Zaks Investment Advisory Service

Exchange-Traded Funds: Financial Instruments for the Thinking Investor

We have discussed a fairly large number of financial instruments over the course of our previous programs: from stocks and bonds to investment funds, both open-end (mutual funds) and closed-end ones. And on several occasions, we mentioned a financial instrument called an exchange-traded fund, or ETF. ETFs were not created that long ago, in the mid-1990s, but underwent real development in just the past few years. There were 180 ETFs in 2004. Now, there are about 600 of them.

What is an ETF? An ETF is a special type of investment fund. Like all other investment funds, ETF assets are mostly composed of securities, stocks or bonds. Almost all ETFs are index funds, i.e. their list of securities matches the list of a corresponding index, in the same proportion. The makeup of securities comprising the fund changes only when stocks are added or removed from the index. ETFs are easiest described when compared to open and closed investment funds.

Various types of funds differ from each other by how and where their shares are purchased and sold, and how they are quoted. As we once mentioned, an open investment fund (which is what we usually call a mutual fund) constantly issues and buys back shares. Should you decided to invest $1,000 in the Vanguard 500 Index Fund, you go to Vanguard, either directly or through a broker, and buy the fund’s shares, which are issued especially for you. Vanguard, for its part, uses your money to pick up some additional securities. Your operation with Vanguard is priced on the basis of the net asset value (NAV) at the end of the trading day, i.e. the price at which you could have purchased or sold the fund’s stocks does not change over course of the day. I would like to remind you that the net asset value is the net value of stocks (or in practice – securities in the fund), on a per-share basis. Since no one knows where the day’s trading will end, NAV is impossible to predict precisely, and the buyers and sellers of open-ended funds only know their prices approximately.

Closed-end funds, on the other hand, issue socks just once, at the very start of their existence (in a so-called initial public offering). After that, the number of stocks in the fund remains fixed. If you decide to buy the fund’s shares, you do so on the stock exchange, where these shares are traded. The prices of closed fund stocks change throughout the day, and may significantly vary from the net asset value.

ETFs are similar to both open and closed funds. ETFs are similar to open funds in a sense that their number of stocks is not limited. And they are similar to closed-end funds because their shares are traded on the stock exchange. Because of the specific nature of the structure of ETFs and the possible arbitrage, their share price is usually very close to the net asset value. I will not go into the technical details of how exactly ETF shares are formed, but suffice it to say that this is done on the basis of large blocks of shares, which are bought and sold by large financial companies (institutional investors); these blocks are then split up for sale to individual investors. This process is described in detail here, for example. I, on the other hand, will simply describe the merits of ETFs, of which there are many.

First of all, ETFs may be used to execute very precise investment strategies. Investors use them to place money in perfectly defined, specific sectors of the world financial markets. Because ETFs are passively managed funds and each one of them imitates only one index, investors know which particular stocks or bonds their money is buying. If, for example, investors want to place money on biotech stocks, they have at least five biotech ETFs at their disposal, with investors free to pick the one that suits them best. On the other hand, if the person is interested in international investments and would like to get some South Korean shares, the investor could buy a fund that imitates one of the indexes on the South Korean exchange. I would remind you that active fund managers, while following a certain investment policy determined by the board of directors and described in the fund’s prospectus, may still, within the frameworks of this strategy, buy all sorts of different securities. Investors who place their money in actively managed funds do not know for sure what exactly it is they own at any precise moment: information that may be learned from the fund’s reports is usually outdated. Investors who trust the ability of active fund managers to pick growing stocks find nothing wrong in this. ETFs, on the other hand, best suit a different type of investor: ones that want to diversify their investments, but still do so within very specific frameworks, which they set themselves. ETFs present enormous opportunities for these types of investors. Some of these strategies may be executed by investing money in ordinary index funds. But compared to these, ETFs cover a far wider investment area. With the help of ETFs, investors may place money in large, mid-sized or small companies, in so-called “growth” or “value” companies, in various sectors of the economy, as well is in stocks of different countries and regions. With the help of ETFs and similar instruments called ETNs (more on these later), investors may even purchase commodities such as oil.

ETFs possess several further advantages compared to other types of funds. One of these is their low service fee, as a result of which, most ETFs have an incredibly low expense ratio. We will talk about these and other advantages in our next program. But with this, we will have to draw today’s program to a close. This was Sergey Zaks. Thank you for your attention and until next time.