• Understanding Exchange Traded Funds

Goddy Egene writes on the Exchange Traded Funds and their benefits to investors
An Exchange Traded Fund (ETF) is a marketable security that passively tracks an underlying basket of assets such as stocks, currencies or bonds. Holders of ETFs are allocated units also called shares and are entitled to a proportion of the profits such as earned interest or dividend paid on the underlying assets. Assets tracked by ETFs are usually represented in an index which form the basis upon which the ETFS can be created. At its core, ETFs have many features similar to Mutual Funds (MFs). For example, an investor seeking exposure to banking stocks may buy units of an ETF tracking these stocks and each unit purchased represents the investor’s proportional interest in the pooled assets. Also, ETFs are generally managed by a fund manager for a fee as with mutual funds.

However, unlike MFs, ETFs provide more flexibility and liquidity as they do not have a minimum purchase limit and can be sold directly in the market, provided there is a willing buyer. Also, ETFs provide investors with the opportunity to build standard portfolios with management fees significantly lower than those typical of actively managed Mutual Funds.

Furthermore, the high level of transparency on both holdings and the investment strategy enable investors effortlessly evaluate an ETF’s potential returns and risks. On the contrary, Mutual Funds may offer more liquidity to investors during a period of market illiquidity, since the fund manager normally sets aside a certain percentage of the mutual fund as cash, to meet likely redemptions.
Difference between ETFs and MFs

ETFs are traded during trading day, while MFs trade at closing Net asset value (NAV). ETFs have lower operating expenses, while operating expenses of MFs vary. ETFs have no required investment minimum, while most MFs have investment minimums. ETFs are more tax efficient, while MFs are less tax efficient. Also, ETFs have no sales load, that is no extra fees on subscription, while MFs have sales load. ETFS do not retain cash to meet redemptions but MFs usually set aside cash to meet redemptions.
How ETFs Work

Funds from different individuals/corporates are pooled and invested to track an index. This may be a stock index, commodities, and fixed income assets among others. Units of an ETF are available to the investing public and may be bought and sold through brokers or by approaching the fund manager. ETFs are traded like common stock on an exchange and the price of an ETF fluctuates as it is bought and sold through brokers or by approaching the fund manager.

Furthermore, ETFs are traded like common stock on an Exchange and the price of an ETF fluctuates as it is bought and sold. An ETF’s market price is the price at which units in the ETF can be bought or sold while the net asset value (NAV) represents the value of each unit’s portion of the Fund’s underlying assets and cash at the end of the trading day. The NAV is determined by adding up the value of all assets in the fund, including cash, subtracting any liabilities and then dividing that value by the number of outstanding units.
There may be differences between the market closing price for the ETF and the NAV.

However, any deviation should be relatively minor due to the redemption mechanism used by ETFs which keeps an ETF’s market value and NAV value reasonably close. This redemption mechanism keeps the market price of an ETF and NAV in line as market value naturally changes during the trading day. If the market value gets too high compared to the NAV, a pre-appointed Authorised Participant (AP) steps in to buy the ETF’s underlying constituent components while simultaneously selling units of the ETF. Alternatively, the AP can buy the ETF shares and sell the underlying components if the ETF market value gets too far below the NAV. Also, another use of the NAV is to compare the performance of other ETF funds, as well as for accounting purposes.

Benefits of ETFs
Diversification: One of the benefits of the ETF is diversification. Prior to the growth of ETFs, it was expensive for retail investors to hold assets such as gold, emerging market bonds or alternative assets but ETFs have made most areas of the capital markets accessible for any investor with a brokerage account.

Transparency: Another benefit is that transparency as ETF providers display their entire portfolios daily through their websites. Contrastingly, MFs, by law in Nigeria, are only required to report their portfolios quarterly. Hence, ETFs offer greater transparency.

Liquidity: Since ETFs are exchange-traded they can easily be bought and sold in the secondary market throughout the trading day as opposed to MFs, where a Fund manager provides liquidity for redemptions in exchange for units from the investor, based on the day’s closing price.

Lower average costs: When compared with MFs, ETFs offer lower costs. For example, capital gains taxes are generally lower for ETFs compared to traditional MFs due to the structure of each trade within the ETF.

Immediate Dividends: Dividends paid on most open-ended ETFs are immediately reinvested back into the Fund while the time frame for reinvestment for traditional funds may vary.

ETFs in Nigeria
The pace of development of ETFs in the Nigerian market has been somewhat slow. ETFs were first introduced on the Nigerian Stock Exchange in 2012 with the launch of a commodity ETF, NewGold, tracking the global commodity price of gold as the underlying asset. Only eight ETFs are currently listed on the NSE and they account for less than 0.5 per cent of the NSE’s market capitalisation.
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