjusted rate of return of these funds.

What are Stock ETFs?

There are many types of ETFs available to investors that can be used for a variety of investment outcomes. However, ETFs that track shares and are the most common. These usually replicate a share index or invest in a collection of listed companies grouped by sector, geographical location or some other common feature. Investors should carefully consider the merits and risks of ETFs that track niche sectors like technology or healthcare against more straightforward products which simply seek to replicate a major stock index like the UK’s FTSE 100 or S&P 500 in the US.

Stock ETFs allow investors an easy way to diversify by buying a basket of shares or assets in a single trade. Investors can also diversify across ETFs so there's less chance of loss if an ETF provider collapses. These ETFs also have a low management expense ratio (MER) and are often significantly cheaper than actively managed funds.

What are Bond ETFs

Bond ETFs track an index of bonds, allowing individual investors exposure to an asset class that used to be difficult to access. While bonds are the underlying investment, the fact that these ETFs trade on a centralised stock exchange give them some attractive ‘equity-like’ features. The bonds in the portfolio will vary from, for example, US Treasuries to high-yield bonds, with both long-term and short-term holding periods. One of the benefits of investing in traditional bond funds is the chance to receive fixed payments on a regular schedule and this is also the case with Bond ETFs.

However, investors should note that while equity ETFs hold every security in their index, that is usually not possible with bonds where there may be hundreds, even thousands, of individual securities. This forces bond ETF managers to pick and choose which securities in the bond index to include in the ETF. These will usually be the most representative sample of the index, based on credit quality, exposure, correlations, duration and risk.

What are Sector or Industry ETFs?

Industry sector ETFs concentrate on particular parts of a global or domestic market. Virtually every major industry group has multiple indexes that track industry performance. The obvious benefit of Sector ETFs is they provide a means of investing in an entire industry. However, investors should be aware that concentrating on a specific sector brings higher risk along with the promise of better returns.

For example, an ETF tracking an energy, real estate or biotechnology index is likely to experience wide swings in the value of the underlying stocks investments. It is also worth noting that the cost of investing in large industry sectors is less than the cost associated with more concentrated industries. As with Stock ETFs, these products trade directly in the underlying stocks and shares in an index to replicate the performance of the market.

What are Commodity ETFs?

Commodity ETFs are similar to Sector ETFs as they single out a certain section of the market, in this case a commodity like precious metals or oil. Commodities such as gold are traditionally used as a store of value and a hedge against inflation, but retail investors have not always had direct access to these sorts of investments. Because commodities are typically negatively correlated with other asset classes, such as stocks and bonds, they offer investors a good way to diversify their investment portfolio. However, investors should note that Commodity ETFs do not directly own the asset. Instead, these ETF consist of derivative contracts that emulate the price of the underlying commodity.

What are International ETFs?

International ETFs can offer investors affordable access to global markets. Depending on an investors domestic market, an international ETF generally offers exposure to foreign markets without the need for an international share trading platform. However, the convenience of being able to invest internationally through an investment vehicle trading in your local currency does not remove the currency risk implicit in all international investing. Currencies are constantly fluctuating and these movements will either enhance or diminish returns from international investments.

For this reason fund managers and ETF providers often offer both currency hedged and unhedged ETFs that track the same underlying index/securities - but offer different exposure to the impact of foreign exchange rates on returns. For example, a currency-hedged ETF allows the investor to replicate the holdings of different international indices but provide reduced concerns of a fluctuating home currency negatively impacting their returns.

What are Factor or Smart Beta ETFs?

Factor ETFs aim to walk a line between traditional, index-tracking ETFs without getting into the complex and time-consuming activity of stock picking. Although a form of active management, these funds usually just have a bias or ‘tilt’ towards certain stock characteristics, like value, size, momentum, quality, dividend yield or low volatility. This investment strategy aims to improve on simply ‘buying the market’ as an index tracker of the S&P 500 or the FTSE might do.

It also means taking on significantly more risk than investing in the broader stock market but has the potential to achieve specific risk and return objectives. As a result, Factor ETFs are generally only appropriate for experienced long-term investors who want to pursue a specific strategy and are looking for more transparency than you'd find in a traditional actively managed fund.

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FURTHER READING

• 7 reasons why Sharesight is better than a spreadsheet

• How Sharesight calculates your investment performance

• How to get the most out of Sharesight’s performance tracking features