Get to grips with all the lingo associated with passive investing.
In this glossary, we break down the various terms and phrases that investors interested in index funds and exchange-traded funds (ETFs) will encounter when researching what to buy.
We have split the jargon buster into a ‘nuts and bolts’ of key terms for beginner investors to get to grips with. Once digested, why not move on to the more technical lingo on how passive investing works.
For those interested in active funds and investment trusts, we have separate guide.
The nuts and bolts
The managers of actively managed funds attempt to outperform a benchmark, most commonly a comparable stock market, by researching, analysing and actively selecting what the manager believes to be the best investments to buy.
The ability to potentially provide a better return than the market is the key attraction of actively managed funds, but there are no guarantees of outperformance.
Historically, ETFs have been seen as an alternative to active management. Most ETFs passively track a basket of stocks for, in most cases, a much cheaper fee than active funds.
However, there is a growing trend, mostly in the US, for active managers to use the ETF structure.
- Fund Finder: active versus passive
- Active versus passive: a brief introduction
- Tom Bailey: active funds are useful – without being in your portfolio
An ETF issuer is the company that runs and maintains an ETF. The biggest in the world are BlackRock and Vanguard. These companies earn a fee from running the ETF, which is taken as a percentage from the fund’s assets under management.
ETF units or shares
When an investor buys into an ETF, they are buying shares of the ETF. These shares will trade a specific price, usually reflective of the value of the ETF’s underlying holdings.
As the name suggests, these are funds designed to track the up and down movements of a stock market index. Index funds are also known as tracker funds or index-tracking funds.
Index funds and ETFs are structured differently. The main difference is that ETF shares are listed on the stock market and can be bought throughout the day. Index funds offer daily dealing, but the purchase is not executed until the end of the day following the market close. For long-term investors, the difference is not important.
Net Asset Value (NAV)
This figure represents the value of the ETF’s underlying holdings, meaning the collection of shares or bonds it owns. The NAV per share of an ETF should be similar to the price of an ETF share. When price and value diverge, authorised participants (see below for definition) step in to arbitrage the difference away.
One of the core arguments for passive funds is that fund managers cannot consistently outperform a stock market index. Rather than trying to buy the best shares, passive funds aim to replicate the performance of an index.
A simple way to understand the difference between active and passive is to think of active managers as trying to uncover needles (good shares) in a haystack (the market). Passive funds, meanwhile, buy the whole haystack, knowing that the needles are in there somewhere.
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A physical ETF buys the shares of the underlying index that it is supposed to mirror. This means that if you use a Vanguard ETF to track the FTSE 100, Vanguard buys the shares held in the index in question.
Stock market index
The most famous indices attempt to gauge the direction of share prices in specific countries. For example, the FTSE 100 and FTSE All-Share follow the ups and downs of UK companies, while the S&P 500 and Dow Jones industrial Average track US firms.
However, in recent years indices have become much more diverse. There are now thousands of indices to choose from, tracking niche sectors, themes, factors or regions. Indices can be constructed and weighted in a variety of ways.
ETFs track an index, replicating its performance. Indices are usually maintained by a third party, such as S&P Global Indices, MSCI or FTSE. The ETF issuer will pay a licence fee to these index providers in order to track them. However, some fund houses create their own unique indices.
You can read guides to some of the world’s most important indices here:
Synthetic ETFs, in contrast to physical ETFs, do not own any of the shares in the index they follow. Instead of buying the shares, the index is replicated through so-called swap transactions. This means that the ETF provider enters into an agreement with a financial institution that is then obliged to deliver the index return.
When an index the ETF intends to track is not liquid or easily investable, synthetic replication tends to be preferable.
- Tom Bailey Column: this ETF risk is overstated by fund managers
- What are synthetic ETFs and are they too risky?
Delving into the more technical jargon
At the heart of how an ETF works is a special group of professional investors called “authorised participants”. These professional investors have special authorisation to create or redeem (destroy) shares in a specific ETF, hence the term “creation/redemption process”. Most authorised participants are market makers or large investment firms.
Creation and redemption
This is a core feature of how ETFs work and ensures that its price and net asset value (what the underlying investments are worth) do not diverge.
To understand how this works, imagine shares in an ETF are trading at £10.03 each. However, the fair value of each share, based on the underlying value of its holdings, is £10. That means the shares are trading at a 0.3% premium, or 3 pence per share.
This means there has been a lot of demand for the ETF in question. Therefore, more shares in the ETF need to be created. To do this, an authorised participant (AP) will go into the market and buy the basket of stocks the ETF tracks, in proportion to their weighting in the index.
The AP will then go to the ETF issuer and trade this underlying basket of shares for shares in the ETF. This means that the ETF has created new shares. The AP will then take these ETF shares and sell them on the open market.
