What are Exchange Traded Funds (ETF)?

Pinoy Money Talk

What are Exchange Traded Funds?

Simply speaking, Exchange Traded Funds or ETFs are an open-end investment fund which tracks a basket of assets and traded on a stock exchange.

What does it mean by “open-end” investment company?

As an “open-end” investment company, an ETF can issue and redeem shares to the public anytime.

In contrast, a “closed-end” investment company has a fixed amount of shares available to the public and, once fully subscribed, new investors can only purchase shares, not from the company anymore, but from other investors.

The “open-end” characteristic of an ETF makes it more liquid and tradable, as such, can be easily converted to cash with a known market price.

What does it mean by “tracking a basket of assets”?

The “basket of assets” refers to an index or a benchmark figure used to describe the overall performance of a market.

In the Philippines, the commonly used index or basket of assets is the Philippine Stock Exchange index (PSEi), a basket of 30 PSE-traded companies that describes the general performance of the Philippine stock market and, ultimately, the Philippine economy. The latest PSEi stock composition can be found here.

By “tracking” the index, an ETF utilizes a passive trading strategy in which its ultimate goal is merely to mirror the performance of the index.

For example, let’s assume the PSEi ended the year with a 30% growth. An ETF tracking the PSEi would try to achieve a similar performance and would likely book a return close to +30%. It would not be surprising if a slight variance occurs because of tracking errors and fees, among others. Rarely would an ETF outperform the benchmark index since ETFs are usually not actively managed, that is, they are not designed to beat the performance of the index. They are merely intended to mirror or track the index performance.

What’s the difference between a stock and an ETF?

When an investor buys a stock, he or she invests in the company and expects to profit from the growth of that company.

Investors of ETFs, meanwhile, also expect to profit from similar growth of underlying companies included in the tracked index, but they are more diversified since the index is comprised of more companies.

This diversification strategy is a two-edged sword. If one company is growing profitably, direct investors would profit hugely from the investment. In the case of an ETF investment, however, even if one company grows exponentially, if other companies included in the index are underperforming, the income from the ETF will be tempered.

In cases of severe downturns, meanwhile, a direct investor of one losing company would suffer from huge stock price declines. An ETF tracking a diversified index would minimize losses because of the diversification strategy.

In terms of liquidity and tradability, stocks and ETFs are very much alike. Both instruments can be easily bought and sold in the exchange during trading hours. They can both be traded between or among investors, without the participation anymore of the ETF issuer.

Although ETFs will have its Net Asset Value per Share (NAVPS) at the end of every day, the price at which an ETF may be bought or sold may differ and, like stocks, its price depends on the expectation of the investor in the future cashflow of the basket of assets comprising the ETF.

What’s the difference between ETFs and Mutual Funds or UITFs?

1University of Santo TomasManila97%192196
2Pamantasan ng Lungsod ng MaynilaManila91%113123
3Velez CollegeCebu City87%142162
4De La Salle Health Sciences InstituteDasmarinas City82%168203
5Cebu Doctors' UniversityMandaue City77%124161

Mutual funds and unit investment trust funds (UITF) are still slightly different from each other (see Comparison of Mutual Fund vs. UITF), but they both refer to a collective scheme that pools investments from the public to be used for investment in various asset classes.

ETFs are similar in the sense that they collect investments but, instead of actively trading to beat the index as in mutual funds or UITFs, the money is invested to track the performance of an index. (It should be noted, though, that some mutual funds and UITFs are also currently designed to track the PSE index.) It can then be expected that ETFs will have similar or slightly lower returns than the tracked index. Rarely, though, will an ETF have higher returns, unless the fund is actively traded.

In terms of pricing, ETFs, mutual funds, and UITFs all have end-of-day NAV, representing the “Net Asset Value” of all underlying securities owned by the fund. Mutual funds and UITFs are required to disclose their NAVs at the end of the trading day.

In the case of ETFs, the PSE additionally requires them to disclose the iNAV every minute during any given trading day. The iNav is an approximation of the current value of the basket of securities on a per share basis. This supposedly tells investors the real-time value of their ETF investment in order for them to have an idea of the current market price of their ETF. This is the guiding price that ETF investors can use to perform a buying or selling transaction on the exchange.

What are listing requirements for ETF companies?

In the ETF rules issued by the PSE, an ETF applying to list must have a minimum paid-up capital of at least P250 million. The ETF company may offer its securities to the public upon approval of listing application, but will not be covered by the IPO listing rules of the PSE. The lock-up and track record requirements in the IPO listing rules will also not apply.

In terms of the index that the ETF endeavors to track, the PSE requires that underlying securities comprising the index must be listed and traded in a registered exchange and have sufficient liquidity. The ETF shall also disclose the liquidity criteria and methodology in the Fund Prospectus that will be available publicly.

What are the continuing listing requirements for ETF companies?

Like regular minimum public ownership rules, ETFs are required to maintain public ownership of at least 10% of its issued and outstanding shares. This means at least 10% of the issued ETF securities should be held and owned by the general public.

The ETF must also have an Investor Relations Office whose role it to manage the fund’s investor relations program and provide facilities for investors to exercise their rights. Also, the general structured and unstructured reportorial requirements shall apply to ETFs under the Disclosure Rules of the PSE in addition to the reportorial requirements under the Securities and Exchange Commission ETF Rules.

How to invest in ETFs?

At present, there is just one ETF available in the Philippines: the First Metro Exchange Traded Fund (FMETF). Buying and selling ETF is just the same as buying and selling stocks in the PSE.

For other educational articles about ETF, check out How to Invest in Philippine Exchange Traded Funds (ETF).

Pinoy Money Talk is an educational website about money, banking, investments, and personal finance which started in 2005. Its group of five writers consists of one equity research analyst, one fintech startup owner, one finance educator, and two investment professionals.