Updated on March 30, 2023
ETFs are like that kid no one paid attention to in school, but now they’re all grown up, and everyone wants a piece! Whether your foray into the world of ETFs was preceded by a frenzy surrounding meme stocks, or you’re into the thematic options that give you a chance to make money while investing in companies that mirror your values, this article titled ‘A Comprehensive Guide to Valuing ETFs and Determining Their Profitability’ will give you all the tools you need to earn your seat at the ETF table.
Since their introduction into the investment world, Exchange Traded Funds (ETFs) have offered investors a wide range of benefits. Similar to mutual funds, ETFs offer investors a unique way to pool their money and invest in different securities and assets. With recent concerns about the possibility of an impending recession, many investors are considering adding ETFs to their investment portfolios.
What is an ETF, and how does it differ from traditional investing?
An exchange-traded fund is a type of investment security that operates like a mutual fund. With ETFs, investors pool their money together to invest in a group of securities such as stocks, bonds, commodities, etc. ETFs usually track a specific index, sector, commodity, or other assets, and investors can trade them on the stock exchange in a manner similar to regular stocks. The structure of an ETF is flexible, and brokers can design it to track anything from the price of a particular commodity to a diverse group of securities. They can even structure it to track particular investment strategies.
An ETF is referred to as an exchange-traded fund because it’s traded on the stock exchange in the same way stocks are. The ETF’s market price oscillates throughout the trading day as shares of the ETF trade on the market. One of the key attractions of ETFs is that there are multiple assets within an ETF, making it easy for investors to diversify their portfolios. ETFs can contain different types of investments, such as stocks, commodities, bonds, or even a mixture of all. An ETF can hold hundreds or even thousands of stocks across different industries or focus on one particular sector.
Types of ETFs
Different types of ETFs are available to investors for the purposes of income generation, a hedge against inflation, speculation, and diversification. Let’s briefly look at the different types of ETFs.
Passive and Active
In general, investors group ETFs as either passive or actively managed. Passive ETFs strive to recreate the current performance of a larger index, for instance, the S&P 500. Brokers may also create them to benchmark a particular sector or commodity index. On the other hand, active ETFs do not replicate any index. The fund’s portfolio managers make decisions about which securities to place in each portfolio.
Investors use these types of ETFs to generate a regular income. The income distribution with bond ETFs largely depends on the current performance and policy of underlying bonds. These include anything from government bonds, corporate bonds, and state or local bonds. Bond ETFs do not have a fixed maturity date and typically trade at a higher price or discount from the actual underlying bond price.
These ETFs focus on a group of stocks from a single industry or sector. For instance, a stock ETF might benchmark technology, mining, or automotive stocks. The point behind this type of ETF is to provide investors with diversified exposure to a single industry. These usually capture high performers and new entrants in a particular industry in one basket to maximise the upside.
Industry/ Sector ETFs
Here are funds whose primary focus is a specific industry or sector. For example, an agricultural sector ETF would primarily focus on companies operating within the agricultural industry.
As you can already guess from the name, commodity ETFs track the index performance of companies that invest in commodities such as gold, silver, or oil. Investors love commodity ETFs for the diversification they offer investors, which makes it easy to hedge against potential market dips.
These ETFs attempt to make gains from stock dips by shorting stocks. Shorting is the process of selling a stock in expectation of a future decline, then repurchasing it at a lower price. Inverse ETFs utilise derivatives to short stocks. Here, the fund’s portfolio managers make bets on when the market will decline and place their positions accordingly.
Although there are many similarities between ETFs and traditional funds, the two also have some notable differences that are important for investors to be aware of.
Differences between ETFs and traditional funds
- When it comes to traditional funds or mutual funds, investors conduct trade through a fund manager (or other financial advisor/ intermediary). On the other hand, ETFs trade on an exchange like shares, thus allowing investors to trade them through a brokerage account.
- Fund managers set mutual fund prices once a day. Conversely, investors can trade ETFs on major stock exchanges anytime during the trading day. The prices oscillate depending on a wide range of factors, just like shares. This offers investors a wider range of trading flexibility than when they’re trading mutual funds.
- Mutual funds require investors to deposit a minimum investment. This is typically a flat figure that isn’t tied to the fund’s share price. On the other hand, ETFs do not require a minimum initial investment and investors can them purchase as shares.
- Traditional funds are usually professionally managed funds. This means that fund managers determine what stocks or other securities they will include in the fund. Most ETFs, on the other hand, benchmark major indexes and attempt to replicate their index performance.
