The Role of an Exchange Traded Fund (Etf)

An index tracker, index fund or exchange traded fund (ETF) is a type of collective investment in transferable securities, replicating an index, and is market traded. An index tracker is designed to replicate the performance of an equity index, bond index or an index of raw materials.

Most trackers reproduce a general index of the stock market or a sector index, for example, pharmaceutical companies, regardless of the exchange on which they are listed.

The basic concept originated from the American Stock Exchange (AMEX) where most ETFs in the U.S were listed about two years ago. The market changed significantly over the past few years when passive providers such as Barclays Global Investors iShares introduced their first offering.

Today it is the largest provider of iShares in the world with approximately US$435 billion. The total market for ETFs is globally estimated at around US$862 billion.

The main argument for the purchase of the ETF for investors are the relatively low fees. Simulating a passive index fund costs a company much less than an active fund management. In this way the ongoing management fees are usually much lower, through the acquisition on the stock exchange, although direct and indirect costs are incurred.

The costs include order commission, brokerage fees and bid-ask spreads, even though these are usually modest in comparison with the initial charges of classic mutual funds, which may consitute about 5% of the paid capital.

Provision distributors rarely recommend these low-cost items, because their commission paid on funds usually incoporates a sales charge. Providers of exchange traded funds argue that over a longer period index trackers cut on average slightly better than the average actively managed fund.

This is because it is not regularly reached by the market average return which would be necessary to offset the higher costs.

Unlike a traditional investment fund, the tracker does not require the use of financial analysts. Instead, it needs a passive management tool. Its proponents believe that financial analysts are not able, over a long period to beat the indices. Thus, it is useless to pay for their service, and investors should buy a fund that replicates a market index.

The active portfolio management approach aims to beat its benchmark index and thus achieve an excess return (outperformance).

The risk management include passive approaches which bear systematic risk, while active management approaches brandish unsystematic risk. Systematic risk describes the dependence of the common securities on market movements, otherwise known as market risk.

This risk, which all securities are equally exposed, can not be removed in the portfolio. And when it goes beyond market risk, it becomes unsystematic risk, and there are distinctions between risks of the residual factor in the index of listed companies. The central feature of the unsystematic risk is that it can be reduced with increasing degree of diversification in the portfolio.

Since replicate passive investments such as traditional passive index funds or ETFs with their respective benchmark indices, point towards the same diversification of the market and the same risk.

 

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