In 1993, State Street Global Advisors launched the first ETF in the U.S. history, SPY, which tracks the S&P 500 index. As a result of its history, SPY is also one of the largest ETFs in the world.

After decades of development, ETFs have become an individual asset class. Today we will explore various aspects of ETFs, and how to use them from an asset allocation perspective.

Summary

• As early as 1989, there were attempts to launch a stock fund that participated in the S&P 500 index, but it was ruled by the Chicago Federal Court that this type of fund was classified as a futures contract and could not be traded on the stock exchange.
• Modern finance based on the market efficiency theory triggered a massive migration of market participants: from active management (trying to beat the market) to passive management (trying to replicate the market). ETFs provide individual investors with a tool for passive index funds.
• ETFs now represent the simplest investment tool for market indices, industry themes or asset classes. Since its inception, the ETF market has grown significantly and is used by all types of investors and traders around the world.
• Investors should pay attention to the expense ratio, management type, asset size and liquidity, and the underlying assets when choosing an ETF, in order to find the most suitable tool for their needs.

The Birth of ETFs

ETF stands for Exchange Traded Fund, also known as index stock fund. As the name suggests, ETFs are funds that can be traded like stocks on exchanges, but are not limited to investing in stocks.

As early as 1989, there were attempts to launch a stock fund that participated in the S&P 500 index, but it was ruled by the Chicago Federal Court that this type of fund was classified as a futures contract and could not be traded on the stock exchange.

In 1990, another attempt appeared on the Toronto Stock Exchange, which initiated a unit that tracked the TSE 35 index (the 35 largest stocks on the Toronto Stock Exchange), abbreviated as TIPs 35. Many people also consider this to be the first ETF in the true sense of the word. Later this ETF was acquired by iShares and became iShares S&P/ TSX 60 Index ETF (XIU).

In 1993, State Street Global Advisors launched the first ETF in U.S. history, SPY, which tracks the S&P 500 index. This ETF is still one of the most popular and actively traded ETFs today. Although SPY was launched in 1993, it was not until 15 years later that actively managed ETFs entered the market.

ETFs have become an important asset class with their low fees, trading flexibility and diversification features. After decades of development, they reflect the interest and demand of investors for index investing.

Index Investing and Active Management

Modern finance based on the market efficiency theory triggered a massive migration of market participants: from active management (trying to beat the market) to passive management (trying to replicate the market).

Whether it is TIPS or SPY, they both track a specific index: when academia proposed the advantages of passive investing in the early days, Wells Fargo and American National Bank launched index-type mutual funds for institutional investors as early as 1973.

Compared with mutual funds with higher fees, complex processes and lower liquidity, ETFs have provided a convenient way for mass investors since their inception, and have continued to grow and develop. The rapid development of ETFs reflects the interest and demand of investors for index investing.

The conclusion of index investing and passive investing is based on an important assumption. The most basic assumption is that markets are efficient, meaning that public information is reflected in stock prices, so investors cannot beat the market with publicly available information.

In addition, the choice and compilation of indices will also have a significant impact on this investment strategy: mainstream indices are usually weighted by market value, and the size of constituent stocks is directly reflected in their weights.

However, under the current trend of index investing and passive investing; active investment management has its advantages and necessity from multiple perspectives depending on investment objectives and management methods: such as investors who want to achieve higher than benchmark expected returns; investors who have higher demand for risk management; or indices that cannot meet diversification needs.

Four Key Factors to Consider When Choosing an ETF

Investors should analyze and judge from the following aspects when choosing an ETF:

Expense Ratio

Funds usually charge management fees, and ETF prices also reflect related fees.

This fee is called expense ratio or total expense ratio (TER), which reflects the cost of tracking an index benchmark by an ETF: usually this fee consists of commissions, transaction taxes, custody fees, management fees and miscellaneous fees.

