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Many eggs, many baskets. How exchange-traded funds work

In addition to government bonds, there are many other instruments on the exchange, often more interesting ones. But it is difficult and expensive to follow and buy every security. Today we will talk about how to reduce risk and use multiple instruments at the same time.

Don’t keep your eggs in one basket

Financiers often talk about diversification. In ordinary life, the same thing is called not putting all your eggs in one basket.

Let’s say you invested in five companies. Is it safe? No: if one of the five companies goes bankrupt, you lose 20% of your capital. Securities are not insured deposits: if a company goes bankrupt, you lose all the money you invested, not just the shortfall in income.

The solution is obvious: put your money in different places. In the stock market, that means investing in stocks and bonds, in different companies and preferably in different markets and countries. The more spread out your money, the less risk there is.

But the more papers, the more work they require. You will have to constantly search the market for interesting companies worth investing in. And you also have to keep track of all the securities you have already bought: hold them or sell them. There is also a growing capital requirement: you are unlikely to be able to buy many different stocks at one time. They will be sold by the dozens and hundreds, each of which can be worth several thousand rubles. As a result, the minimum entry threshold into several markets at once will require capital of several millions.

ETFs instead of individual securities

ETFs, Exchange-Traded Funds, can help diversify your securities portfolio.

An ETF is a set of securities. When you buy a share in a fund, it’s as if you become the owner of a small part of that set.

An ETF FUND is a portfolio of other securities

Let’s imagine that there is a fund that holds two types of shares: half of them are Apple shares and the other half are IBM shares. If you buy one share of such a fund, you would be buying shares of Apple and IBM in equal proportions.

A more realistic situation: the fund has shares of 50 companies in certain proportions. Buying one share of the fund, it’s as if you are buying shares of all 50 companies in the same proportions.

Index ETFS

In the financial market, there is the concept of an index. An index is a speculative portfolio of some securities that the stock exchange or some company considers a benchmark. For example, I can make a list and put in it 100 companies whose securities I would consider important. Or 50 companies with a green logo. Or 42 companies whose names rhyme with my name. The criteria could be anything. And that would be my index.

The index value is a virtual number that is needed to estimate the change in stock prices within the index. It is calculated in a complicated way, but it is not so important by itself. What is important is how the index value changes over time.

The absolute value of the index usually does not matter, only its change over time is important.

An index is an information product; you can’t buy it on the stock exchange. Think of an index as a recipe for soup: it tells you what you need to buy in order to make it tasty. It’s the same with an index: it tells you which securities you need to buy in order to get the right portfolio. But if you want to dine out, you don’t need the recipe, you need the soup itself.

You can take an index and buy all the stocks from it yourself. It’s very complicated and expensive, but purely theoretically possible. Imagine that you need to make soup out of 500 ingredients, each of which is sold only at a wholesale warehouse and only from 10 kilograms. It’s the same here: the S&P 500 Index includes 500 companies whose shares can be worth anywhere from a few hundred to a few thousand $, and not every single one can be bought in a single instance.

Another option is to go to a cafe and order soup there. The chef has already bought all the necessary ingredients and made a huge pot of soup. You will be poured one plate from this common cauldron. It’s the same with an index fund: a special management company has already bought all of the necessary index securities and cooked them into a ready-made fund. You are sold a share in the fund, as big or as small as you want.

The share price of an index fund will repeat the dynamics of the index – just as the price of soup will repeat the dynamics of the prices of individual products. If the index rose by 10%, then the share price of the fund should rise by 10%.

You can find out which index THE ETF-FUND is based on and how the fund replicates the dynamics of the index from the fund’s documentation.

For example, the description of the FXIT index fund says that the fund is based on an index of U.S. IT stocks. This means that the shares of this fund will go up and down depending on the state of THE U.S. IT MARKET.

I recommend index ETFs because they protect against buying a cat in a poke: you clearly understand that the choice of fund securities is based on something reliable and time-tested. It’s like with chicken noodles: you understand what they’re made of and that there’s nothing to spoil them, unlike Royal Fantasy soup, which can have a hell of a lot in it. Of course, indexes are also a kind of speculative tool, and people make them. But nothing more precise and transparent has been invented yet.

