Look Under the Hood of Your ETF Investments
With over 1,700 U.S.-listed exchange traded funds to choose from, investors will inevitably find multiple options to track a single investment theme. However, no two ETFs alike, even if they provide exposure to the same market.
“All exchange-traded funds are not created equal. Before you invest in an ETF, it’s a good idea to know how ETFs can differ from each other,” according to the Financial Industry Regulatory Authority.
Specifically, FINRA breaks it down to four characteristics that help define the ETF investment vehicle, including regulatory structure, management style, investment objective and benchmark index.
For starters, most ETFs are registered with the Securities and Exchange Commission as investment companies under the Investment Company Act of 1940 and publicly trade shares are registered under the Securities Act of 1933. The 1940 act requires funds to register with the SEC, include a board of directors, limit the use of risky investment strategies, maintain a cash hoard for redemptions and provide disclosures for investors. The 1933 act ensures companies provide relevant information through a prospectus and registration statement. While some ETFs that track currencies and commodities are not registered investment companies, they are registered under the Securities Act. [What Index ETFs Can Do For You]
Looking at the management style, funds can be actively or passively managed. Many ETFs passively reflect the performance of a target market index, similar to index mutual funds. Additionally, some ETFs also take a sampling strategy whereby only take a portion, or sample, of the target index to mimic the overall benchmark performance. While various ETFs may track the same index, different fund providers may take slightly varying samples that could cause their ETF products to differ from one another. More recently, some investors have also turned to actively managed ETF strategies crafted by an active portfolio manager who buys and sells stocks on their own investment style instead of passively reflecting a benchmark index.
Fueling the rapid expansion in the ETF space, more providers are coming out with interesting and new investment objectives. For instance, a growing number of new index fund products track customized investment objectives, or so-called smart-beta strategies, that promise to provide enhanced returns or lower volatility, compared to traditional beta-index funds. Additionally, some passive ETFs try to generate multiple or reverse returns to a target index – these type of ETFs are often referred to as leveraged or inverse ETFs. [Look Before Leaping Into Smart-Beta ETFs]
Lastly, investors should know what their ETF tracks. As the ETF industry comes out with more products, the variety of benchmark indices has also increased. While some indices cover broad markets, such as a total stock market or a aggregate bond index, an index can focus on a narrow target, like smaller companies, market sectors and international corporations, among others.
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed this article.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.
