ETF stands for “Exchange Traded Fund”, a synonym for “Trackers” or “Listed Index Funds” – financial jargon which doesn’t really give the non-expert a very clear idea of what this is all about! In fact these are continuously-listed funds, traded just like traditional shares through orders to sell or buy, and whose purpose is to reflect as closely as possible the performance of a given index.
The fund may include a group of several dozen or even several hundred securities, with the aim of duplicating either the largest and best known indices or a particular sector of activity or geographical zone; or it may be based on specific financial criteria linked to the distribution of dividends or a given PER. ETFs possess many advantages which are the keys to their success: flexibility of use, diversification, and cost reduction (a highly sensitive point of course for any financial product!).
They can often be an alternative to direct holding of shares by individual investors and in this respect they are therefore in competition with unit trusts or investment funds. Apart from the underlying, the main advantage of ETFs for the investor is diversification, i.e. the distribution of risk across the whole of a stock market at the lowest cost.
The other advantage of ETFs is that a high degree of diversification can be obtained by investing in a dozen Exchange Traded Funds where otherwise hundreds or even thousands of different shares would be required, with all the attendant costs!
Certain rules should nevertheless be followed when selecting EFTs:
- quality of index tracking is an absolute priority;
- liquidity: possibility of buying and selling at any moment;
- finally the analysis of a possible counter party risk (physical replication involves risk linked to the loan of securities, thus relatively god security, while synthetic replication leads to a counter party risk).
While ETFs are certainly not magic products or the Holy Grail that every investor is looking for, they nevertheless possess undoubted advantages that investors should know how to combine and integrate, with the sole aim of improving the performance of their investment portfolios.
