What is an ETF?


#1

One thing that neither of the ETF articles mention is what an ETF is. It tracks a set of stocks/assets… so what does that mean in practice?
Say, your ETF tracks two stocks, 50% of A and 50% of B. When I buy 1 share of that ETF, am I effectively buying 50% of a share of each of those companies? OK, so now I sell my 1 ETF share, as one element of ETFs is that they are tradeable. Am I free to chose my sale price, or am I forced to price it in line with the calculated value from those underlying shares (adding together 50% of each of the current share prices of A and B)? If so, how is this enforced?
Or looked at another way, how does buying an ETF compare to buying the same proportion of fractional shares in the underlying stocks?


Basics you need to know about investing (a very easy read)
#2

Hey @EdZ good question. What it means in practice structurally can vary quite a bit. An ETF could track 2 stocks but that doesn’t mean that 1 share matches up to 1/2 a share of each company. That’s all dependent on how many shares the ETF has issued vs the stake it has in those companies.

Also you wouldn’t own shares in those companies - you have exposure but not ownership

The best analogy is that an ETF is its own public company, but whose only purpose is investing in other companies. The performance of that company is a proportional aggregate of its investments.


#3

Also you would not choose your sale price as such. The market will price the shares of the ETF and you can decide whether or not to take it.

The market price of ETF shares basically tracks the aggregate of its investments, but sometimes there’s a slight variation in the market price vs the value of the underlying investments (called net asset value). There are multiple reasons why this might happen which I can delve into unless this is becoming complex/uninteresting?


#4

No, that would be very interesting.


#5

So ETFs will usually have their net assets valued by external administrators (usually once a day at end of day). Meanwhile the market price of the ETF is moving throughout the day so supply and demand will keep some variance from the net asset value.

However a non-exotic ETF will tend not to vary too much from net asset value because they have pretty simple mechanisms to maintain the accuracy of how they track their underlying investments.


#6

The link to Rob’s advanced explaination alluded to in the last paragraph isn’t hyperlinked:


#7

Hey thanks @Diversify. We moved our blog platform recently so might have lost a hyperlink. Nice catch.


(Jeff puckering) #8

How close to the truth is this analogy? How does an ETF come to life? If it is a company does it make money somehow?

Sorry questions coming in thick!


(Vladislav Kozub) #9

ETFs are created and administered by financial institutions. Their profit is the commission you pay (usually 0.01% to 1%).


(Jeff puckering) #10

Is there any competition with them then, could you get competing FTSE100 tracker ETFs with different commission?


(Vladislav Kozub) #11

Yes, as they are managed differently, they may have even the same set of securities but different allocations. S&P 500 is covered by about ten different providers for instance, if not more.


(Jeff puckering) #12

does that mean I can buy an ETF to have instant diversification then further diversify that by splitting my investment using fractional shares into multiples of the same Tracker each with slightly different allocations? Meta diversification!


(Vladislav Kozub) #13

ETF of ETFs? I think these may exist too :thinking:

Also, you are basically reshuffling your eggs within the same single basket as you still have the same companies with slightly different weighted averages. If you were to meta diversify, you would consider the US, UK, Japan, EU, Hong Kong and various mid/small caps across all of these exchanges. Little to none of crypto, precious metals and commodities will do as well. Then top it up with boring bonds, gilts and Nationwide 5% interest account. Then ask @stephen what whiskey has growth potential just in case all markets fail, that would be your alternative investment. Now that is meta diversification :ok_hand:

If no sarcasm, pick a few ETFs/shares you have faith in and stay the course. Markets always go up long term, but be cautious, Nikkei225 from 1990 can happen to anyone too!

Not advising of course, only listing the options.


#14

Yamazaki 12 year old, grab those bottles and stash ‘em (if you can find them).

In my opinion, do your own research of course (which can be fun in itself!)


(Jeff puckering) #15

ETFs of ETFs… inception…

Appreciate the answer, I know multiples of he same ETF would have limited value but I’m learning a lot about the mechanism by just by exploring possibilities.

And thanks for your summary of what an extremely diversified portfolio might look like! Seems pretty exhaustive, anyone think there is anything @Vlad may have missed?


#16

Gold coins stashed in a safe somewhere?


(Matteo) #17

I have a question about ETF what happens if the company that runs them go bust? Is it something that should be considered or is an event so rare that can be safely ignored?


(Vladislav Kozub) #18

In theory, nothing dramatic. Assets are with custodian and unaffected.

The question is actually rather thoretical as investment management companies are not supposed to be subject to credit risk and therefore very seldom go bankrupt.

The problem which could arise if a universal banking group with an investment management company AND an investment bank AND a custody AND fund administration department would collapse taking down all its subsidiaries.

So what happens if the custodian/fund administrator fails? The rule is that client assets are strictly segregated and should be unaffected.


(Matteo) #19

Thanks for the reply!


Basics you need to know about investing (a very easy read)
(Rob) #20

Not entirely relevant to your question but events similar to what you’re asking have occurred. A long time ago, only for a short period of time and never happened again (I think). But when ETFs aren’t physically backed you need someone to support/insure the ‘value’ of the ETF. Unfortunately in ETFSecurities case that insurer was AIG. As their credit rating slipped market-makers considered the risk of making a liquid two way market in these products too high and bailed from the order book. Liquidity ran dry. You couldn’t trade this stuff. Not only were you trapped but ISA eligibility became an issue as there is a provision in the rules that assets held in an ISA must be semi-easy to redeem if necessary. For about 10 days in 2008 I spent most of my day fielding questions about why clients couldn’t trade this stuff. Thankfully ETFSecurities fully collateralised all their synthetic ETFs and the order book magically sprang back to life. I believe this practice is now commonplace in order to prevent a re-occurrence.

Random news links from the time:


Key take away - you live and learn. This type of event is not commonplace. Nothing to fear. If concerned or curious google your chosen ETF and have a look for keywords like UCITS, Reporting Status, Replication method etc. Then rest easy and go do something more exciting with your day!