An exchange-traded fund (ETF), as the name suggests, is a fund whose shares are traded on a stock exchange. Shares of ETFs can be purchased and sold on the stock exchange the same way as regular stock. An ETF is an open-ended fund which means there is no limit to the number of units/shares available. As more people invest, more units are created. This means that the price is driven entirely by the changes in the investments' underlying value (Obot, 2020). Some argue that ETFs are hybrid investment funds that combine the benefits of open-ended funds, like mutual funds, and the flexibility and liquidity of the closed-ended funds, like the stock market (Goodacre, 2018). However, mutual funds, hedge funds, and ETFs are all examples of open-ended investment funds. Investment management and stockbroking company, Redmayne Bentley, defines an ETF as follows:
‘‘Exchange Traded Funds (ETFs) are index-tracking funds which are listed and traded on a stock exchange like listed company shares. When buying a share in an ETF you are effectively buying a portion of the assets of a fund. These underlying assets are usually shares in the companies which make up the index or sector. ETFs allow UK investors to gain exposure to both domestic and overseas indices such as the FTSE 100, FTSE 250 and S&P 500 and allow exposure to these indices in one simple transaction. ETFs can offer a very low cost, straightforward method of stock market investment. Their aim is to track an index by holding the underlying shares or a derivative equivalent, allowing you to diversify a portfolio to reduce risk’’.
Terminology
Before we move on, it is imperative to know some key terms related to an exchange-traded fund (ETF) market. It will help to 'digest' the article more effectively without turning the attention away from the text to seek the meaning of unfamiliar words.
Authorised participant (AP). It is a recognised body that has a relationship with an ETF provider to create or redeem exchange traded funds (ETFs). Most APs are market makers or large investment houses.
Collective Investment Scheme (CIS). CIS, sometimes known as a 'pooled investment' - is a fund that usually has several people contribute to it. The fund manager of a CIS will invest investors' money into one or more types of asset, such as stocks, bonds or property. If a CIS is not authorised or recognised it is considered an unregulated collective investment scheme (UCIS) (source: the FCA).
CREST. It is the central securities depository for markets in the United Kingdom and for Irish stocks. It stands for Certificateless Registry for Electronic Share Transfer. It is accessed by a number of different professionals ranging from investment firms, brokers, and international banks—all of whom allow retail investors to hold securities electronically (source: Investopedia).
EEA Competent Authority. EEA CA is an equivalent to the UK’s Financial Conduct Authority, in countries of the European Economic Area (EEA). For example, in Germany, The Federal Financial Supervisory Authority (BaFin) brings together under one roof the supervision of banks and financial services providers, insurance undertakings and securities trading (source: BaFin).
The Financial Services and Markets Act 2000 (FSMA). FSMA is an Act to make provision about the regulation of financial services and markets. It created the Financial Services Authority (FSA), the predecessor of the FCA (source: The UK Legislation).
Main Market. Main Market of the London Stock Exchange (LSE) is a world leading market for the admission and trading of equity, debt and other securities. It is a home to more than 1,000 companies from 100 countries, including many of the world’s largest, most successful and dynamic companies (source: London Stock Exchange).
Listing particulars. Information issued by companies which are seeking admission of certain types of securities to the Official List in circumstances where a prospectus is not required under the Prospectus Regulation (EU) 2017/1129. They contain detailed information about the securities and the issuing company. The information required to be set out in listing particulars is determined by the Listing Rules and the Financial Services and Markets Act 2000 (source: Thomson Reuters, Practical Law).
Official List or ‘listing’. The Official List is the definitive record of whether a company’s securities are officially listed in the UK. Among other things, each entry in the Official List shows the: i) security listed; ii) its issuer; iii) the security’s listing category - the set of obligations that apply to the issuer regarding that particular listing (source: The FCA)
Net Asset Value (NAV). NAV is defined as the value of a fund’s assets minus the value of its liabilities (source: Corporate Finance Institute or CFI, n.d.). In the context of an ETF sector, NAV is calculated as dividing end-of-day market price of ETF’s underlining holdings by total number of ETF units in the market (source: Citibank).
Undertakings for Collective Investment in Transferable Securities (UCITS). UCITS is a set of voluntary rules which many ETFs follow. ETFs which are UCITS compliant must follow minimum standards - that includes holding a diversified portfolio, publishing clear guidance on their charges and taking steps to safeguard investors' money (source: Hargreaves Lansdown).
