What is an ETF?
ETF is the acronym for Exchange Traded Fund, a term by which a particular type of mutual investment fund or Sicav is identified and whose main features are:
- it is traded on the Stock Exchange like a share;
- it tracks the reference index (benchmark) through a totally passive management.
An ETF summarizes the typical features of a fund and a share, enabling the investors to exploit the strength of both instruments:
- diversification and reduction of the risk typical of funds,
- flexibility and transparency of information typical of shares listed in real time.
The advantages of ETFs
The advantages of ETFs are:
- To take position in real time on the target market with one single purchase transaction: By purchasing an ETF it is possible to take position on a market index (for example FTSE MIB, DAX, Nasdaq100, S&P500) in real time for a price that perfectly reflects the value of the fund at that given time.
- To track the performance of the benchmark index: The ETF allows to obtain a return equal to that of the reference benchmark through a “totally passive management”, i.e. replicating exactly the composition and weights of the index to which it refers. It must be considered, however, that if the reference currency is other than the trading currency (which is always the euro), the return of the ETF may be different from that of the benchmark as a result of the devaluation/revaluation of such currency compared to the euro.
- To have a market price that is constantly aligned to the NAV: Thanks to the particular mechanism referred to as creation/redemption in kind, which enables the participants to create and redeem the units exchanging the ETFs with all the securities making up the reference index and vice-versa (primary market), the price on the Stock Exchange is constantly aligned to the official value of the ETF, the Net Asset Value (NAV): then, the risk of buying (selling) an ETF with a higher (fewer) price than the NAV is reduced, but this risk can't be excluded.
- To obtain a broad diversification: To invest in an ETF means to take easily position on a market index, which consists of, in general, a large basket of securities, thus diversifying and decreasing the investment risk.
- To reduce the costs of one’s own portfolio: The ETFs are subject to a low total annual commission (TER) applied automatically in proportion to the holding period, whilst the investor is charged no “Entry”, “Exit” and “Performance” fees. The investor must only take into consideration the fees applied by his own bank/broker for the purchase and sale on the market.
- To benefit from periodical proceeds: The dividends or interests that ETF collects in relation to the shares/bonds included in its assets (as well as the proceeds from the re-investment of these) may be re-distributed periodically to the investors or permanently capitalized in the assets of the ETF. In both cases, the beneficiary is only the investor.
- To reduce the issuer’s risk: The ETFs listed on ETFplus are, depending on the instrument, Mutual Investment Funds or Sicav (UCITS). It is a known fact that UCITs have segregated assets with respect to those of the companies, which take care of their creation, management, administration and marketing activities. Therefore, ETFs are not subject to the insolvency risk in the event of default of the above-mentioned companies.
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.
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.
The creation and redemption process requires the authorised participants to buy and sell the securities making up the benchmark index in order to create or redeem the ETF shares/units. Consequently there is a liquidity match between the ETF and the reference market, thus the spreads and the countervalue of the orders displayed on the trading book have the same conditions you might face buying or selling directly the index components.
However, in order to guarantee the maximum liquidity, it is required that for each ETFs a specialist displays on continuously basis bid and ask orders for a minimum quantity and a maximum spread as established by Borsa Italiana.