ETFs vs. Index funds
What is an index fund?
An index fund refers to a type of exchange-traded fund or mutual fund that tracks the returns of a market index. For instance, it might track the S&P 500, the Russell 2000 index, or other major indexes. These funds are ideal for retirement accounts as they offer the diversity and stability needed for risk-averse individuals.
One of the most notable differences between ETFs and index funds is the fact that investors can trade ETFs at any time of the day, similar to stocks. In comparison, brokers can only trade index funds at a set price at the end of the trading day. Depending on an investor’s reason for investing in these assets, the time allotted within the trading window might be a big hindrance or not even matter at all. For long-term investors, this shouldn’t be too much of a challenge.
However, there are other factors that distinguish ETFs from index funds. Let’s explore both the differences and similarities.
Differences between ETFs and index funds
ETFs will usually have a lower minimum investment requirement than index funds. An investor typically only needs enough to buy one share in order to opt into an ETF. However, when it comes to index funds, the case is vastly different. Index fund brokers often set minimums that are higher than the typical share price.
Capital gains tax
In comparing ETFs and index funds, ETFs are the more tax-efficient option due to how their structure. When an investor sells an ETF, it is usually to another investor, which means the asset ownership transfers from one person to another. Therefore capital gains taxes are levied on only the seller.
However, for an investor to retrieve their money from an index fund, they must redeem it from the fund manager, who sells the security to generate the necessary cash and complete the transaction. If this sale generates a profit, the net gains pass on to each investor with shares in the fund. This means an investor could owe capital gains taxes without ever having sold a single share.
Although both investment vehicles are relatively low-cost options, their individual charges vary. For instance, an investor might have to pay a flat commission fee to their broker each time they buy or sell an ETF. Additionally, ETFs carry a cost called a bid-ask spread, which isn’t initially obvious during the purchase of the index funds.
Similarities between ETFs and index funds
ETFs and index funds group different securities into a single investment option. For instance, stocks, bonds, commodities, or other security. Investors are increasingly turning to these types of investments for a few reasons, as seen below.
Both ETFs and index funds can help an investor easily diversify their portfolio by virtue of the wide basket of securities held in a single investment. For instance, an ETF tracking the S&P 500 can give an investor exposure to hundreds of the country’s largest stocks.
Due to the fact that both ETFs and index funds are passively managed funds, investors incur fewer charges in the form of management fees and brokerage commissions. In this way, they have a distinct advantage over actively managed funds because they cut the middleman out of the equation.
Investors who participate with the long game in mind flock to ETFs and index funds for the strong benefits they offer over the long term. Passively managed funds benchmark large indexes’ movements and guarantee positive returns based on historical index performance.
How to estimate the value of an ETF using different asset pricing models
As stated earlier, holding other things constant, the fair value of an ETF is determined by the value of the underlying assets. Consequently, a good understanding of different asset valuation models for analysing stocks and bonds in ETFs will come in handy.
When determining which valuation method to use in stock valuation, it is easy to become intimidated by the number of valuation techniques available. There are valuation methods that only seasoned investors would grasp and others that are simpler to understand for even beginners.
It is crucial to remember that no single technique is appropriate for every situation. Different sectors/ industries and stocks have unique characteristics that determine which valuation method to apply. Here is how to calculate the value of an ETF.
There are two broad categories under which all valuation methods fall: absolute valuation and relative valuation.
This model tries to find the intrinsic value of investments using only fundamentals. Focusing on fundamentals includes things like dividends, cash flow, and the growth rate for a single company. The valuation models included under this category are the dividend discount model, discounted cash flow model, residual income model, and asset-based model.
In contrast, the relative valuation model compares the company in question to other companies. This involves calculating multiples and ratios like the price-to-earnings (P/E) ratio and then comparing the findings with the multiples from similar companies.
Let’s take a look at these valuation models in more detail.
Dividend discount model (DDM)
The dividend discount model is one of the easiest and most straightforward of the absolute valuation models. This model focuses on a firm’s ‘true’ value of investments based on the dividends a company pays its shareholders. Investors rely on this model because it focuses on dividends which usually represent the actual cash flows going to the shareholder. Therefore, the present value of these dividends depicts what the shares are worth.
Discounted cash flow model (DCF)
Supposing the company doesn’t pay a dividend or it does so irregularly? In this case, investors use the discounted cash flow model to value the company’s shares. This model uses the company’s discounted future cash flows to value the business. The main benefit of using this method is that it can be applied to many types of companies that do not pay dividends.