What is the power of ETFs

Less hassle. Working with ETFs, you don’t have to deal with a large number of instruments, assemble and balance your own portfolio of securities, and deal with the problems of accessing markets in other countries. The fund does it all for you.

In addition to diversification, investing through the fund removes some of the routine tasks from the investor – such as reinvestment.

The bond’s yield calculated by the exchange implies reinvestment of coupons. That is, with each coupon payment, you have to buy the bonds anew with them.

Investing through a fund removes some of the routine tasks from the investor

Each purchase is an additional action for the investor. Now imagine that there are 50 securities in the fund, each has its own coupon payment dates, and you have to keep track of each one. A bond ETF does everything itself.

Cheaper. The entry threshold for ETF FUND stocks is sometimes thousands of times less than the entry threshold for individual instruments in a fund’s portfolio.

Through funds, you can also invest in portfolios of stocks and bonds of different countries. Through the funds, money market instruments and commodities become available.

Of course, all this happiness does not come for free. There is a management fee for the fund – these may be figures in the region of 0.5-1% per year and this amount does not include the commission of the stock exchange, broker or custodian. Management fee reduces the value of the fund shares, you do not have to pay it separately.

Where does the ETF share price come from?

The price per share of a fund is the result of dividing the value of everything in the fund by the number of shares issued.

Lets take yhis as an example: the value of the fund’s assets is 300$. Usually the term NAV is used – the net asset value.

If the fund itself issued 100 shares, the value of the assets per share is 300 ÷ 100 = 3$. This is the estimated price of the share or NAV per share. Knowing the estimated price, we know the fair price of the share.

The ETF FUND’S calculated share price can be found on the fund’s website and other sources, such as the websites of stock exchanges or news agencies.

The market price of the fund’s shares on the stock exchange may differ from the calculated one due to the balance of supply and demand. Theoretically it can be anything, even 1% of the settlement price, even 1000%. But the thing is that with big deviations from the price these shares will not be bought or sold. To prevent this from happening, someone on the exchange will act as a market maker.

A market maker is a bidder who does not need the stock himself, but is always ready to buy if you want to sell, and will sell if you want to buy. His job is to make sure that the fund’s stock prices stay around the settlement price and no one panics. Brokerage firms usually do the market making, but there are also specialized organizations.

In the illustration, the market maker gives the best selling price. And his bid to buy is only 20 cents worse than the best price:

A market maker is like a reseller at the car market. If he sees that someone is selling paper very cheaply, he buys it and resells it at the normal market price. If you want to buy, the market maker will give you the normal price.

FXIT and FXUS equity funds: invest in U.S. stocks

With Finex funds, you can invest in stocks in Germany, Japan, the United Kingdom, Australia, China, THE UNITED STATES and Russia.

For example, FXIT is an index stock fund of information technology companies from THE UNITED STATES. When you buy FXIT shares, it’s like buying a whole set of stocks, such as Apple, Microsoft, and Google, with one share of the fund itself now worth less than 100$. The biggest weight in FXIT’S portfolio is occupied by Apple shares. See the fund’s website for the full composition.

Another fund in the U.S. market, FXUS, consists of a broader set of stocks. FXUS includes shares of such well-known companies as Exxon-Mobile, Johnson & Johnson, Coca-Cola, and Disney.

The FXIT and FXUS funds are interesting because they make it easy to invest even with small capital in the U.S. market, one of the world’s major stock markets.

Change in the ruble price of shares FXIT and FXUS in percent, change in the dollar rate in percent

Remember

  1. To avoid losing money on stocks and bonds, don’t keep your eggs in one basket: invest in different instruments or use ETFs instead of individual securities.
  2. AN ETF FUND is a finished set of other securities.
  3. Investing through ETFs removes some of the routine tasks of managing a securities portfolio from the investor.
  4. The entry threshold for ETF FUND stocks is sometimes thousands of times less than the entry threshold for individual instruments in a fund’s portfolio.
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