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What are ETFs?
Exchange-traded funds, or ETFs, are investment funds that trade on stock exchanges just like shares. In other words, you can buy and sell units of an ETF on a stock exchange.
ETFs typically track an index, such as the OMX Helsinki 25 or MSCI World. Similar to index funds, ETFs are primarily passively managed funds. They track the selected index passively, and when markets rise or fall, the values of the funds track these movements.
ETFs have become popular due to their low costs, good diversification and varied selection.
Are ETFs suitable for your portfolio?
Costs of ETFs
ETFs usually have lower costs than actively managed funds. This is because most ETFs are passive index funds. Managing these funds doesn’t take a lot of effort, and no monitoring or active trading is required from the portfolio manager. ETFs do not aim to outperform the benchmark index but to match its performance. The ongoing charges of ETFs typically range between about 0.2% and 0.8%.
Good diversification
There are thousands of ETFs that track different indices around the world. This offers small-scale investors a good opportunity to invest in markets that would otherwise be unavailable to them. Thanks to the varied selection, ETFs provide a broadly diversified portfolio and have become a popular option for monthly saving.
When choosing an index, you should consider how the index matches your portfolio and risk tolerance. If you invest in a certain sector or a small geographical area, your portfolio may become too concentrated and be exposed to changes in the market or sector, for instance. Investors should be aware of how concentrated indices are, what sectors they want to focus on and how the performance of individual sectors affects the performance of the index.
Returns of ETFs
The return of an ETF is in practice the return of the benchmark index minus the management fees and other costs. If the fund’s investments grow by 7% a year, for instance, and the management fees and costs are about 0.3%, the fund's return is about 6.7% a year. In addition to the management fee, ETFs may have other costs that affect the total return. For this reason, the return on an ETF, as a rule, is not higher than the return on the index the fund is tracking.
Investors should also keep in mind that usually the return on ETFs is the average market return as they track a specific index. When the markets rise or fall, the values of ETFs track these movements.
Tracking error of ETFs
To be able to track the index as closely as possible, the issuer of an ETF buys and sells shares continuously, which results in trading costs for the fund. The management fees and trading costs of ETFs are considered to be the primary factor causing a difference between the underlying asset and the ETF (called tracking error). Besides costs, investors should compare the historical tracking error of various ETFs, because it affects the fund’s return.
Accumulating or distributing ETF?
You should also consider whether you want a distributing ETF that pays dividends to investors or an accumulating ETF that reinvests interest and dividends. If you want a cash flow, you should choose a distributing ETF. Please note that you have to pay tax on the return you get. You’ll make the most of compound interest with an accumulating ETF as dividends and returns are reinvested instead of being paid out to investors. Usually you only need to pay taxes on an accumulating ETF when you sell it.
Physical ETFs
Physical ETFs own their underlying assets (such as shares or bonds) and divide the ownership into fund units. Unitholders are entitled to receive their share of the profits, such as the accrued interest or dividend yields. As ETFs trade on the stock exchange, you can buy and sell units as easily as shares during stock exchange trading hours.
Market making
In addition to the buy and sell orders submitted by other investors, all ETFs have continuous buy and sell quotes set by a market maker, who is the ETF’s issuer or its contracting partner. Market making improves the liquidity of the ETF and keeps the market values of the ETF and its portfolio close to each other.