Price to Earnings Ratio (PE ratio)
This is also popularly known as the price multiple, and it compares the stock price to the company’s earnings per share. A stock’s PE ratio shows the number of years of current earnings the company must earn to recoup the amount spent on the stock. PE ratios can be applied to compare a stock market’s value to similar companies or to the historical valuation of the company in question. However, investors do not usually use this ratio in isolation.
The Price Earnings to Growth ratio takes into account a company’s earnings and growth. For instance, if two stocks are trading on a PE ratio of 15, but one company reports growing earnings at 10% while the other has an earnings growth rate of 20%, the second is expected to generate higher returns. The lower the PEG ratio, the cheaper a stock is based on earnings and growth.
Price to sales
This method divides a company’s market value by its annual revenue and is a quick way to compare stocks within an industry. PE ratios prove to be of little use if the company isn’t earning profits. In this case, it is better to use P/S ratios.
However, it is important to note that different industries earn varying profit margins; therefore, P/S ratios vary from industry to industry.
Price to Free cash flow
There are certain cases where a company’s earnings are not a reliable reflection of profitability due to the use of complex accounting. Cash flow can help calculate the value of the company’s stock. Free cashflow is calculated by adding a company’s investing, financing, and operating cashflow, then dividing this by the company’s market capitalization. Although this method yields figures that are higher than P/E or P/S ratios, it can still be used to make comparisons of companies within a given sector.
The comparables model
This model is a last resort used by investors when the other methods can’t be applied to the valuation of a company or if they want a quicker route. This model doesn’t try to find the stock’s intrinsic value like the previous valuation methods. Instead, it compares the stock’s price multiples to the benchmark and determines whether it is undervalued or overvalued.
This is because the method is based on the Law of one price, which states that two similar assets should typically sell for similar prices. This method is based more on intuition than logic, making it very popular amongst investors.
Tips and strategies for analysing ETFs and calculating their value
The value of an exchange-traded fund (ETF) typically depends on the value of its underlying assets or securities. This is referred to as its creation unit (CU); however, determining the value of actual ETF shares is slightly more challenging than the individual assets themselves.
This is because, in most cases, arbitrage is used to maintain the price of the ETF shares in line with the price of underlying assets. However, various factors hinder the effectiveness of arbitrage in setting ETF prices: dividends are accrued, expenses are paid, and the value of ETF shares often deviates from the value of their underlying assets. For example, many ETFs consisting of international assets will inevitably trade at different times from the underlying international assets, thereby causing disparities.
For this reason, investors and brokers rely on different indicators to determine ETF valuation depending on various factors such as type of ETF, where the ETF and underlying asset trade, and other available information like net asset value, indicative value, total and estimated cash, outstanding shares, and for specific funds, accrued dividends.
The easiest way to check the value of an ETF is to check the price quote if the fund is under active management. However, if it is not, here are some methods you can use to determine the value of the ETF.
When calculating the NAV of an ETF, the method is similar to that used in the case of mutual funds. This basically involved summing up the total assets and subtracting the total liabilities, divided by the outstanding number of shares.
NAV = (Assets – Liabilities) / Shares Oustanding
Traders typically apply NAV to compare different ETFs’ values and calculate their performance statistics. However, this method might not represent the current value of an ETF. This is because the component prices vary throughout the trading day, yet they only calculate NAV at the end of the day.
Indicative Value (IV)
This is calculated using the most recent prices of the underlying assets as opposed to the previous day’s closing prices. This method is most useful when assessing the value of infrequently traded ETFs, although care must be taken as sudden spikes or dips can skew the value.
In addition, IV is only calculated every 15 seconds by the exchange that lists the ETF. The only price provided is the last price- not the bid or ask prices. This limits the value for traders. The value of IV is also limited for ETFs with underlying securities trading in vastly different time zones, for instance, ETFs with international securities or where trading has stopped for one or more of the underlying securities.
Consequently, ETF traders might choose to use estimated NAV (eNAV), where IV is adjusted by a specific formula deemed to represent price changes caused by an event that would significantly affect the ETF price—for instance, multiplying the NAV by a percentage change in a representative index. Traders often use eNAV to determine bid and offer prices.
Indicative value = ∑ (Last Price × Shares of Each Asset)/CU Shares + Estimated Cash/CU Shares
Cash levels change in an ETF because of dividends, management fees, and from alterations in the portfolio. Therefore, brokers and traders need to know the cash associated with the creation unit (CU) in order to create or retrieve cash from a CU. There are two cash numbers most ETFs publish daily: total cash and estimated cash.