For example, the most well-known ETF SPY has a fee rate of 0.095% per annum, the QQQ ETF that tracks the Nasdaq index has a fee rate of 0.2%, and the SQQQ ETF that is three times short on the Nasdaq index has a fee rate of 0.95%. The fund management fee of ETFs is usually lower than that of traditional funds, but since ETFs have similar liquidity to stocks, the management fee collection model on traditional funds cannot be implemented on ETFs: the expense ratio is an annualized number, but it is apportioned and deducted at the end of each day. With the effect of compounding, long-term fees will magnify the actual amount collected, and many investors will overlook such fees.

Management Type

Most ETFs aim to track or simulate an index, belonging to passive investment tools; but there are also actively managed ETFs managed by fund managers on the market: such as the ARK series of ETFs in the U.S. market.

Different types of ETFs have different analysis and focus points. For example, actively managed ETFs will focus on returns above the benchmark index; passively managed ETFs will analyze tracking errors and other available information.

Market Cap and Liquidity

A larger ETF can spread more fixed costs and have lower liquidity risk; high liquidity usually also reflects smaller tracking errors.

ETFs with too small asset size may face delisting risks: the reason may not be because of poor performance, small-scale ETFs may still be delisted when making money; most of the time it is because the scale is too small and the fund company thinks it is not cost-effective, and then chooses to delist. Futures and leveraged ETFs may also have this problem. Investors should avoid ETFs that are too small and too niche when choosing.

Underlying Assets

ETFs are roughly divided into two categories: physical asset ETFs and synthetic ETFs. Physical asset ETFs directly buy assets according to the relevant benchmark ratio, but some ETFs also only buy part of the assets; synthetic ETFs do not directly purchase the relevant benchmark assets, but use financial derivatives to replicate the performance of the underlying assets.

Understanding the underlying assets tracked by ETFs is very important. As a flexible investment tool, ETFs can be used to invest in stocks, bonds, commodities or other types (leveraged or inverse) of investments.

Different asset types have different risk and return characteristics. For example, stock ETFs usually have higher volatility and growth, while bond ETFs have lower volatility and stability. Commodity ETFs are affected by supply and demand and market sentiment, while other types (leveraged or inverse) of ETFs have higher leverage risk and tracking error. Investors should choose suitable underlying assets according to their risk preference and investment objectives.

How to Use ETFs

ETFs can buy a basket of underlying assets, achieve diversification with low cost, and should be used as part of an investment portfolio rather than all. Their use also needs to be combined with the existing portfolio composition; investors can choose suitable assets, markets and indices according to their preferences and forecasts.

The simple trading process of ETFs like stocks makes them develop rapidly, but everything has two sides. The simple trading process sometimes also makes investors trade more frequently; and index components are more limited to large-cap stocks (especially outside the U.S.), investors who want to invest in companies with growth potential may not be able to achieve ideal allocation directly from ETFs.

Back to the root cause of many problems, whether passive or active investment should be chosen: passive investment does not try to profit from short-term price fluctuations, but holds for a long time and obtains long-term returns. However, passive investment does not mean risk-free. Passive income only theoretically brings market returns to investors, but different market performances are very different. Participants will also affect market performance; simple passive investment is not enough. Investors still need to start from an asset allocation perspective;

Active investment does not mean frequent trading or necessarily aiming to beat the market (the highest-return portfolio may not necessarily be better than others. Without risk concepts, returns often cannot protect long-term interests for investors). The meaning of active investment lies more in providing a structured way and process to realize research investment ideas, predict excess returns, quantify risk management, build portfolios and provide a standardized and evolvable scientific framework.

Ideas and Suggestions

ETFs should be used as part of an investment portfolio and combined with personal investment objectives for allocation. Professional investment managers can empower investors in standardized processes, establish sound scientific investment and analytical processes.

At the same time, you can also participate in different ETF trends through structured products/derivatives, and achieve different purposes such as rising participation, income enhancement, lower protection or principal protection through different structures.