Part 1: Introduction to ETFs
Since its origination in 1993, the ETF (Exchange Traded Fund) has taken the financial markets by storm. An astronomical rise in its popularity has seen global investors trade a record 53.8 trillion USD in 2022. While a lot of people have heard of this highly popular investment tool, only a small fraction of investors truly understands the complex market mechanisms underlying the ETF that allow for its unique properties. In this series, we are going to explore the dynamic world of ETFs investing together with Invesco, one of the world’s largest asset managers with ca. 1.5 trillion USD AUM. In part 1 of the series, we will explore the general characteristics of ETFs and their relevance to investors together with Jolien Brouwer, ETF Sales Manager Benelux at Invesco. In the following articles fixed income ETFs and synthetic ETFs are explored.
The Exchange Traded Fund
An ETF is a basket of securities that trades on the exchanges like a stock. ETFs are generally issued by financial institutions, such as Blackrock, Vanguard, or Invesco, and offer clients exposure to a wide variety of stocks, bonds, or commodities1. ETFs have the general characteristics of a mutual fund, such that they are professionally managed and offer clients diversification benefits, but unlike a mutual fund trade continuously on the exchange throughout the day. This mechanism is possible through the creation and redemption process, which is a unique characteristic of ETFs.
ETF shares can be bought on the stock market by investors, allowing them to own a fund with a great variety of stocks without the need to buy every underlying stock individually. This allows investors to diversify their holdings at low costs. The major difference between an ETF and a mutual fund is the daily liquidity. Just like with stocks, it is possible to implement trading instructions to the order by, for instance, adding a limit order. A mutual fund can only be bought or sold once a day and can even take several days to settle. Another significant difference is that an ETF can be less costly to manage as it generally follows an index and does not require a team of analysts to determine the constitution of the fund. There is often more flexibility when it comes to the constituents of mutual funds, as the manager has more freedom to choose underlying holdings. This active management is also what you pay for as an investor.
ETF Primary and Secondary Markets
ETFs operate in two markets: a primary market and a secondary market. The secondary market refers to the buying and selling of ETF shares on-exchange or over the counter (OTC). The primary market refers to the place where authorized participants (APs) transact with ETF issuers to create or redeem ETF shares. APs are parties that have the contractual ability, however not the obligation, to trade ETF shares for the underlying assets of the fund.
The creation and redemption allow APs, together with the ETF issuer, to create new ETF shares or redeem existing ones. This process is essential in keeping the ETF share price close to the net asset value (NAV) of the fund.
Creation happens when the ETF share price is trading above the NAV of the fund. The AP can buy baskets of stocks on the exchange that are representative of the fund or provide cash, and trade these with the ETF issuer for ETF shares. The AP can then sell these newly created ETF shares on the secondary market for a profit. The creation process causes the fund to grow both in number of shares outstanding as well as in the total amount of assets.
The opposite of the creation process is the redemption process. If the ETF share price is lower than the NAV of the fund, APs can buy ETF shares on the secondary market and trade these for the baskets of underlying stocks with the issuer. The APs then sell these stocks on the open market and profit of this arbitrage. This arbitrage mechanism causes the ETF share price to stay close to the NAV of the fund. Through the redemption process the total size of the fund decreases. The main advantage of these two market layers is the increase in liquidity. Shares of the ETF can be traded easily without the need to buy or sell the underlying multitude of shares.
“What are factors that investors should consider when selecting an ETF for their investment portfolio?”
That is always a challenging question to answer as this is different for everyone and determined by your own investment goal, risk appetite and time in the market. However, there are a few key things to remember. For instance, you can consider what an ETF adds to your portfolio in terms of regional and sectoral exposure. Also, it is wise to look at costs and how dividend is treated. ETFs are long term investments and in the long-term costs do have an impact on your results. Dividend is the only free lunch out there, as in that long-term dividend can lead to exponential growth. If you opt for a distributing ETF you will have to reinvest the dividend yourself, which an issuer can do much more efficiently. So, if you do not need the dividend you might want to consider an accumulating ETF. There are many aspects to consider and the most important one is that “it’s not timing the market that counts, but time in the market”.
“What choices do you make when composing the ETFs to best suit the clients’ needs?”
The client base of ETFs is just as diverse as the number of ETFs out there. So, we make products for starting retail investors looking for simple building blocks for their portfolio, and for large institutional clients looking for low costs exposure to multifactor ESG ETFs. Per client type the requirements can be very different. Usually, it all starts with what we hear in the market. We will always consider how an ETF fits in our strategy and if it can be interesting for more than just one group of clients. Also implementing ESG is an important factor.
“How does Invesco stay competitive in the rapidly evolving ETF industry, and what steps
are taken to ensure that the ETF offerings remain relevant and attractive to investors?”
As a top 10 ETF issuer we are constantly working on new product developments and current product enhancements. We listen to what our clients are looking for and strive to come with suitable ETFs. A large part of our decision making is determined by availability of cost-efficient indices, liquidity of the underlying, regulation and the competitive landscape. As these aspects will determine if the ETF will be suitable for clients, and not for instance be very expensive due to illiquidity of the underlying. Sometimes we come up with ETFs that might not seem to be very interesting on the short term yet have potential to be in the future. Our job is not only looking at current trends and developments, but we also need to be relevant in 10 years’ time and need to come with ETFs that are interesting for early adopters now so that they will be relevant for all investors in the long run. Constructing new ETFs is a very delicate process that can take up to many months and sometimes even years.
The relevance of the ETF is ever-increasing in the world of asset management and its dominance is likely to remain. Learn more about ETFs in part 2 and part 3 of the series, which will explore fixed income and synthetic ETFs with Invesco. If you are interested in working in this industry, check out the vacancies of Invesco by clicking on the button below! Moreover, the Financial Career Platform has many other vacancies within the Asset Management industry and beyond. Besides that, FSR will organize the Asset Management Tour in the beginning of November where you can have the opportunity to visit various asset managers. Stay tuned!
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1 Commodities can be traded as swaps using a synthetic ETF or physically by using an exchange traded commodity (ETC)
The information provided in the article is intended to be used and must be used for informational purposes only. Our content is not intended as, and shall not be understood or construed as, financial advice.