ETFs, or listed index funds, are financial products that allow you to invest in a basket of values representative of a stock market index, such as the CAC 40, the S&P 500 or the MSCI World. They offer several advantages to investors, such as simplicity, liquidity, diversification and low costs. But how do ETFs work and how are they valued?
## How ETFs work
An ETF is issued by a management company, which buys the securities making up the reference index, respecting their weighting. For example, to create an ETF on the CAC 40, the management company must buy the 40 shares that constitute it, in proportion to their market capitalization. The ETF is then listed on a stock exchange, like a traditional stock, and can be bought or sold at any time of the day, at the market price.
The objective of an ETF is to replicate as faithfully as possible the variations of its benchmark index, both upwards and downwards. An ETF is said to be passively managed, because it does not seek to beat its index, unlike active funds, which select securities according to specific criteria. ETFs are therefore transparent, because their composition is known in advance and does not change, except in the event of a change in the index itself.
## The evaluation of ETFs
The price of an ETF is determined by supply and demand in the market, but it also depends on the value of the securities that compose it. In effect, an ETF represents a fraction of the underlying portfolio, which itself has a value. This value is called the net asset value, or NAV (Net Asset Value). It corresponds to the sum of the market values of the securities held by the ETF, divided by the number of units of the ETF in circulation.
The net asset value of an ETF is calculated daily by the management company and published on its website. It serves as a reference to evaluate the performance of the ETF, and to compare its price with that of its index. The difference between the variation of the ETF and that of its index is called tracking error. The smaller this gap, the more faithful the ETF is to its index.
There are two types of ETFs depending on how they track their index: physical ETFs and synthetic ETFs. Physical ETFs actually hold the securities of the index, while synthetic ETFs use derivatives, such as swaps, to exchange the performance of the index for that of another basket of securities. Synthetic ETFs present counterparty risk, i.e. the risk that the issuer of the swap will not honor its commitments.
## The advantages and risks of ETFs
ETFs have many benefits for investors, including:
- Simplicity: an ETF provides access to a wide range of markets, regions, sectors or themes, in a single transaction. Simply choose the index that corresponds to your investment strategy, and check the quality of the ETF that tracks it.
- Liquidity: an ETF can be bought or sold at any time of the day, at the market price, unlike traditional funds, which are only tradable once or twice a day, at the closing price. The liquidity of an ETF depends on its trading volume, which reflects its success with investors.
- Diversification: an ETF makes it possible to reduce the specific risk linked to a single stock, by investing in a basket of diversified stocks. It also allows you to benefit from the overall performance of a market, without having to select individual stocks. The easiest way to diversify your portfolio is to use a global ETF, which tracks an index of thousands of companies from different countries.
- Low costs: an ETF has significantly lower annual management fees than active funds, because it does not need a management team or in-depth analysis of values. Management fees are generally less than 1%, compared to around 2% for active funds. Furthermore, ETFs have no entry or exit fees, you simply have to pay the brokerage fees linked to the transaction.
ETFs also present risks, which you should be aware of before investing, including:
- Market risk: an ETF follows variations in its index, which can fall or rise depending on economic, political or geopolitical conditions. The risk of losing all or part of the invested capital therefore exists, as with any stock market investment. You must therefore be aware of the volatility of the chosen index, and adapt your investment horizon accordingly.
- Currency risk: an ETF denominated in a foreign currency, such as the dollar or the pound sterling, is exposed to fluctuations in the exchange rate against the euro. Currency risk can have a positive or negative impact on the performance of the ETF, depending on whether the currency strengthens or weakens. There are currency hedged ETFs, which use futures contracts to neutralize the effects of currency changes.
- Counterparty risk: a synthetic ETF, which uses derivative instruments to replicate its index, is exposed to the risk that the issuer of these instruments does not respect its commitments, in the event of bankruptcy or payment default. This risk is limited by regulations, which require synthetic ETFs to hold collateral, that is to say a set of quality securities, the value of which must be at least equal to that of the swap.
## Conclusion
ETFs are innovative financial products that offer investors a new way to access stock markets, by tracking variations in a benchmark index. They have many advantages, such as simplicity, liquidity, diversification and low costs, but also risks, which must be known and controlled. ETFs are suitable for all investor profiles, whether beginners or experienced, and for all investment strategies, whether conservative or dynamic.