Here, total cash refers to the amount attributed to each creation unit in the prior trading day so that cash can be created and redeemed at NAV. This helps prevent dilutions that might be caused by the creation or redemption process. Alternatively, estimated cash is the amount of cash that is expected to be available at the end of the trading day.
Total cash = Outstanding shares/ CU Shares x Total cash
Cash per ETF Share = Total Cash/ CU Shares
ETF shares constantly change as the authorized participants create new shares or redeem old ones. Therefore keeping track of the number of outstanding shares provides a quick view of whether demand is increasing or decreasing for the ETF.
Now that you’ve understood how to calculate ETFs’ value let’s explore different strategies you can apply when selecting ETFs.
Strategies for analysis when investing in ETFs
This is one of the most basic investment strategies used by traders. It is a technique that involves buying a set fixed dollar amount of an asset on a consistent basis, regardless of the changing cost of the asset. This investment strategy is perfect for beginners as they can invest a small amount regularly while they learn the ins and outs of trading ETFs.
Here an investor allocates a portion of their portfolio to different asset classes such as stocks, bonds, commodities, and cash with the aim of diversifying their portfolio. The fact that ETFs don’t require a huge amount in order for an investor to begin their investment journey encourages the use of this investment strategy.
This refers to ETF trades that seek to benefit from the sizeable swings in stocks or other instruments like currencies or commodities. These can mature in a few days or even take weeks, unlike day trades which are typically left open overnight.
ETFs are suited to swing trading because of their diversified nature and tight bid/ask spreads. Additionally, ETFs are available for a wide variety of asset classes. Therefore, an investor can choose to trade an ETF that is based on a particular sector or class of securities.
With ETFs, investors find it easy to practice sector rotation based on different stages of the economic cycle. For instance, assuming an investor has invested in the biotechnology sector via the iShares Nasdaq Biotechnology ETF. Should they choose to switch, they can take their profits from this sector and rotate to a more defensive sector depending on movements in the market.
This is the term used to refer to the act of selling a borrowed security or financial instrument. It is usually only undertaken by seasoned investors due to its high investment risk. However, short selling through ETFs is better than shorting individual stocks. This is because there is a lower risk of a short squeeze and a lower borrowing cost.
Betting on seasonal trends
ETFs are a great way for investors to earn profits from seasonal trends. By following the market closely, investors can quickly recognize certain trends. For instance, when traders buy or sell en masse and thereby plan their positions accordingly. This is especially true in the case of commodity ETFs.
A hedging investment strategy is the buying or selling of an investment security in order to offset the potential decline in the value of another asset or security. For instance, an investor with a large long-term position in stocks might opt to sell a stock ETF short or purchase inverse ETFs. This would be a positive guarantee of future result if the long stock positions fall in price.
This refers to the practice of buying ETFs that concentrate on trending investment themes as opposed to specific types of asset classes. For instance, a thematic ETF might invest in stocks of companies that may benefit from the current focus on environmental sustainability, green technology, metaverse investments, and the like.
The final step to fully understanding the world of ETFs is to consider the investment risks and rewards when deciding whether to invest in an ETF.
Risks factors when investing in ETFs
One of the biggest risks when it comes to ETFs is market risk. Similar to mutual funds or close-ended funds, ETFs are simply investment vehicles. They are a neat package that houses the underlying investment. For instance, if stocks take a dive, nothing about the inherent advantages associated with ETFs will save your portfolio if it’s heavily invested in the stock.
The other investment risk with ETFs is the ‘attractive risk.’ Investors today receive hundreds of ETF options. They all offer attractive features and benefits. This can make it challenging for an investor to base their decision on concrete facts. Instead, they get caught up in what the ETF looks like.
ETFs are an amazing investment tool and have opened the market up to many unique ideas. An investor can choose ETFs that focus on traditional investments like commodities, currencies, and the like. However, it doesn’t stop there because investing in ETFs that offer more complex or exotic options such as metaverse, digital currencies, and the like is possible. Without due diligence, investors can find themselves in highly speculative and possibly underperforming investments.
There are many ETFs on the market that are very popular among investors and those that are ignored. Every year, brokers remove roughly 100 of the unpopular ETFs.
However, an ETF shutting down doesn’t necessarily spell doom for investors. They receive back whatever they invested- it is also unpleasant. It results in lost time and opportunity. This is because they could have invested the money in something else and received huge returns.
