Exchange-Traded Funds And “Smart Beta”: How To Buy Entire Markets

What are ETFs?

Exchange-traded funds (ETFs) track the movements of an index, making it easy to invest in a whole host of markets – from Indonesian shares to gold. Like Amazon and Radiohead, ETFs have exploded in popularity since being launched in the 90’s – and there are now about 5,000 globally investing more than $5 trillion.

ETFs have many similarities with traditional tracker funds, which also copy the performance of an index such as the S&P 500. But their particular success is largely due to the ways they resemble stocks.

How are they like stocks? Well, as the name suggests, ETFs trade on exchanges (venues that connect people wanting to buy with those looking to sell). This means they can be bought or sold at any time during the working day – unlike most traditional funds, which can typically only change hands at the end of the day.

And, as with stocks, investors can also sell ETFs short (betting that the price will fall) or purchase options (wagers that the ETF will be trading above or below a certain price on a future date). They’re also like stocks in that some ETFs are incredibly popular with investors, changing hands thousands of times a second, while some trade much less frequently.

Types of ETF

As we said, there are over 5,000 different exchange-traded funds out there – and growing.

Why have they become so popular? As well as offering easy access to a diverse bunch of investments, ETFs generally charge lower fees than traditional funds and have no minimum investment amounts. The average ETF charges about 0.4% (so if you invested $1,000 you’d have to pay about $4 a year), compared with about 0.7% for a traditional index fund.

You can buy ETFs to track almost any financial market you can think of: from Thai stocks and the US dollar to platinum futures and German government bonds. You can even get ETFs for specific industry sectors – like tech stocks or petcare providers.

Put it this way: if stocks were pieces of music then ETFs would be Spotify playlists. Instead of selecting an individual track to listen to, you just choose a theme (like tropical house or Mellow Mondays) and get a bunch of music that fits that description.

So ETFs are purely passive? Most ETFs just aim to track the performance of a market, which allows them to keep fees low. But there are a few funky numbers out there. Inverse ETFs rise in value when the index they follow falls (and vice versa). For example, the ProShares Short S&P 500 ETF would gain 3% if the S&P 500 index of US stocks dropped 3%. Leveraged ETFs, meanwhile, multiply the moves of their underlying investments – so if the S&P 500 rises 2%, a 3x leveraged ETF would climb 6%. There are also leveraged inverse ETFs – but you can probably figure that one out yourself.

Next we’ll explore even more specialized sorts of ETF – active ones. In the meantime, why not spin some “German government bond” vibes on Apple Music?

Active ETFs and “smart beta”

For most of their history, ETFs were purely passive products – tracking a market such as the S&P 500 or gold as closely as possible for a low fee. But recently companies have launched active ETFs – where money managers make decisions on what to buy and sell, like a traditional investment fund.

But why would anyone do that? A bit of action gives the ETF the potential to beat the performance of the wider market (though many academic studies have shown that passive tracking beats the majority of active managers eventually). While more expensive than their passive cousins, active ETFs also generally offer lower fees than traditional funds.

Are there other ways to beat the market? Some ETFs sit halfway between passive trackers and active stock-pickers – these are known as “smart beta” ETFs, and have grown in popularity since first hitting the market a decade ago. Smart beta ETFs use computer-defined rules to pick investments with certain qualities (known as factors), rather than a human asset manager’s judgment.

Popular factors include value (buying stocks that are cheap); size (buying stocks that are small); and volatility (buying stocks with littler price swings). Over the long term, stocks meeting these criteria have historically risen slightly more than the market as a whole (though that’s no guarantee it'll happen in the future).

How does this work? The theory is that factors exploit investors’ human failings, which direct more money than is justified to certain stocks – like favoring glamorous companies with fast-growing profits over cheap ones, or plumping for the biggest names in a sector over smaller “hidden gems”.

Building an ETF portfolio

You can use ETFs as part of a broader investment mix – or you can construct an entire portfolio from ETFs. They make it easy to build a balanced portfolio, where any losses in one investment are hopefully mitigated by gains elsewhere.

How do I start? With more than 5,000 ETFs to choose from, you’re going to have to do some whittling down. Bear in mind that the more ETFs you buy into, the more expensive it’ll be to adjust the portfolio: every trade in every ETF will attract a broker fee – on which more in the next session...

How many ETFs will I need? ETFs’ breadth means you can build a pretty diverse portfolio with just two: one tracking global stock markets and one tracking a broad measure of bonds. This setup has the virtue of simplicity – it’s really easy to track performance over time and rebalance between the two if you feel the need.

If you want to go broader, try splitting your investment between half a dozen ETFs. Perhaps a general US stocks ETF, one for major non-US stock markets, an emerging market stocks fund, and a few bond baskets of varying risk levels. You could even add ETFs tracking commodities like gold or oil.

What else do I need to think about? Make sure the holdings of your various ETFs don’t overlap too much – or else you’re reducing your diversification. ETFs are very transparent – revealing every day exactly what they’re invested in – so you can check that out easily enough.

Above all: focus on fees. Make sure you know how much the ETF provider is charging you per year, and how much your broker will charge you to buy and sell.

How to buy an ETF

To buy your first ETF, you’ll need to open a brokerage account.

OK – how do I do that? There are lots of online services where you can buy, sell, and monitor your ETFs; some of them even still have phone lines. Just sign up! Popular US brokerages include E*TRADE, Charles Schwab and Fidelity. In the UK, you’ve got companies like Hargreaves Lansdown and Charles Stanley.

Just watch your trading fees. For example, if you have to pay $10 commission per trade to your broker but only intend to feed $100 each month into an ETF, you’ll be losing 10% of your investment immediately. In such cases you’d be better off pooling your money and making fewer, larger deposits – or skipping ETFs altogether and using a traditional tracker fund (where you don’t have to pay for each trade).

So do these brokers make the ETFs? Some do – Charles Schwab and Vanguard, for example, are both brokerages and providers of ETFs. And some even let you trade their own ETFs with no commission. Big ETF providers that don’t offer consumer-facing brokerage services include Blackrock (iShares), ProShares and State Street (SPDR).

You can also invest indirectly in ETFs by giving your money to a robo-advisor to manage on your behalf. Robos are automated investment platforms that invest your money across several ETFs, among other things, in order to meet your goals. Read our pack on robos if you want to know more!

And that’s that. You’ve completed our pack on ETFs and smart beta, and now have the knowledge you need to get involved, if you so desire.