Exchange Traded Funds (ETF) FAQs

Exchange Traded Funds (ETFs) are a specific type of a more general category of Exchange Traded Products (ETPs), meaning something that is traded on the stock exchange. They are “funds” as they involve a collection of assets that are grouped together to trade as a normal stock. This group of stocks, or ETF, can be bought or sold as a single entity on the stock exchange. Its value is linked to an index of the composite stocks, which fluctuates according to their individual value. ETFs can be collections of stocks, bonds or derivatives, for example, often chosen according to a specific theme or sector.

ETFs (Exchange Traded Funds) are “funds” as they encompass a range of stocks. They bear some similarity to mutual funds, which are professionally managed investment funds that pool money from many investors to purchase securities. Both mutual funds and ETFs reduce risk by spreading exposure over a range of companies. However, mutual funds can only be traded at the end of the day according to the end of day price and are therefore less responsive to an investor’s decisions. ETFs are more flexible – they behave like a single stock, and so can be traded intra-day. Mutual funds are usually actively managed with higher expense ratios. In contrast ETFs are passively managed according to transparent rules, and have lower associated costs.

An index is a tool to track the performance of a group of assets. It does this using rules to establish its metric and methodology. The collection of assets indexed could include a broad range such as Standard and Poor’s 500 Index, or a smaller sub sector such as companies involved in either the 5G-related or quantum computing space. In the case of financial markets, stock and bond market indices consist of a hypothetical portfolio of securities which can be passively managed according to the rules of the index. In contrast to fund portfolio management, where fund managers pick stock and try to time their market moves, index-linked investing involves a fund manager simply creating and maintaining a fund that mirrors the securities of a particular index. You cannot invest directly in an index, so index funds are those funds that track the performance of the chosen index, for a given fee.

Though its formula and definition may vary between different companies, assets under management (AUM) is the total market value of the investments that a person or entity manages on behalf of clients. In the case of Defiance ETFs, AUM represents the current value of the funds under Defiance’s management. AUM can fluctuate daily according to the trading patterns of a particular ETF, though funds with larger AUM are often more easily traded.

An expense ratio is what ETFs charge their shareholders to cover the fund’s operating expenses. It is expressed as a percentage of the value of shares that the investor holds. In a mutual fund, costs of selling and buying securities within the fund are not included in the expense ratio, and these can add extra costs and erode returns. In contrast, the expense ratio for an ETF is the only ongoing relevant cost that the investor encounters (excluding trading or brokerage fees).

Stock, shares or equity all describe the same thing: a form of security that indicates the holder’s ownership of a portion of the issuing corporation. Companies issue or sell stock to raise funds for their businesses, allowing them for example, to expand their services or production, research new fields or reduce their debt. Stocks are subject to government regulation to ensure fairness and transparency, encouraging their central role in most investment portfolios. Investors buy stock for a number of reasons: to profit when the stock value rises, to receive the dividend payments (shares of profit) that the company distributes to shareholders, or to have the right to vote in decisions about the company.

Stock or share prices are affected by broad economic factors, the sector in which the specific company operates, government policies and natural events. Investor confidence can also influence the price. While historically stocks have outperformed most other investments in the long run1, researching and picking a stock is a timely and demanding process. Many investors prefer to diversify their portfolio by investing in a fund, a group of stocks. This reduces their exposure to any one company and can facilitate targeted investment in a specific sector with a lower down-side than if they concentrate all their resources into a single company.

Thematic investing refers to investment strategies that offer exposure to companies involved in a specific field, industry or sector. Instead of tracking the whole S&P for example, a thematic ETF might concentrate on companies involved in the quantum computing space, or the pharmaceutical industry. Even more specific, there are ETFs for various levels of development of pharma companies (IBB and IBBJ for example). Such thematic ETFs could be more risky, to the extent that they focus on a single sector rather than the wider market. However, the level of risk is linked to the breadth or depth of the sector that they target – the smaller the niche, the greater the potential volatility in that sub-sector. In contrast, broad thematic ETF offers investors great flexibility to express their social, economic or political views, their priorities or predictions in their investment portfolio.

The traditional conflict between passive and active fund management, places active management as potentially more effective, with managers able to add value in challenging or complex circumstances. In opposition, the classic paradigm has passive management as more cost efficient, and not necessarily less profitable.

Rules-based ETFs offer a middle way through this binary paradigm, aiming to bring the investor the best of both the passive and active models. Rules-based ETFs choose their constituents based on a set of criteria or factors defined by the fund manager, but are then passively managed in the sense that the manager makes no further interventions in its operation. The fund will be re-balanced once or twice a year to ensure that all constituents conform to the defined criteria. Criteria could include company size, the stock’s historical performance or volatility, or the sector in which the company operates.

Disruptive technology refers to technological innovation that significantly changes the way a sector or strata operates. This could apply to whole industries, specific businesses or consumers. Disruptive tech provokes paradigmatic change in practices or habits as a result of widespread acknowledgement of its superiority.

Historically, the invention of the car, electricity and television constituted disruptive technologies of their eras. More recently, the emergence of e-commerce, GPS, renewable energy and streaming services are considered disruptive innovations. In the future, the 5G roll-out, quantum computing, space travel and artificial intelligence signal potential paradigmatic changes in the way people live, work and pursue leisure.

The Financial Industry Regulatory Authority (FNRA) is the single largest independent regulatory organization that oversees the securities industry. It writes and enforces the rules for over 3,500 brokerage firms, 154,000 branch offices, and nearly 625,000 registered securities representatives, as of 2019.2 It also administers the qualifying exams that equip professionals to sell securities. FNRA’s stated aim is to protect investors and ensure market integrity while promoting dynamic and progressive capital markets. Its regulation ensures that investors can act with the confidence that investment product advertisements are truthful, that they have complete information about the product and that only licensed and qualified agents can sell securities.