Exchanged Traded Funds (ETFs) are one of the most recommended financial products on the market. Personal finance website absolutely can’t shut up about these, and attribute to them the virtues of diversification, passive investing, low fees, and probably the cure for blindness and leprosy. But what’s less often explained are ETF replication methods, and the different risk factors that come with them. Here’s a quick rundown for our busy single-digit millionaire readers:
What even is an ETF in the first place?
Back in 1976, Vanguard founder Jack Bogle launched the first-ever Exchange Traded Fund (ETF). The ETF was based on an idea that pissed off Wall Street fund managers to no end:
The idea behind the ETF is that fund managers – particularly the type who try to time the market, and buy low and sell high – are rubbish at their jobs. Most of them don’t generate market-beating returns, and charge high management fees.
So the ETF, rather than try and chase returns like a fund manager, simply tracks an index. You would hook up this ETF-thingy to something like, say, the S&P 500 or the DJIA, and the ETF would buy a bunch of stocks that replicates (i.e., creates a mini-version) the said index.
So if the index moved up or down, the ETF would move in tandem. If you have an index tracking the S&P 500, and the index moves up one per cent, your ETF will move up (close to) one per cent as well, and vice versa if it moves down.
As there isn’t any active management, an ETF has no fund manager babbling about magical chart patterns, and being an overpaid fortune-teller.
Because the ETF just has to keep tracking the index, even the dumbest computer algorithm can be used to do it; and this can shave expense ratios (the portion of returns paid to keep the fund running) to as low as 0.16 per cent.
Today, most financial planners advise having at least some portion of your portfolio in an ETF.
(Conversely, some finance industry players will rant and scream at you about how ETFs are evil, because that’s what you do when the machine threatens your job, damn it.)
But not all ETFs are made the same way
We’ve been kind of vague here about how the ETF duplicates a particular index; and that’s because it gets a bit complicated. Not all ETFs use the same approach, or “replication method.”
Depending on how exactly an ETF replicates an index, you do face slightly different risks. Here are three general approaches:
1. Full Replication ETFs
This is the most traditional way to run an ETF. A full replication ETF literally buys and sells all the stocks, bonds, other securities on the index etc. in sufficient proportion to mimic the index.
This is the most transparent, and easiest to understand among the replication methods. For that reason, it’s preferred by the “I only invest in what I understand” crowd.
The problem with full replication ETFs is that it’s not always cost-efficient. Having to buy hundreds or even thousands of the different securities to mimic the whole index – even the shares of the tiniest companies on the index – gets pretty expensive. We won’t get into it here, but suffice it to say all the work of shuffling around securities is not free.
There’s also a higher risk of tracking error. Factors like timing (e.g., sometimes a stick price changes just seconds before an ETF algorithm buys or sells it), or the make-up of an index changing drastically before the ETF can rebalance to match it, can cause discrepancies between the ETF’s return, and the returns of the underlying index.
That’s why earlier, we said that if an index is up one per cent, the ETF pegged to it is up close to one per cent.
2. Sampling, or partial replication ETF
At some point, some finance experts looked at all the junk an ETF must buy to mimic an index, and decided it was what they in high finance technically call “damn stupid.”
So along comes the notion of sampling, or a partial replication. This means that, instead of buying literally everything to mimic the index, an ETF can just buy some of the most major assets. For example: instead of buying everything to mimic the Straits Times Index, an ETF could consist of just the top 30 biggest companies by market capitalisation.
The argument here is that any major changes in the index are probably coming from the big players anyway. So the ETF may as well spend less money buying and selling all the tiny bits of a market, and just track the companies that can truly make a difference.
This has its own pros and cons. On the one hand, it can mean lower expenses, and hence more of the return going to your pocket. On the other hand, it also means the ETF may miss out on some market movements.
For example, you may have a small-cap led bull run: a moment when all the small businesses are doing very well, but the larger ones are stagnant. In this instance, your ETF may not reflect the pick-up in the overall index, as its busy following just the biggest companies.
There’s also the issue of diversification. If you pick an index such as the Straits Times Index, for example, most of the major companies are going to be banks. This means that your Straits Times ETF is not as diversified as you may imagine, and is more deeply tied to Singapore’s banking industry.
3. Synthetic ETF
Inevitably, we reach the point where some finance industry players say “why do I even have to buy things in the index at all?”
To over-simplify a little:
The person running a synthetic ETF is off doing something else altogether (usually involving derivatives like swaps), and doesn’t buy any of the underlying assets in an index. All this person does is pay you what the ETF would have paid out*.
Hence the term “synthetic,” as there’s no real buying and selling of the assets in the underlying index.
Synthetic ETFs have the least tracking error, since they don’t need to bother with all the messy buying and selling of the actual assets. The downside to all this is counterparty risk.
As in, that person who promises to pay you what the index delivers? You’re trusting them to do it.
If they suddenly ghost you and start hiding in a hovel in Brazil, that’s just too bad; because your ETF doesn’t have any of the actual assets underlying the index, remember?
Of course, there are all sorts of regulations to prevent this from happening; but if you’re not the trusting type, you may well insist on a “real” or full replication ETF instead.
*Not directly, usually the money comes from a bank. We aren’t explaining that in this article, because we don’t want to be responsible for the many readers who would drop dead from boredom. But follow us if you’re really interested, and we may cover it in future.
Which ETFs should you buy?
This is a question we can totally answer, if we wanted to get fined up the wazoo by the Monetary Authority of Singapore.
Seriously, there’s no single answer that will apply to everyone, due to different risk profiles, financial targets, and different life situations. You need to get a qualified expert to work out what’s okay for your specific scenario.
What we’ve given you here is just an explanation that doesn’t involve 270+ pages of Wall Speak gibberish. For more help or questions, you can follow us on Single Digit Millionaire, or email us.