The way ETFs are created and marketed opens investors up to the ‘latest fad risk.’ This is when an investor gets swept up by the hype surrounding a new ETF product without conducting their own due diligence. Like in the real world, fads soon fade, leaving nothing but ashes and tears. Investors new to the ETF game might choose to stick to traditional investments.
Three’s a crowd risk
Similar to the fad risk, this involves the phenomenon that as more investors catch wind of the latest hot investment, many rush in to take advantage. This ultimately has the effect of watering down the whole’s value and ruining the opportunity for the pioneering investors.
Unlike mutual funds, ETFs carry an inherent trading risk in the form of transaction costs. Similar to stocks, an ETF has a spread that can vary in amount from one day to the next. Additionally, an ETF could trade for a penny for the first 100 shares. Then increase its spread to a quarter in order to trade quicker. These variations in trading costs can easily eat into your returns. Therefore it is important to fully understand the ETF’s liquidity before you invest.
Opportunities when investing in ETFs
Let’s end our journey on a positive note by exploring the reasons to invest in an ETF.
ETFs are quickly gaining popularity, with more and more investors taking them as seriously as their other investments. For instance, investors- including governments- are increasingly investing in bond ETFs instead of bond mutual funds. This is evidence of how mainstream ETFs have become. It lends a level of trust to investors that are new to the concept.
ESG taps in
Following the 2020 pandemic, more investors in the ESG (environmental, social, and corporate governance) crowd are investing in ETFs. This opens interesting investment options up to the market. For instance, causes or companies that focus on issues like climate change, racial justice and inclusion, and the like. Capital inflows into ESG-focused mutual funds and ETFs more than doubled in 2020 to $51 billion.
These days it seems like there is an ETF for everyone. Thematic ETFs have ushered in a new wave of investment avenues that cater to the interests of the investor. Everything from metaverse ETFs, Tech ETFs down to those focused on environmental and social issues is available for investors. Thematic ETFs give investors a chance to tap into trends. This is true for those that could have long-term implications on how we work, live, and relate to each other.
Although we noted earlier that ETFs are mostly passively managed, the tide is also turning in that quarter. Thanks to the SEC rule adopted in 2019 that enabled active management for certain ETFs. There’s now a new breed of actively managed ETFs. ETF traders call these ‘nontransparent’ ETFs. This is because they don’t have to disclose the fund’s portfolio holdings daily. Instead, these ETFs issue quarterly reports that disclose their fund’s portfolio holdings.
One of the most attractive aspects for investors regarding ETFs is their tax efficiency. Some of the efficiency is possible because of their low portfolio turnover- especially in the case of index funds. Another reason is the way brokers create and redeem ETF shares. Unlike mutual funds that must, at times sell underlying securities to pay shareholder redemptions that trigger capital gains taxes, ETFs don’t have to do this. They use authorized participants to redeem shares on their behalf.
As you can see, investing in ETFs comes with a host of advantages. However, you’re probably still looking for quick tips you can apply as you consider whether or not to invest. Here are a few quick tips to keep up your sleeve.
Tips on buying and selling when investing in ETFs
Use limit orders
Limit orders make it possible for you to specify the market price at which you are willing to purchase or sell shares. Although they are not instantly executed, they ensure that your order is filled at your preferred price. A buy order, on the other hand, is only executed at the limit market price you set or lower.
ETFs carry two prices- the current market price per share, and the net asset value per share (NAV), which refers to the value of the underlying assets. These prices are sometimes different, so it is important to know them when you’re considering buying or selling. For instance, if the share price is above the NAV, the ETF sells at a premium. Conversely, if the price is below the NAV, it trades at a discount.
Timing is everything
Like most things in life, timing is key when it comes to ETFs trades. Investors are often advised to ‘wait out the chaos’ and avoid trading within the first and last half-hour of the trading window. This is because steadier gains can be made during ‘quieter’ times in the market than at the peak of volatile periods.
Exchange-traded funds have gone from being just a fad to becoming mainstream. Your initial introduction perhaps involved meme stocks, metaverse ETFs, or more traditional options like commodity ETFs. If so, following the tips and information outlined in this article titled ‘A Comprehensive Guide to Valuing ETFs and Determining Their Profitability,’ you are well on your way to becoming a season ETF investor.
What are risks factors when investing in ETFs?
- Market risk
- Attractive risk
- Complexity risk
- Shutdown risk
- Fad risk
- Three’s a crowd risk
- Trading risk
What are Opportunities when investing in ETFs?
- Gaining popularity
- ESG taps in
- Thematic ETFs
- Active ETFs
- Tax efficiency
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