What is an ETF and how it differs from an index fund

ETFs have positioned themselves as an alternative to traditional investing. An ETF stands for Exchange Trade Fund, which has been translated into Spanish as an exchange-traded fund. This product mixes two different worlds: that of investment funds and that of shares. In a very short way, it could be defined as an investment fund that is bought and sold as a share instead of being subscribed and repaid with shares as a fund to be used.

What is an ETF

Therefore, exchange-traded funds or ETFs remain investment funds, because they have within them a basket of financial assets and listed securities. But to hire them you have to do the same as with the shares of Telefónica, Repsol or Danone. That is, launch a buy order through a broker.

The main consequence is that a publicly traded fund can be bought and sold at any time, which is not the case with other funds. With an investment fund the market value is determined at the end of the day, while with an ETF it is calculated in real time, based on the buy and sell orders that are crossed.

In the beginning, there were almost only ETFs of one type, passively managed ETFs. That is, those that aimed to replicate the movements of an index, which could be fixed income, stocks, currencies, commodities … What was sought was to have exposure to the companies that make up the S&P 500, the Nasdaq or the Eurostoxx, but with very low costs and with greater flexibility of buying and selling.

However, with the passage of time and with its popularity, the offer and variety have grown considerably. First, ETFs were born that also tracked sector indices, such as technology ETFs, banks, telecommunications, etc. or geographies.

But new modalities have also emerged, such as ETFs that have allowed you to invest lower in these indices, known as inverse ETFs, or in a leveraged way (doubling the downward or upward movements of the index). For example, you can hire a reverse ETF that goes up than the one that goes down the S&P 500 or there is a leveraged ETF that if the index goes up 1% its value makes three times, 3%.

Passively managed ETFs vs actively managed ETFs

Finally, the next evolution has been ETFs that are no longer passive investments. Or at least, not on large indices, but on what we could call actively selected ETFs or actively managed ETFs. What do they consist of?

Active selection ETFs replicate an index, but are created from scratch with specific criteria. For example, they have a certain level of debt, liquidity, profits, valuation… And these indices are sometimes created by the managers themselves who launch the ETFs. In reality, it is still an indexed management, because an index is replicated that is created expressly following the active and fundamental selection criteria of the management and analysis team and that is modified only at the end of each quarter. Here are the ETFs that are launching houses like Fidelity or Franklin Templeton.

On the other hand, there are pure actively managed ETFs, which look even more like a traditional investment fund in the essence of their portfolio, since there is a management team that can change the portfolio at any time, but that can also be contracted on the stock exchange as a stock. The most famous here would be ARK Innovation, by popular American manager Cathie Wood, which invests in innovative technology companies. The difference with a traditional actively managed fund? Again, the flexibility to buy and sell it and the costs.

The management fee of ETFs is usually lower than that of a regular fund, but with the variety of ETFs the diversity of fees has also increased. An active ETF typically has lower fees than a traditional actively managed fund, but higher than a passive ETF and even higher than a traditional passively managed investment fund, known as index funds.

What differentiates passive management from active management is the role of the manager. In the second, this manager is more dynamic and applies active investment strategies, moving money to try to make a profit. This results in higher operating costs (the fund has to pay fees per trade) and a larger management team that analyzes the market and looks for opportunities.

Conversely, in a passively managed fund, the management team will simply mimic the composition of an index to track its behavior or, failing that, create a new index for a given sector or asset (TECHNOLOGY company ETFs, gold ETFs, S&P500 index fund..).). The result is that much fewer operations will be carried out and the figure of the manager will be almost testimonial. That’s why their management fees will be lower. In addition, it also involves a different investment approach and strategy. One of the newest and easiest ways to invest in passive management currently are roboadvisors, in Finect we leave you our section where you can find the best evaluated and you can compare.

Differences between passive ETFs and index funds

Exchange-traded funds are not the only passive management tool. Index funds are another alternative that is often confused with the former. The reality is that an ETF and a publicly traded S&P 500 fund are investing in exactly the same thing: the 500 largest companies in the United States, but they do it in different vehicles.

In both cases the goal is to replicate a certain index, but the way to do it is different and also the operational one. These are the differences.

  • An ETF works like a stock and can therefore be bought and sold during the trading session and by placing the buy and sell order at a certain price. An index fund works like a traditional investment fund, where a subscription order can be sent during the day, but which is executed at the end of the day at the price set by the manager after calculating the value of the portfolio. That is, in the ETF you can know the price at which you buy when you place the order, while in the index fund, you do not. It may seem like a minor detail to the long-term investor, but when choosing between two almost equal products, it is an important difference.
  • An ETF must be 100% invested while an index fund must hold a mandatory percentage of liquidity.
  • ETF replication is usually more accurate than that of an index fund. Its evolution is much more related to that of the index.
  • ETF management fees are usually lower, although as we have already seen it depends on the type of ETFs in particular that we are buying. If it is an actively managed ETF, it may cost us more than an index fund. In addition, there are other additional costs to take into account,such as brokerage, brokerage or deposit omissions. Even in the case of ETFs with little trading, there can be very important differences in the buy and sell ranges, which make the operation more expensive.
  • Taxation is different. In other markets, ETFs have tax advantages over funds, but not in Spain, because they do not share the taxation of investment funds, but of shares. Therefore, transfers cannot be made from one ETF to another without a tax toll, but every time it is sold with profits you have to pay capital gains taxes.
  • Monthly purchases versus monthly contributions. To invest in an index fund you can give periodic orders to contribute money to that fund with the periodicity you choose, however with an ETF it is not so easy to periodically plan purchases.

