ETFs (Exchange Traded Funds. An Exchange-Traded Fund (ETF) is an investment vehicle that pools investors’ money and uses it to acquire a portfolio of underlying assets.
These assets may include equities, government securities, corporate bonds, commodities or other financial instruments.
The defining feature of an ETF is that the fund itself is listed and traded on a stock exchange.
An investor therefore does not have to purchase every underlying security individually. Instead, the investor purchases units of the ETF and, through those units, obtains economic exposure to the portfolio held by the fund.
ETF: Its unique features
In simple terms, an ETF allows an investor to buy a basket of investments through a single listed security.
For example, suppose an ETF is designed to track a banking index consisting of 10 listed banks.
Rather than an investor separately buying shares in all 10 banks, the investor can buy units of the ETF. The ETF holds the underlying bank shares in accordance with its investment mandate.
The investor therefore owns units in the fund, rather than directly owning each of the individual bank shares.
When an investor places an order to buy an ETF on the exchange, the transaction is similar to buying an ordinary listed share.
The value of those units change according to the performance of the ETF’s underlying portfolio and market demand.
You are not directly buying the underlying securities from the ETF when you purchase a unit on the exchange. You are buying an existing ETF unit from another market participant. This is where the ETF structure becomes more interesting.
ETF units can be created or redeemed through specialised participants, commonly referred to as Authorised Participants (APs).
When demand for the ETF increases, an Authorised Participant can provide the required basket of underlying securities to the fund in exchange for newly created ETF units.
The reverse can also happen. When ETF units are redeemed, the fund can return the underlying basket of securities to the Authorised Participant.
This creation-and-redemption mechanism helps the ETF maintain a close relationship between its market price and the value of the assets it owns.
An Example:
Assume a banking ETF holds:
- KCB
- Equity Group
- Co-operative Bank
- NCBA
- Absa
- DTB
- I&M
- Stanbic
- HF Group
Instead of purchasing each bank individually, an investor could purchase units of the banking ETF. If the banking sector performs strongly, the value of the ETF would generally increase. If the banking sector performs poorly, the ETF would generally decline.
The investor therefore obtains diversified exposure to the banking sector through one listed instrument.
This is particularly useful when the investor wants exposure to a sector but does not want to make a separate investment decision on every company within that sector.
Where Does the Investor Make Money?
An ETF investor can potentially earn returns through two main channels.
Capital appreciation:
If the market value of the ETF rises above the investor’s purchase price, the investor can realise a capital gain by selling the units.
Income distributions:
If the underlying portfolio generates dividends or interest, the ETF may distribute part of that income to investors, depending on the fund’s structure and mandate.
Therefore, an ETF can provide both capital-growth exposure and income exposure, although this depends entirely on the assets held by the particular ETF.
The Major Advantage: Diversification
The biggest conceptual advantage of an ETF is not simply that it is easy to trade. It is diversification.
Suppose an investor has KSh 100,000. Buying one individual bank exposes the investor primarily to the performance of that bank. Putting the KSh 100,000 into a banking ETF spreads that exposure across the securities included in the ETF. One company can therefore underperform without necessarily destroying the entire investment.
The investor has effectively shifted from asking: “Which bank should I buy?” to asking: “Do I want exposure to the banking sector? That is a significant difference in investment decision-making.
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