ETF fundamentals: A quick dive into this asset class

14 May 2024

Jason Xavier, head of EMEA ETF Capital Markets at Franklin Templeton, offers a refresher on the basics of exchange-traded funds.

The ETF vehicle—the basics

Let’s quickly review the basics of  exchange-traded funds. ETFs are open-ended investment vehicles that benefit from the flexibility to trade intraday, just like stocks. This means they can be bought or sold on a regulated stock exchange or over the counter (OTC) via a broker or multilateral trading facility (exchange venue/request for quote [RFQ]) at any time.

The price or value of an ETF is directly derived from the price of the underlying stocks or bonds it invests in. Likewise, the liquidity of an ETF is derived from the liquidity of the underlying stocks or bonds it invests in. Since ETFs are open-ended investment funds, their ability to freely increase or decrease in size, based on subscriptions or redemptions, means that trading volumes—a metric many use to measure fund liquidity – is inaccurate. Trading volumes tell investors what has traded, not what can be traded.

Trading fundamentals

However, let’s stick to the fundamentals I’m keen to discuss. A fundamental principle of investing revolves around risk and return. When considering any investment, the trade-off between risk and return is a key starting factor.

Trading is the same – a continuous trade-off between (market) risk versus return (cost). Understanding and appreciating an investor’s preference for either cost or market risk makes all the difference to their resulting choice for execution. The same applies to trading ETFs. Understanding investor preferences around cost or risk for ETF execution can help make for a more informed and defined method of execution.

ETF investors

International adoption of UCITS ETFs – which stands for undertakings for collective investment in transferable securities – continues to grow. Our conversations with Latin American and Asia-based ETF investors have surged over the course of this year. The cost versus risk trade-off is especially relevant for these time-zone overlapping investors. In fact, a recent conversation with an Asia-based institutional investor got me thinking in more detail about this trade-off.

If urgency is required for an Asia-based investor, then the avoidance of market risk, meaning choosing to execute on-exchange during the last two hours of the Asian trading day (as it overlaps with Europe market hours) makes sense. Otherwise, if an investor is more cost-conscious, trading at the ETF’s net asset value (NAV) might make more sense, just how they would buy a mutual fund or trade over a period of time using an algorithmic trading strategy.

Europe has seen ETF trading evolve significantly over the last decade. Cost versus market risk preference fundamentally drives the options to trade on-exchange or OTC. Appreciating the differing options and aligning those to one’s preference for either cost or risk can help the trader or investor achieve a desired outcome. Before one even considers such elements as trading volumes or the size of an ETF’s assets under management (AUM), one should take the time to better understand the options outlined below.

Professional Paraplanner