Who Trades ETFs?

Investment funds use ETFs because they provide a portfolio foundation that matches market return and provides convenient global market exposure.

Who Trades ETFs?

1) Investment funds
Investment funds use ETFs because they provide a portfolio foundation that matches market return and provides convenient global market exposure. Investment funds are the largest users of ETFs. In 2009 the Chinese Sovereign Wealth fund had 2.4 billion dollars invested in US ETF funds.

2) Retail investors
Smart retail investors are discovering ETFs as a method of matching market performance without the need for frequent supervision. It is also an effective way to collect dividends. Many use ETFs in Self Managed  Superannuation funds.

3) Traders
Traders use the ETFs as a method to improve portfolio returns. They actively buy and sell the ETFs to generate better returns than those available in their home market. They also actively trade international market behaviour using the ETF.

The ETF offers investors a diversified way to play economic sectors, global financial trends, market events and other so-called "special situations."

Exchange Traded Funds (ETFs) are a derivative instrument that trades just like an ordinary share.  They are listed along with ordinary shares on the Australian Securities Exchange. The objective of an ETF is to track and duplicate the performance of a selected index as closely as possible.

An investment fund uses a fund manger to select individual stocks they believe will outperform the market. The result depends on the skill of the fund manager.

The ETF uses a variety of strategies to buy and sell the underlying shares in the index so the value of the ETF is always very close to the value of index. The objective is to match index performance.

The ETF is issued by a third party such as the iShares group. In Australia, Citigroup and Susquehanna have been appointed as Market Makers in the iShares listed on ASX.

The Market Makers are required to make two-sided markets in the iShares within the maximum spread and the minimum quantity specified by the exchange. Additionally, a list of the stocks held in each ETF is published daily on the iShares website.

ETFs cover market indexes, combinations of regional indexes  and  sector indexes. Specialist ETFs cover selected segments of the market, such as the luxury ETF that includes brands such as Louis Vitton and DKNY. Others are reverse ETFs that ‘short’ the market and benefit in a  falling market.

ETFs are bought and sold just like ordinary shares through your broker. Unlike a unit trust, there are no entry and exit fees and the ETF is actively traded during trading hours.

What to look for in an ETF

1) Market coverage
Make sure the ETF covers the market area you want to invest in. Perhaps it is the top 200 stocks in Australia, the S&P 500 in America, or a combination of Korean, Singapore Taiwan and Hong Kong market indexes. 

As more specialist ETFs become available it is easier to trade specific markets or market sectors such as oil or gold. The components of the ETF are listed on the ETF issuers web sites. Find the one that suits your preferred strategy.

2) Tracking
Assess the tracking error in the ETF. A good ETF will very closely follow the behaviour of the underlying index. Some ETFs show some significant  short term deviation from the behaviour or value of the underlying index.

This offers trading opportunities for traders. If you are an investor then look at past ETF history and decide if the tracking error is acceptable.

3) Liquidity
Many people worry about the liquidity in the ETF. The order lines are often very small and turnover also looks small. This is not a problem because the ETF issuer is required to provide liquidity when investors’ want to buy or sell.

The ETF issuers MUST display buy and sell prices within a defined trading range determined by ASX regulations. The ETF issuer will always be available to fill your buy or sell order.

Special ETF risks

1) Beta only
The ETF will only match the performance of the underlying index. If the index increased 10%, then the ETF will increase 10%. If the index falls 10%, then the ETF will fall 10%. The ETF does not offer any leverage. The volatility of the ETF is the same as the volatility of the market.

2) Currency risk
Some ETFs are priced in US dollars,  or another currency. This adds currency risk to the ETF performance because you are buying or selling in Australian dollars at the current exchange rate.  

3) Out of market hours risk
The ETF is traded on the Australian market. If it is an Australian ETF then there is a very close relationship between the performance of the Australian index and the ETF price. If it is an S&P 500 ETF then the market trades only when the Australian market is closed.

The opening price of the S&P 500 ETF in Australia will be the same as the closing price of the S&P in the US.  However, the trading behaviour of the S&P 500 ETF in Australia will reflect the expectations of traders about the performance of the S&P 500 when the US market opens in the evening, Australian time.  The tracking error in the S&P 500 ETF can increase.

Broadly the Australian listed S&P 500 ETF will track the performance of the S&P 500, but the intraday detail may be different. This is the out of market hours risk and it is most significant at the time you buy or sell.

4) Liquidity
Many people worry about the liquidity in the ETF. The order lines are often very small and turnover also looks small. This is not a problem because the ETF issuer is required to provide liquidity when investors want to buy or sell.

The ETF issuers MUST display buy and sell prices within a defined trading range determined by ASX regulations. The ETF issuer will always be available to fill your buy or sell order.

Daryl Guppy, well-known international financial technical analysis expert.  He is an equity and derivatives trader and author of books including Share Trading, Trend Trading and The 36 Strategies of The Chinese For Financial Traders. His weekly analysis newsletters are followed in Asia and Australia.

Information provided is in the nature of general comment only and neither purports nor intends to be, specific trading advice.