3 ETF, a young financial instrument
3.1 An ETF, what is it ?
ETFs are «new» vehicles, they appears in 1993 in the
U.S. At the end of 2007, there were 1171 ETFs in the whole world, with
underlying assets close to $800 billion 10 .
9. The EDHEC European ETF Survey 2014.
10. According to Morgan Stanley.
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An Exchange-Traded Fund (ETF) is marketable security that
tracks an index, a commodity, or a basket of asset like an index fund. Its goal
is to replicate the performance of its underlying index. Therefore, an ETF
which is tracking a particular index, will hold the same securities, and in the
same proportion of this one. An ETF pays out dividends received from the
underlying stocks on a quarterly basis.
Unlike index funds, an ETF trades like a common stock on a
stock exchange. Thanks to its presence in both primary and secondary market,
ETFs typically have higher daily liquidity than traditional mutual funds. The
supply and the demand in the secondary market determine the price of ETF
shares; this later can diverge from the value of the underlying securities net
asset value (NAV). This fact provides an arbitrage opportunity for investors,
one of the main feature of ETF. Note that the arbitrage activity keep very
close the ETF price and the underlying securities NAV.
Furthermore, ETFs have low fees, this is due to the fact that
an ETF is passively managed. Note that few actively managed ETFs exist. This
reduction in cost can be balanced by the fact that investors must pay a
brokerage commission to purchase and sell ETF shares. For those investors who
trade frequently, this can significantly increase the cost of investing in
ETFs.
Its daily liquidity allows a consequent flexibility, that's
why it can be an attractive alternative to implement various investment
strategies like hedging strategies, or to build an investment portfolio. For
portfolio construction, one of the main advantage of this instrument is the
broad diversification that it can provide. Add to total and broad market ETFs,
a lot of type of ETFs exists, like sector ETF, market capitalization ETF
(large, mid, small cap), fixed income ETF, currency ETF, commodity ETF, bond
ETF, etc. The combination of several of them allows the investor not only to
diversify across all the major asset classes but also to diversify into
investments that have a low correlation to the major asset classes
(commodities, emerging
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market...). Furthermore, the diversity of ETFs allows to
achieve specific segment of the market through low-cost indexes. Before, those
segments could be reached through active management.
Another advantage of this instrument is its tax efficiency.
It's come from the fact that most of ETFs have very low turnover, so investors
amass only few capital gains by holding them. Moreover the tradability of ETF
allows to sell it to another investor like a stock, this means no capital gains
transaction for the ETFs. Moreover, ETFs offer better transparency into their
holdings than mutual funds. ETFs disclose their full portfolios on public every
single day of the year.
Overall, ETFs combine the advantages of both index funds and
stocks. They are convenient, cost efficient, tax efficient and flexible; their
diversity allows an investor to easily fill the «holes» in his
portfolio to get a broad diversification. This vehicle provides investors the
market exposure they require, at the level they want, at the time need it.
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