Recently I was sitting in my buttoned-up 2 piece suit discussing a client’s potential investment opportunities, feeling like a boss, and acting like a knowledgeable advisor. It was with deep sated confidence that I professed “. . . playing with the passive game it would be a good idea to allocate a portion of your portfolio to select EFT’s . . .”. The slip of the tongue did not go unnoticed and I was quickly reminded by the client “. . . sorry to interrupt but isn’t it an ETF not an EFT?”.
Perhaps I should have been less confident and more thoughtful.
This article intends to unpack and understand what an ETF (not and EFT) actually is.
ETF vs EFT
Unpacking the acronyms:
EFT: Electronic Funds Transfer
ETF: Exchange Traded Fund
An EFT as I am sure you are aware, is simply a transfer from one bank account to another and has absolutely nothing to do with an ETF. Well except for it having a very similar name. With that simple clarity provided, let us understand what an ETF actually is.
Exchange Traded Fund’s trace their history back to 1993 and have developed a long way over the years. They only became very popular after the 2008 crash. So it has only been in the last decade that they have become extremely popular amongst retail investors (that’s me and you – the ordinary folk). An ETF or an Exchange Traded Fund is quite simply: a marketable (you can buy and sell it) security (think of a stock) that tracks an index (a whole bunch of assets, stocks, commodities, bonds or prices lumped together).
Tell me more . . .?
We are going to break down this definition into 2 different parts:
- An ETF or an Exchange Traded Fund is a marketable security . . .
- . . . that tracks an index
The word “marketable” is there to inform you that the security should be able to be sold and bought at your discretion. You have the choice to choose to buy more or sell your investment. This right cannot be removed by the service provider; thus liquidity is preserved.
The word “security” merely means you buy an actual unit or share (let’s call it a piece) that you will then hold in your own name (or a structure of your choosing). Each piece will have a certain value attributed to it. This value moves according to the index (see below) and will generate a profit or loss depending on the value. You will see the number of units/shares always stays the same unless you buy more or less of them.
Tracks an Index
As mentioned above, the ETF units or shares track the performance of a group of assets. The most common, is one that tracks the “Top X” number shares. For instance, an ETF that tracks the JSE Top 40 will replicate the performance of owning all 40 shares at the same time. When investors refer to “weighting” this is how the ETF is constituted or made up. It merely means how much of each of the shares in the Top 40 are you holding? Some ETF’s have equal weightings which means you would own one fortieth in each share. However, the most common weighting is according to Market Capitalisation. This is where a company with a larger market cap will result in proportionally larger holding and thus those shares have more effect on the ETF.
Remember: Market Capitalisation is the share price times the number of shares. It is often used as an indication of the size of a company.
How is an ETF different to an Index Fund?
An index fund is an actual entity that you will buy into. This fund will track the performance of a select group of assets the same as an ETF but will actually buy the underlying assets and use the index as a benchmark. This is different to an ETF whereby you are not buying into a fund.
So an ETF is merely an investment made up of units or shares and each of those shares derive there value on some form of underlying group of assets. This allows investors with relatively small amounts of capital to buy diverse range of assets.
Remember: Diversity spreads your risk because you don’t need to put all your eggs in one basket.
ETF’s are the easiest and most cost-effective way for the ordinary people to invest. The costs are very low compared to active asset managers. ETF’s do not need anyone to decide when or what to invest in because it is governed by predefined rules.
The low costs, ease of access and variety of products that are ETF’s make it an essential part of any successful investor.
Look out for our next article: “How to select an ETF and what to watch out for!” coming soon.