Back to Basics: What is an ETF?

Amy Thompson-Cobb, aged 10, asks Morningstar analyst Helaine Kang what an exchange traded fund is and how it works

Holly Black 27.09.2019
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Amy Thompson-Cobb: Hello. My name is Amy Thompson-Cobb, and this is Helaine Kang, and today, we are going to be talking about ETFs. What is an ETF?

Helaine Kang: ETF stands for exchange-traded fund. So, ETFs are index funds that track certain indices, or a basket of securities selected via certain criteria. And index funds are a sort of mutual fund. The underlying assets can be anything from equities, bonds or other asset classes like properties or commodities. The main advantage of ETFs is it definitely makes investors' lives easier, because you don't need to select individual bonds or stocks individually, but you buy the whole basket. So, you don't need to study the whole individual assets and then pick your own portfolio.

Thompson-Cobb: When is it good to use an ETF?

Kang: So, active portfolio managers, they actively pick stocks and they pick the time of the market, the best time to buy and sell the stocks. Their aim is to beat the market by buying the cheap undervalued stocks and sell the expensive overvalued stocks. But then, when the market is efficient - efficient meaning the market reflects the fair price of the stocks or underlying assets quickly and effectively - then there's not much room for active managers to outsmart or outperform the market. In that case, investors can better off by buying the market as a whole or a broader segment of the market instead of relying on the small stuff or a small selection of the asset class.

Thompson-Cobb: And when is it not?

Kang: So, not all indices are designed to represent the market as a whole. So, there are many indices that have small number of stocks or a small number of assets. And sometimes these indices try to follow the trend of the market or a segment or sector of the market. So, in that sense, or in that case, active managers who has the expertise in those kinds of small region or country or the sector or industry, they might perform better instead of the whole industry itself. So, that could be the case. For example, like emerging markets, for example, Russia or India, the kind of countries where local knowledge matters more than owning the whole market itself. So, that could be the case to have the active fund.

Thompson-Cobb: ETFs are usually quite cheap. Why is that important?

Kang: Well, the active funds, as I mentioned, they do the active research and then they come at a cost of hiring the whole team of analysts to do their own research and generate the investment ideas. On the other hand, ETFs because they simply follow the indices, they are pre-defined rules-based investments, they come at a significantly lower cost. And these – like fund management maintenance costs at the end of the day, it's either fund itself or investors who needs to pay. So, these differences in cost matters in terms of the fund performance. So, there are many studies that confirm average fund managers they actually underperform the market when the costs are integrated into their performance.

Thompson-Cobb: Thank you, Helaine. Goodbye.

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Holly Black

Holly Black  is Senior Editor,


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