VNQI invests in real estate companies outside of the U.S.. The fund’s high exposure to China and Japan is disadvantageous as these two countries will face

What is an ETF (Exchange Traded Fund)?

ETF (exchange traded fund) is a fund (pooled investment) that is traded on an exchange. It is a liquid security (can be easily converted into cash). It’s a security (normally a share) that simply tracks an index, a basket of stocks or a commodity (such as gold, silver etc.).

What is the purpose of ETFs?

Say, you want exposure to S&P 500 index or FTSE 100. Why not buy a share listed on an exchange (NYSE, LSE etc.) of an ETF that tracks it? At the (similar) cost of buying a normal share in a similar company you get the exposure to the entire index, or in case of a commodity ETF, instead of physically holding and trading a commodity, you trade shares of its respective ETF exchange.

That’s the whole point of ETFs.

The Good

  1. It costs relatively low (relative to mutual funds, unit trusts etc.), and it’s simple to understand. It simply mirrors an index (basked of assets, commodity etc.). If the index goes up 1%, its respective ETF goes up 1% (assuming that tracking error is zero).
  2. These are flexible (you can buy one share or a thousand share) and liquid. You can buy ETFs at any time during market hours.
  3. Great instruments for passive investments; they take away the fund manager, which makes them cheaper since there is no question of commissions/fees.

The Bad

  1. ETFs only mirror the index, so theoretically they cannot beat the market. They are only as good as the market (passive investments.)
  2. Tracking error (difference between the price movement of the underlying index/asset and the ETF). It exists because ETFs sometimes don’t hold exactly all the shares of the underlying index, and other times – in case of commodity ETFs – they might not actually hold the commodity (gold, silver etc.) but create an artificial position through derivatives, and thirdly, if the underling asset is denominated in a currency that’s not the one you’re buying the ETF in (on your local exchange), there can be a tracking error due to currency exchange rate.
  3. Cheap is a tricky term, not all ETFs are cheap. If you seek the cheap ones, better stick with the plain vanilla ETFs, because the sexier exchange-traded funds such as Inverse ETFs, Geared ETFs, and Strategy ETFs can prove costly.

Genesis

In 1990, Toronto Index Participation Shares, started trading on Toronto Stock Exchange (TSE). It started out by tracking the TSE 35 and later the TSE 100 indices, and grew popular among investors.

Due to its popularity the American Stock Exchange tried to copy and develop a product that would satisfy SEC regulations. Nathan Most and Steven Bloom, created Standard & Poor’s Depositary Receipts, in 1993, known as SPDRs or Spiders. It became the largest ETF in the world.

Later in 1995 they introduced the MidCap SPDRs as well.

How is it created?

An ETF owns the underlying asset (bonds, stocks, gold bars, etc.), while fund itself is divided into shares held by different shareholders. The exact structure of an ETF varies according to its country. Even within a country it can have different structures.

If you buy a share of an ETF, you have ownership to the underlying asset. For instance, when you buy a share of the ETF GLD (managed by State Street Global Advisors) you own a piece of gold. But just like a stock, you get the annual report of your ETF.

A shareholder is entitled to a share of the ETF profits (interest/dividends). This ownership interest in the ETF can be easily bought and sold.

How Does it Function?

An ETF tracks an index, a commodity, bonds, or a collection of assets, and its price varies throughout the day, like a normal company stock, based on buying and selling. Unlike the mutual funds, shares in an ETF can be bought and sold throughout the day like a company stock, through a broker-dealer.

Investment Outlook

ETFs offer diversification, low expense ratios, and tax efficiency, as well as the features of stocks; limit orders, short selling, and options.

It depends on your investing style as to how you want the max benefits. These are marketable/liquid securities and many invest in ETF shares for long-term for asset allocation purposes, while some trade its shares frequently with market timing investing strategies.

Types of ETFs

  1. Index ETFs: Majority of ETFs are index funds that replicate the performance of a specific index (stocks, bonds, commodity, currency etc.). They do this by holding in its portfolio either the elements of the index or a sample of the securities of that index. SPDR S&P 500 (SPY) is an example.
  2. Stock ETFs: The popular ETFs track stocks. Many funds track national indexes; Vanguard Total Stock Market ETF (VTI) tracks the CRSP U.S. Total Market Index, while many other funds track the S&P 500. Then there are funds that own stocks from many countries; Vanguard Total International Stock Index (VXUS) tracks the MSCI All Country World ex USA Investable Market Index, and iShares MSCI EAFE Index (EFA) tracks the MSCI EAFE Index. These funds vary according to large-cap, small-cap, growth, value etc.
  3. Bond ETFs: These invest in bonds. Normally their price rises during economic recessions because investors pull their money out of the stocks and into bonds (treasury bonds or corporate bonds).
  4. Commodity ETFs: These ETFs invest in commodities, such as precious metals, agricultural products, or hydrocarbons. These are also referred to by (CETFs or ETCs). The first gold ETF was Gold Bullion Securities, launched in 2003 on the ASX , and the first silver ETF was iShares Silver Trust launched in 2006 on the NYSE.
  5. Currency ETFs: These ETFs invest in currencies. Rydex Investments launched the first currency ETF in in 2005 called the Euro Currency Trust (FXE). Similarly in 2007 Deutsche Bank launched EONIA Total Return Index ETF in Frankfurt tracking the euro, and in 2008 the Sterling Money Market ETF (XGBP) and US Dollar Money Market ETF (XUSD) in London.
  6. Actively Managed: As opposed to index funds, some ETFs are actively managed. These funds have been offered in the U.S. since 2008. The first was Bear Stearns Current Yield ETF (YYY).
  7. Inverse ETFs: Inverse ETFs are created by using derivatives to profit from a decline in the value of the underlying benchmark. Yes, it is similar to holding several short positions to profit from falling prices. Several inverse ETFs use daily futures as their underlying benchmark.
  8. Leveraged ETFs: (LETFs) These aim to achieve returns that are more sensitive to market movements compared to non-leveraged ETFs. There are mainly two types; the bull and bear. A leveraged bull ETF fund might aim to achieve daily returns that are two or three times that of S&P 500. Conversely, a leveraged inverse (bear) ETF might try to gain double or triple the loss of the market.

Similarly, there are real estate ETFs and precious metals ETFs. You can study their universe by asset class, country, region, sector, Smart beta etc.

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