ETF knowledge gap: the key terms to get to grips with

An increasing focus on the cost of investing and disillusionment with the performance of active managers, plus greater choice, have boosted the popularity of exchange-traded funds (ETFs).

However, the terminology and what “ETF” stands for can cause confusion. Below, we explain how these funds work and the key terms to understand. 

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Passively managed funds

Passive funds (structured as index funds or ETFs) aim to mirror the performance of an index, such as the FTSE 100 or S&P 500. In contrast, active funds are those managed by professional investors who aim to outperform an index. However, there’s no guarantees that market-beating performance will happen.

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.

Index funds and ETFs – what’s the difference?

Both are designed to track the ups and downs of an index.

However, the structure is different. 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 isn’t important.

Active ETFs

Active ETFs allow fund managers to use an ETF structure (which allows investors to buy a fund as if they were buying a share, but without paying the 0.5% stamp duty charge) that applies for an investment trust.

For some, an active ETF sounds contradictory. However, it's important to remember that an ETF is just a wrapper, or structure. While historically this structure has been used to track an index of stocks, there’s nothing inherent to the structure that stops it being used to track a basket of shares chosen by a fund manager in the same way a manager of an open-ended fund or investment trust would.

Tracking difference

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 in percentage terms, the better.

Costs have the most significant impact, accounting for most of the deviation from the index in question. The tracking difference can also be affected by transaction and rebalancing costs.

Tracking error 

Tracking error measures the consistency of a portfolio’s tracking difference over time. To do 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.

So, 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.

As with tracking difference, the lower the percentage figure, the better.

ETF issuer

An ETF issuer is the company running and maintaining an ETF. These companies earn a fee from running the ETF, which is taken as a percentage from the fund’s assets under management.

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 prices and values diverge, authorised participants (see below for definition) step in to resolve this.

Authorised participants

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.

Physical ETF

A physical ETF buys the shares of the underlying index that it’s supposed to mirror.

Stock market ETFs generally copy exactly the shares in their benchmark index.

Bond ETFs tend to “sample” the index to replicate its performance without having to copy it exactly. Sampling is a more cost-efficient and practical method than owning thousands of bonds physically, as some will be difficult to trade cheaply, and costs would have to be passed on to investors.

Synthetic ETFs

Synthetic ETFs, in contrast to physical ETFs, don’t 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.

Leveraged ETFs

Leveraged ETFs give the investor multiple times the return of the index, typically double or triple the returns. Some of these ETFs boost returns when an index rises, while others provide “inverse” exposure, meaning the investor is “short”, with their returns based on the opposite of what the index provides.

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.

Exchange-traded commodities (ETCs)

Exchange-traded commodities (ETCs), the structure used for single commodities, such as oil, are similar to ETFs and are 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 isn’t 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.

Smart beta ETFs

These funds aim to sit in the middle of active and passive management by tracking a basket of stocks that have certain fundamentals or characteristics. The main factors tracked are value stocks, size of company, momentum, quality, low volatility, and dividend yield. Such funds aim to outperform, like an active fund. Bear in mind, however, that such outperformance isn’t guaranteed and that smart beta ETF yearly charges are higher than a traditional index fund or ETF.

Market capitalisation (or market cap) weighted

Most index funds and ETFs are market-cap weighted, ranking companies by their size and share price success. 

The market cap of a company is the total number of shares in existence multiplied by the price of the shares. If a company’s share price goes up relative to other members of the index, it will represent a higher percentage of the index.

Equally weighted index

A less common approach is an index fund or ETF tracking an equally weighted index. This means that each member of the index accounts for the same percentage. So, in an index of 100 stocks, each would receive a 1% weighting.