Obinna Chima

Exchange Traded Funds (ETFs) have been described as very important investment vehicles that can help investors maximise their returns considering the uninspiring performance of the stock market.

The Financial Derivatives Company Limited (FDC) in its latest bi-monthly economic report noted that the benefits of having diverse investment products like the ETF cannot be over emphasised.

It noted that while market volatility has made many investors nervous, ETFs have continued to grow.

ETFs are pooled investment vehicles with shares that can be purchased or sold on a stock exchange at a market-determined price. They offer investors access to the markets such as the Nigerian Stock Exchange (NSE), the Standard & Poor’s 500 (S&P 500), the Financial Times Stock Exchange 100 Index (FTSE), and Johannesburg Stock Exchange (JSE) while offering diversification, access to non-traditional asset classes and hedging tools.

Since the introduction of ETFs in 1993, they have gained widespread acceptance in most developed markets. Over the last 10 years, investors’ demand for ETFs (both retail and institutional) has grown markedly, which in turn has led to a greater variety offered by ETF sponsors. Now there is one for almost every type of market index or financial benchmark in existence.

As of September 2015, the ETF and exchange traded products industry managed 5,978 products, representing total assets of $2.8 trillion.

“ETFs are essential in markets with a significant low product to investor ratio such as ours. This gap is expected to be bridged over the coming years. However, our regulators and fund managers have key roles to play in ensuring the right products are introduced to the market and that product proliferation does not lead to investor abuse.

“The Central Bank of Nigeria’s (CBN) recent introduction of a flexible foreign exchange policy and the commencement of a futures forex market leads us to believe that the next wave of market driven changes will be in the capital markets.

“There are plans to introduce esoteric securities, including equity options and futures that would deepen the markets and give investors more confidence in products to meet their investment objectives. We believe that before these products are introduced, other existing products, such as ETFs and mutual funds, will gain greater investor acceptance,” it added.

Shedding more light on how ETF works, the report explained that ETF originates with a sponsor – either a company or financial institution – who determines the investment objective. The originator is also referred to as an active participant (AP). The AP creates a basket of assets (e.g. equities, bonds, commodities, alternative assets, etc.) and in exchange for those assets receives creation units in the form of ETF shares.

Once the ETFs have been listed on the various exchanges, investors can then purchase and incorporate the securities into their respective portfolios. Institutional and retail investors can access ETFs in both the primary and secondary markets.

In the primary market, investors buy these securities directly from the company issuing them, while in the secondary market, investors trade securities among themselves. Investors can buy and sell these shares just like any other shares on an exchange with easily accessible prices. The company with the security being traded does not participate in the transaction. A company publicly sells securities for the first time on the primary capital market. In many cases, this takes the form of an initial public offering (IPO).

ETFs share risks common to other pooled investments such as mutual funds. An ETF is similar to a mutual fund as it offers investors a proportionate share in a pool of stocks, bonds, and other assets and is most commonly structured as an open-ended investment. A major difference is that investors trade ETF shares on the secondary market (stock exchange) through broker-dealers, just like other stocks.

In contrast, mutual fund shares are not listed on stock exchanges. Instead, retail investors buy and sell mutual fund shares through a variety of distribution channels, including investment professionals—full-service brokers or independent financial planners.