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A primer on Exchange-Traded Funds

by Editor

March 8, 2018 | 12:29 am
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An Exchange-Traded Fund (ETF) is a “pooled” investment vehicle that offers diversified exposure to a segment of the financial market. It can invest in various underlying assets e.g. equities, bonds, commodities, currencies, options or a blend of assets. It can also be defined as an investment security (a fund) that is designed to track the performance of an underlying asset benchmark/index or specific sub-benchmark/index.

ETFs are listed and traded on organised securities exchanges such as FMDQ and can be bought or sold during daily market trading sessions. They uniquely offer investors an indirect exposure to the underlying asset classes, in addition to a cheaper means of portfolio diversification. An example of an ETF available in the Nigerian capital markets is the FMDQ-listed Vetiva S&P Nigerian Sovereign Bond ETF (which tracks the S&P Nigeria Sovereign Bond Index).

Offering easy access to virtually every corner of the market, ETFs allow investors, big and small, to build institutional-caliber portfolios with lower costs and better transparency than ever before. ETFs are essentially an evolving capital markets product, and it is imperative for investors to understand their advantages and limitations. This edition of FMDQ Learning explores the features, investment modalities and risks of ETFs.

Features

From bonds to equities and currencies, ETFs exist for almost every asset class. Bond ETFs for example, invest exclusively in bonds of different tenors, yields, investment grades, etc.

In the same vein, equity ETFs have a basket of equities as the underlying asset and can be further classified in terms of geographic regions (such as emerging markets, country-specific, etc.), the component size of the listed companies (small, medium or large), sectors (financial services, oil and gas, transportation, etc.), amongst other classifications.

Similarly, commodity ETFs invest in commodities such as precious metals, agricultural products, or hydrocarbons; whilst currency ETFs track the performance of a single currency in the foreign exchange market against the US Dollar or a basket of currencies. From an investment management perspective, ETFs can be either actively or passively managed.

Actively managed ETFs attempt to out-perform the underlying asset or index using strategies such as market timing, sector rotation, short-selling, buying on a margin, etc. Conversely, passively managed ETFs simply buy and sell securities to closely mirror the performance of the assets or indices it tracks.

As an investible asset class, ETFs offer diversification, income and arbitrage opportunities to investors. Compared to equities and bonds, for example, ETFs allow investors to purchase a diverse array of assets at once through one fund, as opposed to buying a single equity or bond with the associated transaction costs.

Highlighted below are some of the reasons institutional and retail investors favourably consider ETFs: Diversification: ETFs can provide access to a wide variety of sectors and indices through a single fund. For instance, a broad-based bond ETF might contain hundreds or thousands of bonds—more than many actively managed portfolios may typically accommodate.

Accessibility: ETFs provide investors access to all segments of the capital markets through the creation of funds that track hitherto inaccessible asset classes such as gold bullion, emerging markets bonds, and so on.

Replicability: ETFs create an opportunity for fund managers to build portfolios that nearly replicate the ETFs by investing in every security captured by the underlying asset(s) which the ETFs track, according to their set weightings.

Liquidity and price discovery: ETFs are exchange-traded and can be bought or sold in the secondary markets at various times throughout the day, and at prices quoted on the exchanges.

Transparency: Generally, the issuer/fund manager of an ETF provides daily information on the ETF basket to the shareholders, including, but not limited to the Net Asset Value (NAV) of the ETF.

Risk Considerations

Whilst ETFs are often considered relatively less risky than other asset classes because they allow for broad portfolio diversification across various asset classes and markets, ETF investors must be aware of the inherent risks and costs of ETF investments, regardless of the type of ETF or the portfolio strategy.

Some of the key ETF risks include, but are not limited to the following: Market Risk: Like other asset classes, ETFs are exposed to the up and down swings experienced in the financial markets. This implies that the value of an ETF investment may fluctuate in response to economic shifts or asset-specific fundamentals. As an example, the price of a bond ETF will decline (or increase) following a downward (or upward) movement in the prices of the underlying bonds which the ETF tracks. Market risk can be mitigated through efficient capital allocation that reduces exposure to any one (1) asset.

Trading Risk: This refers to the total cost of owning an ETF portfolio. These costs are usually in the form of commissions, sales charges, management fees and other direct trading costs such as the bid-ask spread, etc. Like other assets, ETFs also carry opportunity costs, creation and redemption fees and taxes on interest income and capital gains. Trading risk can be mitigated through robust due diligence which seeks to eliminate inefficient transaction/opportunity costs.

Composition Risk: The composition of an ETF may differ from that of the underlying assets which it tracks. Hence, there is a possibility that, for instance, two (2) ETFs that track the banking sector equity index could report varied performances since they might be tracking a different selection of banks. Composition risk can be mitigated through detailed due diligence prior to investing in the ETF.

Counterparty Risk: This risk emerges when securities lending is applied in the ETF market. It crystallises when a counterparty defaults on the ETF holdings lent them by another party for a short period of time. This risk can be minimised by establishing collateral requirements which the borrower must meet, and which effectively offset counterparty exposures for the lender.

Closure Risk: This occurs when an ETF fund manager prematurely liquidates a fund and pays out the shareholders, incurring capital gains, transaction expenses and in some cases, legal expenses, which ultimately trickle down to the investors in the form of additional costs.

Investors can mitigate this risk by selling off their ETF holdings as soon as the issuer announces it will close.

Investment Modalities

ETFs are similar to mutual funds (that is funds pooled from investors for the purpose of investing in securities such as stocks, bonds, money market instruments and other assets) in that they are both professionally-managed investment schemes which pool investors funds and invest same in equities, bonds, infrastructure and other securities.

The investment modalities of ETFs begin with the creation of the ETF, and subsequent subscriptions/investment in the ETF by institutional and retail investors.

The key steps in this process

Creation of an ETF: ETFs are created (and redeemed) in the primary market through the interaction of various stakeholders including the ETF sponsor (the fund manager), participating dealers (institutions authorised to create and redeem ETFs) and market makers (institutions that provide liquidity and may also function as participating dealers). Typically, a participating dealer applies to the ETF sponsor for a ‘creation unit’ (typically a given amount of ETF shares) in exchange for a basket of securities (called an ‘in-kind’ transfer), cash that equals the value of the ‘creation unit’ or a combination of the two. The redemption process works in reverse, with the participating dealer(s) approaching the ETF sponsor for a redemption.

Listing on an Exchange: Once an ETF has been created and approved by the relevant regulatory authority (for instance, in Nigeria, the Securities and Exchange Commission) it is listed on a securities exchange such as FMDQ where it can be bought and sold by institutional and retail investors in the secondary market.

Investment in an ETF: The participating dealers sell ETF stakes to interested investors (who may further trade/exchange the ETFs with other investors) in the secondary market through licensed brokers. The unit price of the ETF fluctuates daily and typically reflects the approximate value (NAV) of the ETF’s underlying security or group of securities at any given point in the day.

In summary, ETFs provide innovative opportunities for investors to diversify their investment portfolios and to meet specific asset allocation needs. The market for ETFs has grown fundamentally across developed and emerging financial markets over the past decade and is expected to continue in this regard.

FMDQ, in its quest to support development of the markets and the economy alike, is adequately equipped and positioned to support fund managers and to promote the listing of ETFs through its reliable and credible platform for the listing and quotation of investment securities.


by Editor

March 8, 2018 | 12:29 am
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