An Exchange Traded Fund 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. 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 Mutual Funds, 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.
Differences Between ETFs and Mutual Funds:
|Trade during trading day||Trade at closing NAV price|
|Lower operating expenses||Operating expenses vary|
|No required investment minimums||Most have investment minimums|
|No sales load, that is, no extra fees on subscription to the ETF||May have sales load|
|Cash is not retained to meet redemptions||Cash is usually set aside 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.
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 Authorized 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 Exchange -Traded Funds:
- Diversification Benefits: 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: ETF providers, display their entire portfolios daily through their websites. Contrastingly, Mutual Funds, 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 mutual funds, 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 mutual funds, ETFs offer lower costs. For example, capital gains taxes are generally lower for ETFs compared to traditional mutual funds 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.
Exchange Traded Funds 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 introduction of a commodity ETF, NEWGOLD, tracking the global commodity price of gold as the underlying asset. Only 8 ETFs are currently listed on the NSE and they account for less than 0.5% of the NSE’s market capitalization. Information on the respective Exchange Traded Funds in Nigeria can be found on the Securities & Exchange Commission’s website (http://sec.gov.ng/data/) and the Fund Managers Association of Nigeria website (https://fman.com.ng/archive/).
By Fund Managers Association of Nigeria