What is an ETF?

If you are already an investor or you are considering to invest your money on the markets it would be wise to deepen your knowledge about ETF’s. Investing in ETF’s is becoming more and more popular and there are good reasons for that. But first we will get into the question “what is an ETF really?”.

ETF as a reflection of exchange traded assets

The best way to look at an ETF is to see it as an exact reflection or copy of assets already traded at exchanges. These assets may be stocks, commodities, currencies or bonds. It may also be a stock market index which is not a tangible commodity but the underlying value of an index represents the value of the stocks or commodities included.

Tracker or ETF?

In some countries ETF’s are often labelled “trackers” which is a good way of describing the function of an ETF. A tracker is an ETF (and vice versa) so it is just another name for the same thing.

ETF stands for Exchange Traded Fund but the name Tracker better captures the function of an ETF which is tracking an underlying asset as stocks, commodities or currencies. The name Index Tracker is used when an ETF is tracking a market index.

An ETF will not perform better than the underlying value of the stocks, currencies or index tracked, but (even more important) not worse either. This makes an ETF reliable which is one of the main reasons I myself am investing exclusively in ETF’s. An ETF has many advantages to offer which I will explain in another chapter.

What is the difference between an ETF and an investment fund?

We just answered the question “What is an ETF”. While doing that you might wonder “So what’s the difference compared to an investment fund?”. The similarities are obvious, in an investment or mutual fund you would also find a basket of stocks or underlying assets.

However, there is 1 major difference: in an investment fund buying and selling of assets always take place within that particular fund. A mutual fund or investment fund has a designated fund manager that is actively trying to improve the result of the investments by buying or selling at the best possible moment.

An ETF does not have a manager, it just tracks the underlying assets of the ETF. Simple as that.

I will give a straightforward example:
Suppose you will both invest in an investment fund and buy an ETF that are both tracking the DAX index. Suppose the DAX has increased with 10% in 1 year. The aim of the investment fund should be to gain a better result than a 10% return.

The DAX ETF has increased with 10% exactly. However there is no guarantee at all that an investment fund will beat the index. The result may be better of far worse. In many cases we see that investment funds are underperforming on the indices they do tend to track and follow up.

Looking at investments costs there is also a big difference as a mutual fund or investment fund has its own designated manager that is actively buying and selling.

Putting it in other words: the issuing party of the investment fund may earn a substantial income due to charging the cost of management and commissions on the trades they are making whether they make a positive return for their investors or not.

An ETF does not have an active manager and no buying or selling is taking place on behalf of the buyer of the ETF. That makes a big difference. You might say that badly performing investment funds and its high cost of management are the reason for the big shift of money going from funds to ETF’s.

Some costs are charged while investing in ETF’s but they are on a much lesser level than that of mutual and investment funds. So a different answer to the question “what is an ETF” would be: “a much simpler and cheaper investment fund that is exactly tracking the underlying asset”.

How is an ETF being made?

An ETF is created and put on the market by an ETF provider. Suppose one would want to create a DAX ETF, this ETF should be a reflection of the DAX index and always track the DAX index. So what is a provider of such an ETF doing?

They just buy all the shares that are represented in the DAX with the same weighing as the DAX. Such an ETF is called a physical ETF (the underlying assets are bought and kept). Also synthetic ETF’s do exist, then swaps and derivates will make sure that the exact index will be tracked. In a separate chapter I will explain the differences between physical and synthetic ETF’s as the latter ones do have a higher risk.