In doing this, the AP will be able to pocket a profit of 3 pence per share. Selling the shares puts downward pressure on the ETFs share price, hopefully pushing it closer towards the net asset value per share. It may also put upwards pressure on the underlying shares in the ETF, as the whole process has seen APs purchase these shares in the market. This process will be repeated until the price and net asset value converge. Once they do, the arbitrage gap disappears.
If an ETF becomes less popular, with investors selling, the opposite process takes place. Investors selling shares in the ETF will potentially drive the price per share below net asset value. In response, APs will buy the ETF’s shares trading at a discount. The AP will then take these shares to the ETF issuer and “redeem” them. This means that the shares are cancelled and taken out of circulation. In return, the AP receives the basket of underlying stocks, at net asset value per share. These shares can then be sold.
Equal weighted indices
As the name suggests, shares included in this index are each given an equal weighting. For instance, if an index has 100 members, in an equal weighted index each company would always account for 1% of the index.
The key benefit is that it doesn’t have a bias to past winners in the way market cap indices (see below for definition) are said to. Instead, each stock is given the same weighting, regardless of past performance. This means equal exposure to potentially undervalued stocks in the same proportion of anything that’s overvalued.
But there are potential downsides. ETFs using a market cap-weighted index do not need to buy or sell shares very often to keep mirroring the index. A change in price and market cap automatically results in a change in composition with no buying or selling involved.
In contrast, equal weighted indices have to regularly buy or sell to keep to the target weighting as the price of these stocks fluctuate. This creates extra costs for the investor.
- Two alternative ways investors can track the market
- Why an equal weight ETF isn’t just a short-term play
Exchange-Traded Commodities (ETCs)
Exchange-traded commodities (ETCs), the structure used for single commodities, such as oil, are similar to ETFs and often referred to colloquially as ETFs. Like ETFs, they are listed on a stock exchange and traded throughout the day like shares. However, the two are technically different structures.
The reason why the ETF structure is not used for single commodities is because under European regulations ETFs are required to provide a minimum level of diversification. In practice, this means they cannot hold just one type of commodity.
Over the past few decades, academics have discovered that certain characteristics tended to, on average, provide higher returns. The most influential work published was the so-called Three Factor Model by academics Eugene Fama and Kenneth French in the early 1990s.
All this has given rise to “factor investing,” part of so-called smart beta strategies. A “factor” is a characteristic that certain stocks have, causing their prices to move together. Some of those factors have been shown to provide higher-than-average performance over certain periods of time.
There are few widely accepted factors:
• Low volatility
• Dividend yield
All these factors, and many more, can now be tracked by investors through so-called smart beta ETFs. These ETFs will follow an index that screens for these factors, with the aim of outperforming the stock market.
Leveraged ETFs give the investor multiple times the return of the index. One example is the WisdomTree Silver 2x Daily Leveraged ETC. This leveraged ETF aims to provide a return that is double the daily price movement of silver. This means that if the silver index goes up 5% one day, the fund should go up 10%. Conversely, if the index drops 5%, it drops 10%.
As well as commodities, such as gold and oil, leveraged ETFs are often used to provide exposure to major indices. They can also be used to gain “inverse” exposure, meaning the investor is “short”, with their returns based on the opposite of what the index providers. All these products are highly risky.
Most fund houses providing them warn that investors should not hold them for more than one day due to the rebalancing risks.
Market capitalisation (or market cap) weighted
To understand how a market-cap-weighted index works, it is necessary to understand what market cap is. The market cap of a company is the total number of shares in existence multiplied by the price of those shares. So, if a company had 10 publicly traded shares and the shares were trading for £100 each, the company would be said to have a market cap of £1,000.
Therefore, with a market-cap-weighted index the proportion that each company represents in the index is the result of the size of its market cap. If a company’s share price goes up more than other members of the index, it will represent a higher percentage of the index.
Replication: full or partial
Full replication is when an index fund matches all the investments in the index. For example, by buying shares in all 100 companies in the FTSE 100. Whereas partial replication is when an index fund holds a representative sample of an index’s shares. The reason for two methods is efficiency. Holding shares in all FTSE 100 companies is much easier to do than maintaining over 1,700 companies for an index fund that is tracking the MSCI World Index.
ETFs will almost never provide the exact same return as the index they are tracking, mainly due to the fund charge that’s levied. As a result, investors in an ETF will receive a slightly lower return than the underlying index. This is known as the ‘tracking difference’. The smaller the tracking difference, the better.
Tracking error looks at the consistency and volatility of the difference between the performance of the ETF and the index over time.
To calculate this, tracking error looks at the standard deviation of daily returns of a portfolio compared to that of the underlying index. Basically, how often and how wide the performance of the portfolio deviates from that of the index.
A small tracking error indicates that the ETF will tend to follow its benchmark very closely throughout, whereas a large tracking error indicates the opposite.
These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.
Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.