December 23, 2015    3 minute read

The History and Biology of ETFs

   December 23, 2015    3 minute read

The History and Biology of ETFs

Lee Davidson at Morningstar (The History of Exchange-Traded Funds) beautifully explains how exchange-traded products (a class of assets from which ETFs are part) are the result of financial innovation incited by market cycles and by the investors’ desire for greater liquidity and flexibility.

ETFs trace their roots to a more ‘ancient’ financial product – the index fund. As John C. Bogle put it in his book, The Clash of The Cultures: Investment vs. Speculations, index funds ensure that the investor receives her or his fair share of the market’s profits. He also adds that index funds are a logical investment choice if your time horizon is a long-term one. However, BlackRock took index funds further. ETFs, unlike your classic index tracker, are more frequently traded and differently priced: ETFs are priced throughout the day and can be bought and sold whenever the markets on which they float are open. As a result, there can be (sometimes) a difference between the NAV (net asset value) of the underlying securities and the price for an ETF share.

Their flexible nature makes ETFs prone to market movements (volatility) that can be caused by investors’ fear and greed, high frequency trading algorithms, changes in supply and demand across global economies and many other random or non-random factors. Moreover, ETFs can be either synthetic or physical. Traditionally, ETFs were just physically replicated: the fund manager would go and buy the underlying securities of the Index the product is tracking. However, with the magic of financial engineering, they use derivatives (such as swaps) to track the underlying index. This results in counterparty risks and costs resulted from settling swap contracts.

High-yield ETFs track junk bonds and can be either synthetically or physically replicated. These bonds are usually issued by corporations that promise a high return of return because there is a high rate of default. Consequently, when you purchase a high-yield bond, you trade are making a psychological and monetary trade-off between risk and return. The majority of junk bonds come from troubled companies or industries that are in need of capital. For example, energy enterprises (such as oil or coal producers and traders) are in big trouble nowadays. Similarly, debt from emerging markets, as an economic region, is regarded as junk due to the political, economic and social instabilities across these economies. Therefore, ETFs that track energy and metals/mining sectors and emerging markets, according to Goldman Sachs, they are prone to be subject to big cash outflows as investors want to withdraw their money amid the possibility of domino-effect default.

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