What is an ETF?

What is an ETF? We should start by saying that the term ETF is the acronym for Exchange Traded Fund, used to identify a particular category of mutual fund which has two main features: it is traded on the stock exchange as an equity; it guarantees the same returns as the reference benchmark.

Moreover, ETFs are characterised by an innovative working mechanism, defined as “creation / redemption in kind”, making possible a precise index replication and lower costs with respect to a traditional fund. There are currently 28 ETFs listed on Borsa Italiana (click here to access a detail page), and these offer the possibility to operate on a wide choice of equity and bond instruments related to different geographical areas. In practice, ETFs offer the possibility to take an immediate position on an equity index (global, regional, sectorial, etc..) or a bond index (comprising government or corporate securities) by way of a single purchase / sale transaction.

It is very simple for investors to participate in the ETF market: an ETF is in fact bought and sold like equities on the MTA - Borsa Italiana’s Electronic Share Market (MTF segment). Trading is continuous (no auction) from 9.10 a.m. to 5.25 p.m.. This instrument can also be suitably used by small investors, since the minimum trading lot is equal to 1 share /ETF unit. Also as regards charges there are no surprises, since trading costs are indicatively the same as those envisaged for equities.

On the other hand, as far as annual management commissions are concerned, we should pause to explain some fundamental aspects. Each ETF is in fact characterised by its own Total Expense Ratio (TER) which at present varies according to the instrument from a minimum of 0.165% to a maximum of 0.90% per year. The annual commissions are paid in relation to the period the ETF is held and are deducted each day, for the relevant portion, by the ETF manager: it should be noted that in this way the buy and sell prices that the investor can follow on Borsa Italiana (click here to access the quotes page) are already net of such commission and therefore neither end investors nor their brokers are required to make any payment. No “Entry”, “Exit” or “Performance” commission is payable, contrary to what is normally the case with mutual funds.

Other technical explanations of potential interest to investors concern: the Trading and Settlement currency, which is the Euro; settlement, which takes place in Monte Titoli after 3 business days, thereby observing the same procedures also adopted for equities; and the dividends, which are received by the ETF against shares included in its assets and, in accordance with the rules indicated by the manager in the prospectus for each ETF, are either periodically distributed to investors or accumulated in the assets of the ETF in question.

One more point as regards currency: in cases where the ETF has a US index as its benchmark, there is an implied exchange risk exposure (EUR/USD). The index in question effectively represents shares denominated in USD whereas the ETF is traded in Euro, meaning that the ETF’s yield in EUR is the sum of 2 components: the first is the appreciation or depreciation of the “US” index, the second the appreciation or depreciation of the EUR/USD exchange rate.

One question that will almost certainly come to the minds of investors before they start operating in this market concerns the liquidity of the ETFs, namely the ease with which a position can be constructed or divested. The answer to this question is reassuring, since the Liquidity of ETFs is guaranteed by a Specialist with continuous quotation obligations (“maximum bid-ask spread” and “minimum quantity displayed”) as well as by Liquidity Providers (unofficial market makers), where appropriate. To clear any doubts investors may have as to the validity of these instruments, it should be mentioned that for approximately 10 years the principal users of ETFs have been institutional investors, who appreciate their transparency and efficiency standards.

Having explained the main theoretical aspects concerning ETFs it is time to consider the practical aspects. For example, where to apply in order to buy an ETF? Here again the answer is reassuring: the buy/sell request can be forwarded through the investor’s own Bank/stock brokerage company (SIM) via the usual channels (Internet; branch; financial advisor; call centre etc..). Consequently, investors have no need to acquire new notions. These instruments are traded in the same way as for equities, hence no learning difficulties exist for anyone already used to operating via the traditional tools.

In view of their characteristics, ETFs can be suitably used in various different ways: medium/long term investment, trading including intraday and selling short in order to take a bear position on the benchmark index. Owing to the possibility to easily diversify the portfolio, the precision with which the benchmark index is replicated and the low management costs, ETFs are also particularly suitable for constructing an accumulation plan (CAP) through periodic payments, even small, made by individual investors. ETFs are not exposed to the risk of insolvency (and therefore do not require a rating) even in cases where the companies which have handled or are handling activities relating to their creation / management / administration / marketing etc.. are insolvent. This is because the ETFs listed on Borsa Italiana, according to the instrument, are either Mutual Funds or SICAVs whose assets are, as is known, kept separate from those of the aforesaid companies.

On the other hand, it is important to remember that ETFs are clearly exposed to the risk of potential loss of value as regards the shares, bonds or other instruments in which their assets are invested.