What are exchange traded funds (ETFs)?

(Update) To accompany our special report on exchanged traded funds (ETFs) here is a fuller explanation of how ETFs work. They are not as simple as they first appear.

Investors buy shares in exchange traded funds (ETFs) in the same way that they buy shares in listed companies. The difference is that ETFs track an external price of some kind – usually an index like the FTSE 100 or the price of a commodity like gold – while other listed companies try to generate their own value.

Investors buy ETFs in order to get access to the returns of a specific asset. This could be an index like the FTSE 100 or a commodity, like the price of gold. Many other asset classes are covered as well. Generally the investor does not want the ETF to behave differently to the FTSE 100 or the price of gold that they want to track. Investing in a gold mining company could produce huge returns but it is much more risky than investing in the global price of gold. Even large companies like BP face real threats. Tracking the price of oil is a less risky business.  

So ETFs are designed to avoid the problems of discounts and premiums. A premium occurs when all the shares of a company are worth more than the assets owned by that company. An investment trust that owns shares in all of the FTSE 100 companies can trade at a discount or premium. Some of these issues were covered in an recent article about Investment Trusts. But an ETF should not trade at a significant premium or discount (although it does happen).

How is this achieved?

In order to track an index an ETF can own the shares of the companies that make up that index. Or it can make a deal with a bank to pay to match those returns – for a fee paid by investors. This second form is called a ‘synthetic’ ETF and the deal with the bank is usually a swap. iShares, the largest ETF provider in the world, is best known for its real ETFs – sometimes called ‘in-specie’ which means ‘in its actual form’ – which own shares. However it recently announced that it was launching synthetic ETFs.

The same distinction between in-specie and synthetic ETF exists in the commodity space as well. Most commodity ETFs (or ETCs) do not own any commodities. Neither do they directly own any futures contracts which they are designed to track. Instead they own ‘notes’ or a promises from large institutions which promise to pay the returns on the chosen commodity.

However some commodity ETFs or ETCs actually own the underlying commodity they are trying to track. This is usually confined to precious metals because there is a storage cost. So an investor who owns a physical gold ETF actually owns a lump of gold in a vault.

Citywire Selection has picked both a physical gold ETF and a ‘synthetic’ precious metals ETF.

In all of these cases there is a risk that the value of the shares could deviate from the market price of the shares or the commodity owned by the ETF. In the case of gold there are all sorts of conspiracy theories about there not being enough gold to cover the promises of gold delivery – this may have increased the demand for physical gold ETFs. This could have caused the price of shares in physical gold to deviate from the price of shares in non-physical gold ETFs.

The reason this hasn't happened is because of the job done by market makers. They are legally obliged to offer the shares of ETFs for sale but they have a right to create and destroy (redeem) ETF shares. This is one way that they make their money. If the shares of an ETF become more expensive than the assets they represent, then a market maker can buy more of those assets and create more ETF shares and sell them at a profit. The reverse is true when ETFs shares are cheaper than the assets they represent: more discussion here. 

Counterparty risk

There are a number of issues to take into account with ETFs.

Over the last two years counterparty risk has become a major issue for investors. It stems from the widespread use of notes or swaps to replicate the returns on a commodity or an index. These promises to pay depend on the financial well-being of the institution that is making the promise. One example was when fears over the future of the US insurance giant AIG had a knock on effect on ETF Securities' products. Many of these depended on promises from AIG. About £1 billion-worth of ETFs stopped trading until the US government offered to bail out AIG. Citywire Selection holds several ETFS products and the company has now taken steps to prevent a similar event occurring.