As we highlighted in Part 1, there are currently around 8,800 ETFs available globally to investors. From the introduction of the first ETF in the early 1990s, rising investor demand together with technological improvements making them easier to trade and reducing their costs, have been responsible for this phenomenal growth.
Most ETFs are based on an index such as the UK FTSE 100 or US S&P 500 and aim to replicate that index. These ETFs endeavour to track the performance of the index typically by following one of three approaches - either holding all the underlying securities in the same proportions as the index (‘full replication’), or by holding a representative sample of them (either ‘stratified sampling’ or ‘optimisation’).
The are two types of ETF structure, ‘physical’ and ‘synthetic’. A physical ETF designed, for example, to track an index would hold the same underlying securities (e.g. shares or bonds) as the index by directly investing in them. Synthetic ETFs do not hold physical assets but instead use derivatives such as swaps or futures to gain exposure to the appropriate investments or assets – common types include difficult to access commodities such as oil, or shares which are not covered by any of the major exchanges.
Both have positives and negatives. Physical ETFs are more transparent and easier to understand but gaining direct or physical access to certain markets and assets may be limited. Conversely, synthetic ETFs can allow investors to access otherwise hard to reach markets, but the nature of the counterparty agreements underpinning the ETF exposes investors to the risk of those counterparties going bust.
Of the range of asset classes available, equity ETFs are perhaps the most well-known. As well as tracking an entire index, ETFs are available which allow investors to gain exposure to large businesses, small businesses, high dividend paying companies, a specific country, or even a specific sector such as healthcare, or technology.
Other asset classes include fixed income/bond ETFs, commodity ETFs, currency ETFs as well as speciality ETFs which can leverage (i.e. magnify) returns or allow investors to ‘short’ an index, if they believe it will fall in value. There are also ETFs, often referred to as ‘Smart Beta’, covering factors such as minimum volatility (i.e. lower volatility than the market), quality, size, momentum, and value.
Sustainable investing using traditional approaches combined with ESG factors is also possible using ETFs. These approaches include the application of ESG screening to an index as well as investing along themes such as clean or renewable energy, low carbon, climate transition, or green bonds.
We will be publishing further Insights on ETFs over the coming months to give clients an overview of these investments and how they may fit into their strategies. In the meantime, should any readers wish to get in touch to discuss how our investment advice could help them please do contact us at info@arlingclose.com.
Related Insights