Exchange Traded Funds (ETFs) Terminology Explained

Author: Jarrod Purchase

If you’re new to investing in exchange-traded funds (ETFs) and are confused by the terminology, Canstar has all you need to cut through the EFT jargon.

As a record number of investors take up online share trading for the first time, Exchange Traded Funds (ETFs) have soared in popularity. ETFs are just like a managed fund, however, you can trade them on the NZX. So if you’ve been looking for an efficient and cost-effective way to diversify your share holdings, ETFs allow you to buy lots of companies through one product instead of buying them individually.

However, it’s not always easy to cut through all the information surrounding ETFs. If you’ve just started investing in shares, the jargon can be overwhelming. Fortunately, we have it covered for you. Here are the most important things to know about investing in ETFs!

For more information on EFTs check our our story A Beginner’s Guide to Exchange-Traded Funds.

The different types of ETFs

Active ETFs: Also known as ETMFs. The fund manager actively invests the combined funds of all investors to try to beat the market. Active ETFs do not attempt to mimic an index like passive ETFs.

Broad Based ETF: A broad based ETF, sometimes called an index ETF, tracks a group of stocks that make up an index. The fund has exposure to lots of stocks from different industries. If the ETF tracks an international index, it may be called a broad market ETF.

Exchange Traded Managed Fund (ETMF): An active managed fund where the fund manager tries to beat a benchmark.

Geared ETFs: Debt, or leverage, is used to increase a fund’s exposure to the performance of the index or assets that it tracks. Make sure you understand the risk of geared ETFs, because they are highly volatile and can lead to bigger losses.

Hedged ETFs: An ETF with a fund manager who uses hedging to cancel out the impact of currency movements on the performance of the underlying index or assets.

Inverse ETFs: Looking to bet against the market? Inverse ETFs are a special type of ETF used to short the market. The fund manager uses derivative contracts. The performance of the underlying index or asset shares an inverse relationship with the ETF price. For example, if the market drops, an inverse ETF will rise.

Passive ETFs: Seek to match the performance of the benchmark they track.

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Physical ETFs: Imitate a target index by holding some or all of the assets of the index. These ETFs are generally lower risk than synthetic ETFs.

Rules-based ETFs: Also known as strategy based ETFs. The fund manager uses their own selection criteria to pick a limited number of stocks to hold in the ETF. For example, the ETF might only consider ethical businesses or stocks that pay dividends.

Sector ETFs: If you’re looking to invest exclusively in a specific sector, such as information technology or financials, sector ETFs aim to capture the performance of stocks from a particular sector.

Structured products: A form of exchange traded product that relies on contractual obligations and rights against the issuer.

Synthetic ETFs: Financial derivatives are used to simulate the performance of an asset. This is useful where it is impractical to physically hold an asset (e.g. oil). Because the fund does not invest directly in the asset, there is counterparty risk to synthetic ETFs.

Unhedged ETFs: An ETF that does not use hedging to offset foreign exchange rate volatility. The fund’s performance is impacted by currency movements.

ETF third parties

Authorised participants: Financial institutions that create and redeem units in the ETF directly from the issuer.

Custodian: A third-party institution that holds ETF assets for the benefit of unitholders.

Fund administrator: A third party that helps run the ETF. They might prepare financial reports or independently calculate Net Asset Value (NAV) (see explanation below) and distributions.

Issuer: Sometimes called the Responsible Entity, an issuer is the ETF product provider.

Market makers: The brokers, banks, or dealers that provide “bid/ask spreads”. They maintain an active market for the ETF by buying “units” from sellers, selling units to buyers and even creating more units for the fund manager.

ETF investment strategies

Active management: The fund manager actively trades stocks and tries to time the market in order to beat it.

Currency hedged: The ETF has been protected from foreign exchange rate movements. See also hedging and hedged ETFs.

Hedging: Familiar with the expression to hedge your bets? Hedging involves one asset or financial instrument being bought to offset adverse price movements in another asset or instrument. This strategy reduces investment risk but also limits your potential profits.

Leverage: A practice that many businesses and even homeowners around the country do! Borrowing to invest. Beware, however, leverage can increase your losses if things go pear-shaped.

Buying and selling an ETF

Benchmark: An index used to compare the performance of an ETF.

Bid/ask spread: Have you noticed a difference between the highest price a buyer is willing to pay to buy units in an ETF, and the lowest price offered by a seller? That right there is the bid/ask spread. You can view it on the order page within your trading account.

Distributions: NZ investors love their dividends! Distributions are the share of dividends or income earned by the fund that a unitholder is entitled to.

Distribution yield: The return that an ETF pays out each year in distributions compared to its share price. Keep an eye out for a percentage figure.

FUM: Funds Under Management. The total value of money in the fund.

Indirect Costs Ratio (ICR): An estimate of the total costs associated with the fund’s assets. This figure is expressed as a percentage of the fund’s average NAV through a year. It includes investment management fees, operating expenses of the fund, as well as performance fees where applicable.

Issue price: The NAV of the fund divided by the number of units on issue.

Management fee: This fee reflects the fund manager’s costs to manage the fund’s assets. The fee is built into the fund’s daily NAV and the ETF trading price, so make sure you weigh this up before you invest.

Management Expense Ratio (MER): An estimate of the total costs of investing in an ETF compared with the average value of its assets under management. This includes management fees and operating expenses, but excludes the bid/ask spread, broker and platform fees, plus any performance fees. Lower is generally better. However, that doesn’t guarantee the fund will perform better!

Net Asset Value (NAV): The total market value of the assets in a fund, minus the costs, liabilities and other expenses. The value, calculated daily, is measured per unit. You’ll see this listed by the ETF provider, but if you want to calculate it yourself, divide the fund’s total net assets by the number of units on issue.

Units: When you buy an ETF, you own units in the fund. The fund owns the shares or assets.

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ETF assets and instruments

Asset allocation: How the fund has split investment in different asset classes, such as cash, NZX shares, international shares, property and commodities.

Call option: This is a financial instrument that provides the option holder with the right, but not the obligation, to buy an asset at an agreed price up until a particular date.

Derivative: A highly complex contract between two or more parties in which the performance of an asset drives the value of the contract. Examples include, call options and futures contracts, where movements in the price of an asset (e.g. oil) determine the value of the contract. An increasing number of ETFs use derivatives, so read the PDS carefully!

Futures: A financial contract in which one party has an obligation to either buy or sell an asset or financial instrument for a specific price at a fixed date in the future.

Index: A group of shares that represent a market or sector of the market. The index may be market-cap weighted, where the weight of each stock is proportional with the value of each company. Alternatively, the index may be equally weighted, with each stock making up an equal part of the index. Finally, it might be price-weighted, where the influence of each stock in an index is proportional to the movement in its share price.

Trading behaviour of ETFs

Backwardation: Some ETFs trade futures contracts to mimic movements in the price of an asset. Backwardation occurs when a futures contract trades at a higher price near its expiry compared with contracts that expire in the future.

Contango: The opposite of backwardation. This occurs when the price of futures contracts expiring in the future are more than current spot price for a contract nearing its expiry. This typically occurs when the price of the asset is expected to increase over time.

Counterparty risk: The risk an institution defaults on its financial obligations under a contract. Because some ETFs use derivatives to imitate movements in the price of an index or asset, these ETFs are subject to counterparty risk.

Tracking error: In an ideal world, the price and returns of an ETF would follow perfectly the price and returns of the benchmark it tracks. However, sometimes that doesn’t happen and the divergence is referred to as a tracking error.


 

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