In the end, exchange-traded funds and index funds are similar but very different.

Characteristics of ETFs

What are the main features of an exchange-traded fund? In the previous sections we have already seen some of them as the fact that an ETF works as a security and not so much as a fund or that its management is passive and not active. However, there are more things to do with its operation.

  • Transparency. Being a listed asset, it is possible to know its value at any time.
  • Flexibility. An ETF can be bought at any time and the purchase will be effective based on its price at that time, there will be no waiting until the end of the session nor will there be exit windows as happens with certain funds.
  • Liquidity. An ETF can be bought and sold at any time, such as a security. They are 100% liquid.
  • Diversification. An exchange-traded fund is an already diversified instrument in itself. When investing in a basket of stocks there will always be some degree of diversification. With an ETF you can “buy” an entire index without having to invest in each of its shares.
  • Commissions. The management fees of ETFs are lower than those of a traditional fund, although as with any security, you will have to add buy-sell fees if you dedicate yourself to making a very active trade with these funds.

Types of ETFs

All ETFs try to replicate indices, but that doesn’t mean there is only one type of fund traded on the stock exchange. There is actually more than one format depending on the index you are trying to imitate and the characteristics of the background itself. These are a few examples, but you can find a wide variety of ETFs from very different managers on platforms such as Scalable Capital, EVO Banco, Openbank or Renta 4, among others:

  • ETFs on classic stock indices. There are all colors, from Ibex 35 ETFs to Dow Jones ETFs. Its goal will be to behave in the same way as the benchmark.
  • Classic ETFs on bond indices. They are created on bonds or bonds, both public and private. So there can be ETFs on emerging sovereign debt, European, Asian …
  • Active Selection Index ETFs. Replicates the behavior of an index created with a specific goal or criterion. For example, in companies with the highest fundamental valuation of the S&P 500; or in companies with the best combination of debt, book value and dividend yield. These are usually created by the managers who issue that ETF or indexed companies that have agreements with that manager.
  • Monetary ETF. Its goal is to replicate short-term public debt with maximum rating and monetary assets of the interbank market.
  • Commodity ETFs. There are about oil, gas, gold, silver… It is an alternative to invest in gold.
  • Sector ETFs. They replicate indices created by analysis houses on different sectors. They can be technology, automotive and even mining sectors, to complement those of raw materials, for example. For example, ETF manager GlobalX has a wide variety of sector funds, ranging from lithium batteries to uranium companies, genomics companies, among many others.
  • Regional ETFs. These exchange-traded funds collect assets from a specific geographical area and would serve to be invested in a region or country. They do this by replicating fixed or variable income indices from these areas.
  • Global ETFs. They are those that focus on global fixed income or variable income indices such as the MSCI World Index or the AC World Index, for example.
  • Inverse ETFs. They basically bet on the downside to become short, so they make money when the index goes down.

Benefits of ETFs

The main point in favor of exchange-traded funds is that it is an inexpensive investment instrument because it charges fewer fees and has lower operating costs.

In addition, being quoted you can buy knowing the price you will pay. It will be as easy as issuing a comparison order at a specific price. Similarly, you can buy at any time, without waiting and knowing how much you will pay.

Of course, it offers greater diversification than stock market investments, but not higher than that given by other investment funds.

Finally, exchange-traded funds allow you to follow general market trends at a reduced cost and quickly adapt to any changes. And it is that with a single product you can be invested in an entire sector or region, for example.

Disadvantages of ETFs

Exchange-traded funds also have their general disadvantages and compared to investment funds. The first is that there may be additional costs when adding buy-sell and custody fees.

In addition, their taxation is less advantageous in Spain, because they must be taxed on capital gains, unlike funds, where transfers can be made.

Taxation of ETFs

When investing you should never forget the Treasury. Depending on what you invest in, you’ll pay more or less tax. In the case of the taxation of ETFs, both Spanish and foreign, in addition to not being able to make transfers without taxation, the rest of the taxation is the same as for shares. Therefore, you’ll have to pay income taxes every time you buy or sell an exchange-traded fund, regardless of what you do with that money later.

In the declaration, exchange-traded funds will be included in the savings income in personal income tax as a capital gain or loss. This means that the following percentages will be applied to the winnings obtained:

  • 19% for winnings up to 6,000 euros.
  • 21% for earnings between 6,000 and 50,000 euros.
  • 23% for earnings between 50,000 and 200,000 euros.
  • 26% more than 200,000 euros.

The only good thing about taxing ETFs on funds is that, when taxed as a share, the capital gains obtained have no withholdings at the time of sale, so we can count on all the money that has not been withheld until it is time to declare the income, where we will have to pay them.

Is it worth investing in ETFs?

ETFs are a good way to grow your savings at a limited cost and that you can combine with investments in specific funds or in the stock market, for example.

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