How do ETFs work?

• Level: For beginners
• Reading duration: 5 minutes

Exchange-Traded Funds (ETFs) have revolutionised investing when it comes to getting cost-effective and easily traded exposure to different asset classes and markets. ETFs operate just like old-fashioned mutual funds, with the big difference that ETFs are listed on the stock market, unlike mutual funds. While you can trade classic funds only once a day, you can buy and sell ETFs just like stocks at any time during stock exchange opening hours. And because ETFs are index-tracking funds, there are no expensive fund managers or analysts to pay for. This makes ETFs much cheaper than active funds, which are managed by fund managers - and the ironic thing is: in the medium term, index funds beat most actively managed funds, too!

Invest in entire markets with just one ETF

By buying a single ETF, you can easily and inexpensively replicate the performance of a stock market index consisting of hundreds or even thousands of listed companies. ETFs also allow you to do the same with indices on other asset classes, such as bonds or commodities.

Physical and Synthetic ETFs

But how do ETFs track indices? There are two different kinds of ETF:

• With a physical ETF, the ETF provider attempts to track an index by buying the underlying assets of the index with the same weight as in the index, in order to mirror its rise and fall (full replication). If the ETF provider only invests in a selection of the assets, this is called sampling.
• Alternatively, the ETF provider may enter a contract with an investment bank to provide the return of a particular index in exchange for a fee. This is called a synthetic (or swap-based) ETF.

How physical ETFs work

To construct a physical ETF, the provider purchases all or a selection of relevant securities from the index to replicate it. For instance, an ETF designed to track the FTSE 100 index of leading UK shares holds all the companies in the FTSE 100, in proportion to their weighting in the index. For example, if HSBC bank has a 7% weighting in the FTSE 100 index, the ETF provider seeks to invest 7% of its fund's assets into HSBC shares. However, there are also cases where it is not possible or more attractive in terms of the cost-benefit ratio not to hold all the components of the index in the ETF as well. For example, an ETF provider may invest in only a selection of the securities in the index in order to replicate the performance of the index. This replication method is referred to as sampling or optimized sampling if the selection of securities is based on a quantitative method for process optimization. This replication method is used in particular for very large stock indices with several thousand shares, such as the MSCI ACWI. In sampling, the ETF provider attempts to reduce the cost of replication by investing only in selected stocks that it believes best replicate the index performance.

How synthetic ETFs work

A synthetic ETF does not directly invest in the index’s constituents. Instead, the synthetic ETF enters into a contractual agreement with an investment bank, with the latter promising to pay the ETF provider the daily return from the index being tracked, plus any dividends due, in return for a fee. A synthetic ETF can therefore track an index very precisely (before fees) since the investment bank has agreed to pay the exact return to the provider. Synthetic ETFs can be particularly useful for accurately tracking less liquid markets, where it may not be easy to implement a cost-effective physical ETF. Some asset classes, such as commodities or the money market, can even only be replicated by synthetic ETF replication. A potential downside of synthetic ETFs is the introduction of so-called counterparty risk, due to the swap transaction with a third party.