The structure of ETFs and the regulatory framework
Fundamentally, there are four participants in an ETF market, including the fund managers (known as fund sponsors). Authorised participants or APs are middlemen between the fund sponsor or issuer and the investors dealing in secondary markets. Finally, there is a need for stock market regulators who allow the listing and trading
of ETF shares in the stock exchange. An ETF issuer seeking a London listing for its securities has typically two routes to the market (source: London Stock Exchange):
Apply to the UKLA for a London listing and to London Stock Exchange for admission to trading on the Main Market. Please note that since early 2017, the FCA have been phasing out the term UK Listing Authority (UKLA) to refer to the FCA’s primary market functions. Historic documents, however, may still use the term UKLA; or
Apply to London Stock Exchange for admission to trading on the Main Market based on an existing EEA listing utilising a recognised scheme
Figure 1. An overview of two main routes to market using the most common scheme UCITS.
Historically only UCITS compliant ETFs had been listed on London Stock Exchange. However, the LSE has now created dedicated segments and sectors to allow non-UCITS ETFs to list. Figure 1 provides a quick overview of the two routes mentioned above to market using the common scheme UCITS, which stands for Undertakings for the Collective Investment in Transferable Securities. It is a European directive that provides a regulatory framework for ETFs managed and domiciled in the EU and intended for sale to retail clients. If a fund (such as an ETF) is UCITS compliant, it can be marketed to retail investors across Europe because it adheres to the common standard for risk and fund management. The framework was set up to avoid products needing regulatory approval from each individual member state of the European Union (source: IG).
Nonetheless, we are still yet to see how the UK’s exit from the European Union will affect financial services in the United Kingdom, including the regulation concerning the ETF sector. Any ETF that is UCITS compliant must state it in its name, e.g., iShares Core FTSE 100 UCITS ETF. iShares funds are managed by the Blackrock company, an American multinational investment management corporation based in New York City founded by Larry Fink.
Creation of exchange-traded funds
Newly created ETF shares are delivered to market makers or authorised investment houses, known as authorised participants (APs), in exchange for an entire portfolio of shares matching the index (Arnold, 2020). This transaction takes place in primary markets. At this stage, the underlying shares are held by fund managers, while APs who are in possession of ETF shares can now sell those shares to institutional and private investors in secondary markets. To redeem ETF shares, the opposite scenario takes place. Underlying shares held by fund sponsors are delivered to market makers in exchange for ETF shares. Investors can deal, i.e., buy and sell, ETF shares on stock exchanges, like a regular stock of ordinary publicly traded companies. Thus, an investor will use a stockbroker's services, including online providers (e.g., Hargreaves Lansdown). This relationship between ETF market participants (excluding regulatory bodies, such as the FCA) is illustrated in figure 2 below.
Figure 2. How an ETF works. Source: Smart & Zutter (2019).
Smart & Zutter (2019) in their book Fundamentals of Investing presented the example of how an ETF is created using the imaginary exchange-traded fund called ‘Smart Investors’:
‘‘An authorised participant has acquired a portfolio of stocks that includes all stocks in the S&P 500. The total market value of these stocks is $100 million. The AP transfers these shares to Smart Investors, who in turn issues 100 creation units containing 50,000 ETF shares each to the AP. Therefore, the AP holds a total of 5,000,000 ETF shares. The AP sells the shares to investors at a price of $20 each, so the total value of the ETF shares outstanding equals the value of the shares held in trust. Each day the ETF share price will move in sync with changes in the value of the securities held in the trust’’.
ETF's price
ETFs are listed in stock exchanges; therefore, they have prices and Net Asset Values (NAV) (source: Citibank). Since the APs can create new ETF shares or redeem outstanding shares, the ETF share price generally matches the NAV of shares held in trust (Smart & Zutter, 2019). Thus, ETF shares' market price is hugely dependent on the supply and demand of the market, just like for ordinary shares of regular public companies. Despite an ETF's price being set by trading in the stock market, they usually trade at or near the NAV (Arnold, 2020). Citibank Group also states that under normal conditions, the price should be very close to NAV.
Most popular exchange-traded funds
Hargreaves Lansdown (HL), a British financial service company based in Bristol, England, provides a list of the most popular ETFs based on their client holdings. HL itself is a publicly-traded company and the constituent of the FTSE 100 Index. Also, please note that some of these funds are so-called exchange-traded commodities/currencies (ETCs), which follow the price of metals, oil, agricultural products, or exchange rates, e.g., WisdomTree Physical Gold:
iShares II plc Global Clean Energy UCITS ETF (Dist)
iShares plc Core FTSE 100 UCITS ETF (Dist)
Vanguard Funds plc S&P 500 UCITS ETF USD(GBP)
WisdomTree Physical Gold (GBP)
iShares Physical Metals plc Physical Gold ETC
Vanguard Funds plc FTSE 100 UCITS ETF GBP
iShares plc FTSE UK Dividend
Vanguard Funds plc FTSE 250 UCITS ETF
iShares plc FTSE 250
WisdomTree Physical Gold
Benefits of investing in ETFs
Investors can realise their profits from investing in ETFs in two major ways. First of all, they buy an ETF at a price and then sell it at a higher price to make a capital gain. The reverse scenario occurs when investors sell their shares at a lower price resulting in capital loss. Secondly, ETF investors may be eligible for dividend pay-outs. Like some shares and investment funds, some ETFs distribute dividends. Arnolds (2020) suggests that ETFs pay a dividend in line with underlying constituents shares or other income such as interest on bonds, quarterly, semi-annually, or annually. However, investors should always refer to the dividend distribution policy outlined in the investor’s prospectus.
