ETFs: How this Emerging Asset Class Works

An exchange trade fund (ETF) is a special type of investment fund that can be traded on the stock exchange much like a share. Imagine you don’t want to invest in just one company, but in many different firms and sectors. That’s exactly what an ETF makes possible. It bundles together many individual securities – for example, shares of different companies or bonds from various countries – into a single “basket.” When you invest in this ETF, you acquire shares of that basket and benefit from broad risk diversification.

Most ETFs replicate a well-known underlying index, such as the IBEX 35. If the index rises, the value of the ETF also increases; if the index falls, the ETF’s value decreases accordingly. For example, the IBEX 35 index includes major companies, each with different weightings depending on company size. An ETF replicates this index by holding the same securities in the same proportions, so its performance closely tracks that of the index. As the range of indices has expanded, so too has the variety of ETFs available.

Liquidity: ETFs offer a deep pool of liquidity thanks to specialized intermediaries, known as market makers, who commit to offering buy and sell prices throughout the trading session. The spread between these prices, as well as the trading volume, must meet predefined standards supervised by the stock exchange.

The advantage is that, instead of buying stocks individually, purchasing a single ETF share allows you to participate in the performance of the Spanish stock market.

ETFs combine characteristics that make them accessible, transparent, and flexible for a wide range of investors:

• Accessibility: Bought and sold through usual financial intermediaries during stock market hours, as they are listed on the Spanish stock exchange, with specialists providing continuous buy and sell orders.
• Transparency: Composition is always known, with prices, volumes, and daily net asset values (NAVs) published in real time.
• Diversification: Buying a share of an ETF allows an investor to build a broad portfolio, spreading risk across many individual securities. One trade gives exposure to a basket of securities across an index, sector, or asset class.
• Cost efficiency: Passive management and scale often mean lower total expense ratios compared with many active mutual funds.

Like all investment funds, ETFs are collective investment schemes – diversified instruments managed professionally and subject to specific legislation and regulatory supervision in their home countries. An essential feature is that they are separate assets – investors’ money is managed entirely apart from the fund company’s own assets and is therefore well protected.

In general terms, there are two types of ETFs: passive and active.

• Passive ETFs aim to replicate as closely as possible the performance of a specific index. A passive ETF automatically buys all, or at least most, of the securities included in that index, and does so in the same weighting as the index itself. Since there is no labor-intensive selection process carried out by individuals, costs are low, and performance closely tracks that of the underlying index.
• Active ETFs are managed by one or more fund managers. They actively decide which stocks or bonds to buy or sell instead of simply following an index. The goal is to achieve a higher return than the market through skillful stock selection. Managers may, for example, bet on promising trends or avoid certain risks. Actively managed ETFs tend to be more expensive, and there is ongoing debate about whether it is possible to consistently outperform the market over the long term.

There are distributing and accumulating ETFs:

• Distributing ETFs periodically pay out to investors the income generated during the year – for example, stock dividends or bond interest. This may occur once a year, semi-annually, or quarterly. These amounts are credited directly to your account, and you can use them freely or reinvest them.
• Accumulating ETFs retain the income within the fund and automatically reinvest it. This allows you to benefit from compound interest – the value of your holdings increases because the returns earned are reinvested directly. You do not receive regular payments, but your investment can grow faster over time.

ETF shares are traded in the same way as ordinary shares. Investors can buy or sell them through exchange members, including brokerage firms, securities agencies, and credit institutions.

ETFs can invest in different asset classes:

• Equity ETFs: Invest in company shares. Equities offer growth opportunities but also involve higher volatility. If companies perform well, you benefit from rising prices and dividends; however, the value may fall if companies or the economy perform poorly.
• Fixed-income ETFs: Invest in fixed-income securities, such as government bonds (e.g., from Switzerland or the US) or corporate bonds. They are usually less volatile than equities and offer regular interest payments, though returns are typically lower.
• Money market ETFs: Invest in very short-term, secure instruments such as overnight or term deposits. Returns are usually modest, but these ETFs are very stable and suitable for short-term parking of funds.

ETFs suit both individual and institutional investors, thanks to their wide range of strategies. Their versatility allows them to adapt to long- and short-term strategies. Investors can choose based on risk tolerance, income strategies, or tactical assumptions – for example, pro-cyclical vs. counter-cyclical approaches, or region-, theme-, or sector-based investments.

ETFs can also be combined with other investments, such as stocks or active funds, to tailor a portfolio to specific objectives.

ETFs have gained significant traction among retail investors. This is partly due to lower costs compared with traditional mutual funds and the wider variety of investment options they offer.

During recent years of contractionary monetary policy and rising interest rates, fixed-income ETFs became especially popular. Investors sought options that provided both yield and liquidity. Over the last year, active ETFs have attracted attention among retail investors because their transparency and intraday tradability allow for quick decision-making.

ETFs have proven that making composition, fees, and risk metrics public facilitates easier comparison among products – increasing demand for competitive investment vehicles. Additionally, the rise of digital platforms has allowed a significant influx of capital into ETFs through fractional shares and low commissions.