ETF Investing

An Exchange Traded Fund (ETF) is a pooled investment vehicle with shares that can be bought and sold throughout the day on the stock exchange, in the same way that ordinary stocks and shares are traded.

Exchange Traded Commodities (ETCs) are listed debt instruments traded on a stock exchange and backed by a commodity. They are not funds or ETFs.

ETFs and mutual funds both offer diversified exposure to main asset classes and are typically UCITS funds. However, ETFs can be bought through a stockbroker or trading platform at any time during the trading day, while mutual funds are purchased via a fund management company and only once per day. ETFs are priced continuously throughout the day, providing high transparency, whereas mutual funds are priced once daily and their transparency can vary.

Benefits:

Low cost of ownership – ETFs tend to be cheaper than most other funds.  

Liquidity – Creation/redemption process ensures liquidity

Ease of trading – ETFs can be traded on a stock exchange at any time, when open. May be an attractive feature for investors who are looking for more flexibility around when to buy and sell an investment.

Transparency – ETFs are very transparent and usually disclose their full list of holdings daily on the ETF provider’s website.

Index tracking – Physical and synthetic replication models may offer economic advantages

Risks:

Tracking differences: ETFs may not track an index perfectly. The difference between the fund return and index return is called ‘tracking difference’.

Capital risk: Like any investment product, the value of an ETF may go down as well as up, and you may not get back the amount invested.

There are many ways for fund managers to track the performance of an index. These ‘replication methods’ fall into two broad categories, physical and  swap-based (synthetic).

Physical ETFs own the underlying stocks or bonds that comprise the benchmark index; whereas a swap-based ETF aims to deliver the index performance through a swap provided by an investment bank. A swap is a type of derivative contract where two parties agree to exchange (“swap”) one stream of flows for another.  

At Invesco, we pioneered a swap-based method called “physical with swap overlay” whereby the ETF holds a basket of quality securities, which are not the same as those in the index but are expected to produce most of the returns. To reduce tracking error, the ETF has swaps often with multiple counterparties (investment banks) that pay the difference between the index return and the return of the basket of securities.

Learn more about physical and swap-based funds.

Smart beta is a term for any rules-based strategy that uses characteristics other than just geography and market capitalisation to select and weight the securities of the index.