Exchange Traded Fund

What Is It?

ETF stands for exchange traded fund. Imagine you want to buy the stocks of companies like Google, Apple, Amazon and another 50 major technology companies in one go as a single security. You can achieve that through purchasing investment instruments known as ETFs. Essentially, and ETF is a basket of securities that aims to mimic the performance of a wide range of stocks or bonds through a single security.

A major market index that is tracked by ETFs is the S&P 500, which measures the health of the U.S. stock market by tracking the performance of 500 large capitalization U.S. stocks, similar to the purpose of the Kuwait Price Index.

Typically, ETFs are constructed around an existing market index (for stocks, bonds, or another asset class), which allows them to focus on matching that index’s return by holding the assets contained in the underlying index. Simply put, because the stocks or bonds making up an index are public, investment managers (such as Vanguard, Blackrock, etc.) make it more affordable for investors to capture the full market return by developing ETFs for different indices and markets (U.S. markets, emerging markets, etc.). Instead of buying each of the 500 stocks included in the S&P 500, for example, an investor can by an S&P 500 ETF.

ETFs are traded on stock exchanges just like the shares of Apple or other stocks are, meaning that they area liquid and efficient means of further diversifying a portfolio. ETFs can come in a variety of forms, including asset class based funds (stocks, bonds), sector focused funds (technology, energy, etc.) and geographically focused funds.

What Is It Used for?

The popularity of ETFs has risen dramatically as a result of their liquidity and the trend towards passive investing, which seeks to match as closely as possible the performance of a market index rather than to outperform it.

This trend is partly driven by the difficulty active money managers have experienced in outperforming their benchmarks in recent decades. Accordingly, in recent years the market has witnessed increasing allocation of investor funds to ETFs that focus on mirroring market indexes rather than actively picking stocks.

Investors can also benefit from the low management fees charged by the investment companies which sponsor ETFs in comparison with those charged by actively managed mutual funds. This is due both to competitive forces, as ETF sponsors seek to attract investor funds, and to the lack of a need to hire portfolio managers to actively pick stocks.

To outperform an ETF based on the S&P 500, an actively managed fund must not only do better than the index, it must also outperform the index by a large enough margin to make up for the higher management fees associated with being an actively managed fund. The difficulty actively managed funds have experienced in turning in such performance on a consistent basis, when management fees are taken into account, has made the ability of ETFs to provide returns closely paralleling market indexes increasingly attractive to investors in recent years.

Other Considerations

While investors can benefit from the low costs and market return matching aspects of ETFs, because these funds are passively managed they do not offer investors the opportunity to outperform the market index they are based on. Thus, if the market index performs poorly over a certain period of time, so will the ETF based on that index.

This contrasts with actively managed funds, which have the potential of outperforming market indexes. However, given the difficulty involved in consistently beating the market over time, finding an active manager who can provide this type of market-beating performance over a significant period of time can be difficult, which helps explain the rise of passive investing in recent years.