ETFs

An Exchange Traded Fund, or more commonly ETF, is a tool in the financial investment world that helps you choose how to invest in the stock markets and beyond. It is a kind of investment fund but it is constructed differently and has many more advantages.

The peculiarity of ETFs, as you already know, is that they adopt passive strategies. They are created by independent external companies and then issued on the market, like any other listed company. Therefore, performance, but also the risk/return ratio, are perfectly in line with that of the reference benchmark.

So, passive management of ETFs is already an advantage over investment funds that too often underperform the benchmark.

Before seeing the advantages of investing in ETFs, let me show you concretely with an example of what an ETF is. The most famous and important stock index in the world is the S&P 500. This index includes the 500 largest capitalised American companies such as Apple, Amazon, Coca-Cola, IBM, Microsoft, Netflix, Walt Disney and many other famous US companies. This index is constantly updated so that it always contains the 500 best companies. If one loses value, it is replaced with another.

Capitalization is defined as the number of shares issued by a company multiplied by the value of the share. For example, Amazon has issued 506.44 million shares which multiplied by their value ($3,425.52 at the time of writing this text) gives a capitalization of $1,734,820,348,800 (just under $2,000 billion). Obviously, while the number of outstanding shares remains unchanged (those are, regardless of who buys and sells them), the price changes from day to day and with it the capitalization of the company, i.e., in the example of Amazon.

SPY is the ticker (i.e., the identification code) of the ETF on the S&P500. What does SPY do? It simply replicates the performance of the US index. So, if the S&P500 gains 2%, SPY gains 2%; if the S&P500 loses 0.8% SPY loses 0.8%. However, although it is very rare, a tracking error can occur, i.e., a deviation between the actual performance of the ETF and the performance of the reference benchmark. This can have a number of implications, such as high costs affecting the performance of the ETF.

So basically, what is SPY? You have to see SPY as a large basket within which all 500 companies listed on the S&P500 reside. Buying a share of the SPY ETF means investing in all of the top 500 U.S. companies. The same goes for any other ETF that replicates a benchmark (SPY's benchmark is the S&P 500 index).

We must also distinguish equity ETFs, which replicate a stock index (such as the Frankfurt Dax or the Japanese Nikkei) with sectors (such as banking, real estate, pharmaceuticals, etc.) that are monetary, bond, structured. In short, you can invest and construct your portfolio however you believe is best. Moreover, you will see in more detail how you can do this later. ETFs also differ in the type of replication: physical or synthetic. I will cover this aspect with ETCs.

ETFs are generally very liquid instruments, meaning it's easy to find a buyer or seller. And that makes the risk of having to sell with no buyer’s next to nil, which could cause the price of the ETF to fall. However, sometimes you may come across ETFs that have a low average daily trade value, which means they are not very liquid and not ideal to include in your portfolio. But don't worry, there are so many ETFs listed in the various exchanges from which you can invest, you will surely find the most suitable for your investment.

Now I will list the other benefits of investing in ETFs.

1. Easy to trade. ETFs are listed on the Stock Exchange and like common shares, they can be purchased on the platform of any regulated broker (or at least in a bank), immediately and at perfectly known prices. Moreover, the minimum tradable lot is one share. So, even from the point of view of the amount to invest, it is really accessible to everyone.

These characteristics reflect the great flexibility of this instrument, which makes it suitable both for small private investors, who can access the main market indices without having to buy all the securities present in the basket and for larger institutional investors.

2. Transparency. At any time, the investor may know the market price of any ETF and its composition. All the data relating to the ETF are public and can be consulted both on the website of the Exchange where the ETF is listed and on that of the issuing company. So before investing your savings you can properly inform yourself about the ETF you intend to buy.
3. Security. What is invested in ETFs is separated from the capital of the company that issues and manages them. So, the money is still returned to the investor even if the issuing company goes bankrupt. To be fair, this is also a feature of investment funds.
4. Diversification. Diversification is the golden rule for all investors who want to reduce the risks of their investments. As you have seen, investing in SPY (or on any other ETF) does not mean investing in one stock but on a basket of stocks. One advantage of ETFs is that they allow small savers to access markets that would otherwise be difficult to access, such as bonds from Asian countries or equities from emerging countries. You can thus decide to buy several ETFs, thereby further diversifying your investment and considerably reducing your risk.
5. Low risk. By diversifying you have seen that you reduce the risks. By investing in SPY for example, even if one of the companies in the ETF were to go bankrupt, this would affect "on average" 0.2% of your investment. I write "on average" because stocks within the ETF don’t all weigh the same. For example, SPY consists of 6.56% Apple stock, 5.39% Microsoft stock, 4.38% Amazon stock, 1.90% Tesla stock, and so on (percentages are purely indicative, as the S&P 500 index tends to rebalance periodically and consequently so does SPY).
6. Low fees. ETFs, unlike normal mutual funds, do not have entry, exit and performance fees. You will pay only a small commission to purchase and sell (depending on the broker and might range from a few euros to fifteen for banking institutes). The reason for the smaller costs is found, as you have seen, in the "passive" nature of the management of ETFs that, therefore, do not need huge resources relegated to research and detailed analysis of the choice of best stocks, that is, those that need to beat and exceed the benchmark.
7. Shorter disinvestment times. Unlike investment funds, the time it takes to receive your money is much shorter. Once you sell the units of the ETF(s), the money will immediately become available in your account. If you use an online broker, you have to request the transfer to your account, which usually takes a maximum of 48 hours.

If you are wondering why your bank or financial promoter has never suggested you invest in ETFs, the answer is very simple: ETFs do not generate to banks any profit. Never forget that banks will always look out for their own interests, never yours. They have everything to gain if people do not receive proper financial education.