Exchange-traded funds are part of the UCITS investment funds that are publicly traded and regulated across the world. They are able to track the performance of an index, for example, the FTSE UK 100 stock market index, showing whether its value moves up or down. An ETF reflects only a fraction of the value of an index; it can be worth one thousandth of the index’s value. There are various types of exchange traded funds, which are explained below.
A passive ETF works by replicating the characteristics of an underlying stock market index for an investor to buy and hold the position in the long-term, in order to track its movements. Index investing does not seek to beat the market and it has lower management fees, therefore it is cheaper than trading active ETFs. This passive style of investment is the most commonly used.
An active ETF offers a certain degree of freedom to the portfolio manager, who can move away from the composition of the underlying stock market index in order to improve its performance and reduce risks. Mutual fund investors often use day trading strategies for ETFs instead of investing in direct mutual funds, making the portfolio much easier to manage.
Among these passive and active ETFs, there also exists physical ETFs and synthetic ETFs. Within the framework of physical ETFs, portfolio managers buy each of the components of the stock market index directly in order to replicate their performance, and synthetic ETF managers use swaps and other derivative financial products to replicate the performance of the index. Therefore, if physical ETFs can offer the advantage of replicating the performance of the underlying index with great precision, they are generally accompanied by significant costs. Conversely, if synthetic ETFs have more attractive fees, their performance may turn out to be uneven, especially since certain counterparties may be lacking in comparison with financial derivatives.