What is an Exchange Traded Fund?

Exchange Traded Fund

An Exchange Traded Fund (ETF) is an investment fund that is listed on an exchange and traded like equities. Most ETFs are index funds that replicate an equity, bond or commodity index. ETF providers use a variety of methods to reproduce the return of the underlying reference index as closely as possible.

There are three main techniques:

ETFs with full index replication (often referred to as ‘physical’ ETFs)

ETFs using a full replication method hold positions in all the securities of the underlying reference index in proportion to their weighting in the index. This simple and transparent approach results in minimal deviation between the fund’s return and the performance of the index. Although the concept seems straightforward, the approach requires a large capital base and an efficiently organised portfolio management team, since all adjustments to the index have to be made to the fund simultaneously.

ETFs with representative sampling (a form of ‘physical’ ETFs)

Full index replication is not always possible. Some indices include securities that cannot be easily bought by all investors. Insufficient liquidity of individual equities or the adverse taxation of income may make full replication inadvisable. In such cases, representative sampling is the recommended course of action. Representative sampling creates a portfolio using a limited number of securities to replicate the characteristics of the index as closely as possible. Some providers use a mathematical optimization process to determine the allocation of these portfolios, whereas others may use a stratified sampling technique. Despite the use of representative sampling, the fund continues to hold the securities directly.

ETFs with swap-based replication (often referred to as ‘synthetic’ ETFs)

Synthetic ETFs reduce tracking error as the fund does not hold the underlying securities but instead enters into a swap agreement to gain the returns on the benchmark index. This approach is advantageous when it comes to complex country indices such as those of certain emerging markets, since synthetic replication allows less liquid indices to be replicated accurately and efficiently without investors having to forego the desired high level of transparency. In order to ensure that the index is replicated as accurately as possible, an ETF invests in a substitute basket as well as an index swap, and the return of the substitute basket is offset on a daily basis against the index return on the swap. The substitute basket is compiled with a view to minimizing costs and maximizing tax considerations, while complying with legal requirements such as UCITS III at the same time. As part of the heightened requirements in terms of transparency, the composition of the substitute basket is published daily.

Key advantages of ETFs:

Low costs

ETFs benefit from multiple cost savings. First, because index funds do not require active management, so there are no research costs, resulting in low management fees for investors. Second, the total turnover in a typical ETF is only about 3-7% of assets per year, therefore generating fewer transactions than an active fund. These low cost levels support the long-term returns of the fund.

Broad diversification

With an ETF, the investor invests in a securities portfolio that tracks an index. Depending on the index, the portfolio may be comprised of either broad or narrow sections of the overall market. With a combination of different ETFs, portfolios can be constructed which are equivalent to investing in several thousand securities. And ETF portfolios can almost completely eliminate the stock-specific risk of securities investment.

Full transparency

Index constituents are available to all investors, therefore ETF investors are always aware of all the securities in their fund. With the help of the indicative net asset value (iNAV), the fund assets can be compared with current bid and ask prices reliably.

Highly flexible

ETFs are traded throughout the day on the stock market. This allows investors to react quickly to short-term trends without being dependent on closing prices.

Ability to implement complex investment strategies

There are a variety of ways in which ETFs can be used in investment strategies, for instance as a broadly diversified core investment in a portfolio. Their extremely safe and transparent implementation method makes ETFs with direct investments excellent candidates for this kind of core investment.


ETFs are traded on the stock market like equities, during normal trading hours and at the current conditions. Bid and ask prices are constantly provided by market makers, and there are no additional issuing commissions or discounts on redemptions. Efficient pricing and low transaction costs are ensured by having at least one market maker per fund and through the arbitrage mechanism described above.

Negligible discount to NAV

ETFs are a clever combination of closed and open-end investment funds: as with closed-end funds, the fund units can be traded on an exchange. The investor does not purchase his units from the fund management company, but instead on the secondary market. A purchase and redemption mechanism prevents price divergence of the fund units from net asset value, as is often the case with closed funds. If the ETF’s price is higher than its net asset value, authorized participants can return shares or add cash to the fund and sell the newly created units in the market, which then pushes the price back to the net asset value. However, if the ETF is trading below its net asset value, arbitrage is performed in the opposite direction; the authorized participants then purchase units in the secondary market and redeem them from the fund in exchange for securities or cash, which brings the price back to net asset value. This procedure prevents the ETF from building up a premium or a discount to its net asset value. The investor can therefore always be sure of buying or selling the ETF at a price close to its fair value.


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