Understanding the Exchange-Traded Fund (ETF) Landscape
Why were ETFs created?
Before ETFs were first introduced in the 1990s, investors already had a way to access pooled securities and invest in broad markets – this began with the creation of mutual funds about 70 years earlier. However, historically, the fees charged by mutual funds were quite high, and fund information was somewhat limited or infrequent, making comparisons difficult. Applications and redemptions only take place once during a trading day, usually at the end of the day.
ETFs addressed many of these issues, allowing investors to trade flexibly throughout the trading day and generally offering transparency via daily holdings and characteristics. By the end of 2023, global ETF assets under management totaled around USD11.6 trillion.1
What needs do ETFs serve?
ETFs offer investors a cost-effective and convenient way to gain exposure to a broad set of assets, potentially adding diversification where it is desired in a portfolio. They may also be used to access specific segment(s) of a broader market, such as stock sectors or tenor-targeted bonds, thus allowing investors to adjust their portfolio tilts more dynamically or express relative value views. While ETFs have historically provided mostly indexed exposures, a growing number of active ETF offerings have ensured that they continue to serve the changing needs of a broad set of investors.
Categories of ETF
The ETF universe has expanded to cover a broad spectrum of asset classes, sectors, jurisdictions, styles, and investment themes. The most common and liquid ETFs focus on the largest asset classes:
Equity:
The equity ETF landscape encompasses an extensive range of investment strategies. Many equity ETFs are based on a broad index, such as the S&P 500, FTSE 100, and Hang Seng, or companies operating in a specific industry sector, like energy, information technology or consumer staples. Others aim to capture opportunities from businesses of a specific size (small, mid or large) or a certain factor profile (value, growth, dividend).
Fixed income:
The rapid growth of fixed income ETFs has turned what may once have been viewed as a complex asset class into an accessible portfolio diversification tool. From US Treasuries and investment-grade corporates to high-yield and emerging-market debt, there are ETFs to suit a wide variety of risk-return appetites. Furthermore, as the fixed income ETF segment has matured, it has helped to give underlying bond markets a liquidity boost in conjunction with developments in electronic trading.
Real Estate:
Real Estate Investment Trusts (REITs) offer investors access to a grouping of income-generating commercial or residential properties. REIT ETFs provide diversification as they invest in a number of REITs within a single product.
Currency:
ETFs can be based on a single currency or a selection of related currencies. They allow investors to hedge their exposure to the US dollar (or any other currency) or take advantage of fluctuating exchange rates.
Commodity:
ETFs represent a means of access to this asset class, especially for smaller investors, enabling them to take strategic or tactical positions in agricultural products, oil, and precious or industrial metals without the sizeable exposure associated with spot or futures contracts.
Indexed or Active?
ETF investors have a choice of investment styles:
Indexed (or passive) ETFs track an underlying index, including the S&P 500, the MSCI Emerging Markets Index, or the Bloomberg Global Aggregate Index. The aim is to invest in assets that mirror the composition of these indexes and match their returns while keeping management and trading costs low. Because of this, they are not suited to investors whose aim is to beat the market.
Active ETFs are managed with the objective to exceed index returns by seeking to capture opportunities to add value or exploit market inefficiencies. Active ETFs offer the potential for market-beating returns but typically feature higher costs and carry the risk of greater losses and volatility.