ETFs : definition, functioning and how to invest

ETFs are today one of the most popular financial investments for private investors who see the opportunity to diversify their savings with high returns and controlled volatility. First introduced in the 1990s, ETFs aim to replicate the value of a given index and generate the same return as that index. Let's go over this financial product like no other!

What is an ETF ?

In short, an ETF is a basket of shares that can be bought or sold through a brokerage firm on a stock exchange. ETFs exist for almost every possible asset class, from traditional investments to so-called "alternative" assets such as indices or renewable energy.

After several unsuccessful attempts, the history of ETFs began in earnest in 1993 with the product commonly known by its ticker symbol, SPY, or "Spiders", which became the highest volume ETF in history. By 2022, the total capital invested in ETFs was estimated at $6.64 trillion with over 3,000 ETF products traded on various U.S. exchanges.

Learn more about ETF portfolio.

The different types of ETF :

• Index ETFs: Designed to track a particular index such as the S&P 500 or NASDAQ.

• Fixed Income ETFs: Designed to provide exposure to virtually every type of bond available: U.S. Treasury bonds, corporate bonds, municipal bonds, international bonds, high yield bonds, etc.

• Sector and Industry ETFs: Designed to provide exposure to a particular sector, such as oil, pharmaceuticals or high technology.

• Commodity ETFs: Designed to track the price of a commodity, such as gold, oil or corn.

• Style ETFs: Designed to track an investment style or market capitalization, such as large-cap value funds or small-cap growth funds.

• Foreign Market ETFs: Designed to track non-U.S. markets, such as Japan's Nikkei Index or Hong Kong's Hang Seng Index.

• Inverse ETFs: Designed to profit from a decline in the market or the underlying index.

• Leveraged ETFs: Designed to use leverage to magnify returns

• Actively managed ETFs: Designed to outperform an index, as opposed to most ETFs, which are designed to track an index.

How does an ETF actually work ?

An ETF is bought and sold like a share of an ordinary company.

In concrete terms, when an index is created, ETF providers such as Amundi, Ishares or Lyxor can "build" an ETF in collaboration with licensed market makers. These market makers acquire the securities included in the index and then deliver them in the form of ETF units to the provider, such as iShares. The ETF can now be traded on the stock exchange like any other stock.

Read more: What is a data room?

The advantages of ETF :

• Ease of trading - it is possible to buy and sell at any time of the day, unlike most mutual funds which trade at the end of the day.

• Transparency - Most ETFs are required to publish their holdings daily.

• Trading - Because they trade like stocks, investors can place various types of orders (e.g. limit orders or stop-loss orders) that cannot be placed with mutual funds.

• Investing in foreign markets: ETFs allow investors to invest in foreign markets. However, most of them are eligible for PEA, PEA-PME and life insurance (which normally only cover European markets), so it is possible to position oneself on foreign indices while benefiting from the tax advantages linked to these envelopes by bypassing the restrictions linked to the choice of securities.

Disadvantages of ETF :

However, ETFs have some disadvantages, including the following:

• Trading costs: If you frequently invest small amounts, there may be cheaper alternatives by investing directly with a fund company in a no-load fund.

• No outperformance: An ETF's composition replicates that of an index, so it is unlikely to outperform that index.

• Illiquidity: Some thinly traded ETFs have low liquidity.

• Tracking error: Although ETFs generally track their underlying index fairly well, technical problems can create discrepancies.

• Settlement dates: ETF sales don't settle until two days after the trade, which means that as a seller, your funds from the sale of an ETF are not technically available for reinvestment until two days later.

To conclude

ETFs offer an interesting way to invest in the stock market for people who don't have the time or simply the knowledge to invest on a daily basis by following market trends!