What is an ETF?
An ETF (Exchange Traded Fund) is an investment fund that tracks a specific tradable index and pools a diversified collection of securities . At its core, an ETF marries many of the investment features of mutual funds to the trading features of common stocks.
What are the advantages?
A single source of exposure to returns from a diversified basket of securities
Lower management fees compared to active funds, and greater tax efficiency
Great building block that suits both core portfolio allocation and tactical trading purposes
Multiple layers of liquidity from secondary market trading, market makers, and primary market creations and redemptions
Rule-based investment methodology, list of all holdings, intraday NAV, and straightforward expenses
Ability to access a broad range of investment options across geographies, asset classes, and sectors
Asset AllocationAsset allocation refers to the process of selecting a combination of investments in a portfolio among the major asset classes - which traditionally has been a basket of equity, bond, and cash equivalent assets, are recently evolved to include alternative assets such as REITs, private equity, commodities, and derivatives - and within those asset classes, looking at geographical exposures and styles.Many empirical studies have found that asset allocation has superior importance in portfolio performance versus security selection. "Determinants of Portfolio Performance (1986)", a famous study by Brinson, Hood and Beebower, found that asset allocation accounts for 94% of the variation in returns in a portfolio, with market-timing and security selection accounting for only 6%. Ibbotson and Kaplan (2000) found that asset allocation on average explains 104% of portfolio return and 40% of cross-sectional portfolio dispersion.Prof. Raghavendra Rau from the University of Cambridge has further found based on a statistical simulation approach that asset allocation is especially important in times of greater volatility in markets - e.g. during economic crisis.Depending on an investor's risk, return objectives and the time horizon, one's asset allocation will be different. An important component of asset allocation is ensuring appropriate diversification - i.e. "not putting all your eggs in one basket." Such diversification refers to diversified exposures across asset classes and within the asset class.ETFs are cost-effective building blocks that gives easy access to a certain exposure with a diversified basket of securities. As a result, ETFs are commonly used in core strategic allocations, and more oftenly as a tool for tactical allocations as well.
ETF Creation & RedemptionWhile ETFs trade on exchanges like stocks, there is a key difference. A stock has a finite number of shares, an ETF on the other hand can adjust the number of supply via the daily creation and redemption process of "continuous issuance".The creation/redemption process can sometimes be misunderstood by investors using ETFs. It is important to understand that the creation/redemption process is a function of the primary market and that this process facilitates the accessing of underlying liquidity in an ETF. Only Authorized Participants (AP) can interact directly with the fund to create or redeem shares. This is a process being utilized to increase or decease ETF shares in the background based on demand. Many investors do not need to utilize this primary market process first-hand to buy ETFs. Even if the creation or redemption is based on a client order due to thin liquidity in the secondary market, the AP is the one deciding to use the creation/redemption process. It would be beneficial if investors depart from thinking that themselves are doing the actual creation or redemption, but rather taking the view that someone will help facilitate their access into or out of an ETF via the mechanism.When an AP does a creation, the required basket shares of stocks matching the creation unit are delivered to the ETF issuer along with the required cash component, and the ETF issuer delivers ETF shares to the AP. The ETF issuer does not maintain an inventory, but "issues" new ETF shares as part of the creation process. In an opposite situation of a redemption order, AP delivers shares of ETF to the issuer, and the issuer delivers the underlying basket to the AP. Those shares delivered to the issuer are theoretically "destroyed".Source: David Abner, The ETF Handbook, Wiley 2016
What is Smart-Beta？Smart beta has gained great notoriety in the past several years. To stem any misconceptions, the phrase "smart beta" is relatively new, but the investing concept is not novel by any means. Smart beta is primarily rooted in factor investing, a methodology explored as early as 1934 through value investing by Graham & Dodd and later with William F. Sharpe’s study of risk factors on return in the 1960s.Smart beta strategies are designed using a rules-based portfolio construction process of systematically selecting, weighting, and rebalancing portfolio holdings on the basis of factors - that are driven by risk preferences or behavioural anomalies - other than merely price or market capitalization.Why one should consider Smart-Beta? Improve OutcomeSeeks to enhance risk-adjusted returns through exposures of proven factor drivers Reduce Cost Retains many benefits of traditional passive indexing, more cost-effective than active strategies Increase Transparency Rule-based process and transparent disclosures allow investors to make informed decisions Eating Right vs. Investing RightThe food analogy used by Professor John Cochrane from the University of Chicago is very effective at illustrating the risk-based framework - think of risks as nutrients, assets as foods and portfolios as meals.This widely quoted beautiful analogy of what risk factors are to assets vs. what nutrients are to food illustrates both the power of the factor framework for helping investors invest better and the danger associated with undesired or unintended exposures. Recognizing which factor exposures one has is similar to recognizing whether one had a slice of turkey breast, a cheese omelette, or an almond shake - the seemingly very different intakes are nonetheless protein consumptions, with little other nutrients like fiber, vitamin C, or complex carbohydrates. This intuition helps investors to examine portfolio allocation and diversification in a more scientific approach.