You can familiarise yourself with intricacies of the dividend distribution policy by reading the Vanguard ETF Prospectus (page 96). Available at https://www.vanguardinvestor.co.uk/rs/gre/gls/1.3.0/documents/21588/gbFigure 3. Benefits of investing in ETFs. Source: NAPF. Available at https://www.plsa.co.uk/portals/0/Documents/0402-Exchange-Traded-Funds-made-simple.pdf
One of the key benefits of investing in an exchange-traded fund is the degree of liquidity. Since, ETFs are traded on a stock exchange; investors can buy and sell their ETF shares as long as the market is open. The process is called intraday trading or day trading. Mutual funds, which share many common characteristics with ETFs, are not traded on a stock exchange. Therefore, mutual fund investors can buy or sell their shares of the fund at the end of the trading day once a specific formula is applied to calculate the fund's prices. In other words, mutual funds trade only once a day after the markets close, while ETFs investors can sell and buy their shares at any point during the trading day.
Cost-effectiveness is another incentive for individuals and businesses willing to buy into the exchange-traded fund. ETFs often have lower costs than other types of investment funds (source: Citibank), for example, mutual funds or unit trusts. ETFs usually do not incur any exit or redemption fees, and no stamp duty tax is payable on purchase, nor does the ETF pay stamp duty when it purchases underlying shares (Arnold, 2020). Other advantages of investing in ETFs include transparency, flexibility, or diversification.
Brief history of exchange-traded funds
The analysis of the ETF sector's size is beyond the purpose of this article. However, it is worth mentioning that it is on track to outperform mutual funds at some point in the future: "in the next few years, ETFs will likely surpass actively managed mutual funds in advisor asset allocation" (source: Broadridge: 2020). According to Funds Europe (the business strategy magazine for Europe's asset management professionals), the ETF market has doubled in size to more than $7 trillion (as of 2019) since the Great Recession of 2007-09.
The first-ever listed exchange-traded fund was launched on January 22, 1993, on the American Stock Exchange (AMEX), called the S&P 500 Trust ETF (also known as the SPDR or "spider" for short). It is still one of the most actively traded ETFs today, with a total of $352,862.80 million (April 1, 2021) of assets under management (AUM). This ETF is listed on the New York Stock Exchange (NYSE) with a net asset value of $400.56 (April 1, 2021).
In April 2000, London Stock Exchange launched the first UK listed exchange-traded fund. Today, Europe is second to the US biggest ETF market globally, while the outlook and projections indicate significant growth for the upcoming years. According to the Goodacre UK survey, a total of 75% of participating respondents believed that the ETF market would rapidly accelerate between 2018 and 2023.
Bibliography
Arnold, G. and Arnold, G. (2020). The Financial Times Guide to Investing. 4th ed. [ebook] Pearson. Available at: https://www.perlego.com/book/1365862/ In
Citibank (2017). Exchange Traded Funds [online]. Available at https://www.citibank.co.uk/static/documents/Exchange_Traded_Funds.pdf
London Stock Exchange Group (2017). Exchange Traded Funds. Introducing and Operating ETFs in the UK [online]. Available at https://www.lseg.com/sites/default/files/content/documents/LSE_ETF_LISTING_%26_ADMISSION_GUIDE_05.pdf
Redmayne Bentley (n.d.). Exchange Traded Funds (ETFs) Fact Sheet [online]. Available at: https://www.redmayne.co.uk/RedmayneBentley/media/Redmayne-Bentley/Forms%20and%20Brochures/Fact-Sheet_-Exchange-Traded-Funds-(ETFs).pdf
Smart, S.B. and Zutter, C.J. (2019). Fundamentals of Investing, Global Edition.14th ed. [ebook] Pearson. Available at: https://www.perlego.com/book/1032337/
Smart, S.B., Gitman, L.J. and Joehnk, M.D. (2016).Fundamentals of Investing, Global Edition. 13th ed. [ebook] Pearson. Available at: https://www.perlego.com/book/812236/