A Strong Ally for Index Investing! Explaining the Appeal of ETFs

Used widely by everyone from investment beginners to professional investors,
the financial product
“ETF (Exchange Traded Fund)”has been increasing its presence in recent years.

However, if asked “What is an ETF?”, perhaps
surprisingly few people can accurately explain
the differences from mutual funds and stocks,
the mechanics, and the pros and cons.

In this article, we will thoroughly explain
everything from the basics of ETFs and their mechanics,
to the differences from mutual funds and stocks,
and how to utilize them.

What is an ETF (Exchange Traded Fund)?

ETF is an abbreviation for“Exchange Traded Fund”,and in Japanese it is called
“Jojo Toshi Shintaku” (Listed Investment Trust).

As the name suggests, it is
listedon a stock exchange, and it is an investment trustthat can be bought and sold in real-time
just like stocks.

ETFs are managed with the goal of tracking
various indices such as the Nikkei 225, TOPIX,
the S&P 500, as well as bonds, real estate (REITs),
commodities, and currencies.

There are also some
actively managed ETFsthat do not track an index.

Mechanics of ETFs

The mechanics of ETFs differ significantly
from general mutual funds.

ETFs arelistedon a stock exchange, and investors can
buy and sell them through securities companies
just like stocks.

In-Kind Creation ETFs

Many ETFs adopt a mechanismcalled “In-Kind Creation”.

In this process, securities companies or
institutional investors (authorized participants)
contribute a basket of physical stocks
to the management company,
and in return, receive ETF beneficiary certificates.

Because ETFs and the basket of physical stocks
are mutually exchangeable,
the price of the ETF moves
almost identically to the tracked index.

Synthetic ETFs

Some ETFs adopt a mechanismcalled “Synthetic”.

In this case, securities companies contribute cash,
and the management company invests those funds in
index-linked notes,designed so that the ETF price
tracks the index.

Differences between ETFs, Mutual Funds, and Stocks

Types of ETFs

There are various types of ETFs depending on the index they track or the
investment target.

• Stock Index-Linked ETFs: Nikkei Stock Average, TOPIX, S&P 500, etc.

• Bond ETFs: Government bonds, corporate bonds, etc.

• REIT ETFs: Linked to real estate investment trust indices

• Commodity ETFs: Linked to commodity prices such as gold and crude oil

• Active ETFs: Do not track an index; managers actively select stocks

Investors can choose from
a variety of ETFs to suit
their investment goals and risk tolerance.

Benefits of ETFs

1. Easy diversification

Since ETFs track an index
composed of multiple stocks,
you can automatically achieve
diversificationdiversificationby purchasing just one stock.

2. Real-time trading

Just like stocks,
you can trade them
at any time during market hours.

3. Low cost

Generally, they tend to have
lower operating costs (trust fees)than
unlisted investment trusts.
This is because the contents of an ETF are
often index fundsin many cases.

4. High transparency

The holdings and operational status
are frequently disclosed,
providing high operational transparency.

5. Margin trading and stock lending are also possible

Like stocks, ETFs can also be used for
margin tradingandstock lending services.

Disadvantages and risks of ETFs

1. Trading fees apply

Just like stocks,
a
fee is incurred at the brokerage firm every time you trade.

2. Divergence between market price and net asset value

Due to the balance of supply and demand,
the market price may
diverge from the theoretical price (net asset value).

3. Dividends are not automatically reinvested

Unlike mutual funds,
automatic reinvestment of dividends may not be possible.

(When dividends are paid, they are deposited into your brokerage account, so you must buy the ETF yourself if you wish to reinvest.)

4. Liquidity risk

For minor ETFs,
trades may be difficult to execute,
and you may not be able to
trade at your desired price.

5. Some brokerage firms do not support automatic savings plans

Unlike index funds,
there are brokerage firms that allow automatic savings plans for ETFs and those that do not.

How to utilize ETFs

ETFs can be used for various purposes,
not only for long-term investment,
but also for short-term trading, asset diversification,
and thematic investing.

• Long-term savings investment: Leveraging low costs and diversification effects for long-term wealth building.

• Short-term trading: Aiming for short-term price movements using real-time trading or margin trading.

• Thematic investing: Concentrated investment in growth sectors using ETFs linked to specific industries or themes.

• International diversification: Easily diversify investments across global assets with ETFs linked to overseas indices.

What kind of asset classes can you invest in with ETFs?

ETFs (Exchange Traded Funds) offer a range of products
that allow you to invest in various asset classes around the world
due to their diversity and flexibility.

Below, we explain in detail the
representative asset classes that can be invested in via ETFs.

1. Stocks (Domestic/International)

• Domestic Equity ETFs
  These primarily track representative Japanese stock indices such as the Nikkei Stock Average and TOPIX. There are also ETFs focused on specific themes, such as industry sectors, high dividends, and ESG (Environmental, Social, and Governance).

• International Equity ETFs
  There are ETFs that track stock indices of various countries and regions, such as the US S&P 500 and Nasdaq, as well as Europe, Asia, and emerging markets. Global equity ETFs that cover both developed and emerging countries are also popular.

2. Bonds

• Domestic Bond ETFs
  These ETFs track the domestic bond market, such as Japanese government bonds. They are used for the stability of yields and for risk diversification.

• International Bond ETFs
  There is also a wide variety of ETFs that track major international bond indices, such as US Treasury bonds, European bonds, and emerging market bonds. Some products allow you to choose whether or not to include currency hedging.

3. Real Estate (REITs)

• Domestic REIT (J-REIT) ETFs
  These track Japanese Real Estate Investment Trust (REIT) indices. They are popular among investors aiming for high dividends.

• International REIT ETFs
  There are also ETFs that track US, Asian, and global REIT indices, allowing you to diversify your investments into real estate markets around the world.

4. Commodities

• Precious Metals
  There are ETFs that track the prices of precious metals such as gold, silver, and platinum. They are used for inflation hedging and asset diversification purposes.

• Energy and Agricultural Products
  There are also ETFs that track the prices of crude oil, natural gas, and agricultural products like wheat and corn, making it possible to invest in commodity markets.

5. Leveraged, Inverse, and Enhanced Types

• Leveraged ETFs
  ETFs that track an index with a multiplier, such as 2x or 3x the daily price movement. These are intended for traders aiming for short-term price movements.

• Inverse ETFs
  Inverse ETFs that increase in value when an index falls. These are used when you want to aim for profits in a declining market.

• Enhanced ETFs
  ETFs that employ specialized management strategies, such as combining long-short strategies or covered call strategies.

6. Balanced and Active Types

• Balanced ETFs
  Products that invest in multiple asset classes, such as stocks and bonds. They are suitable for investors who prioritize risk diversification.

• Actively Managed ETFs
  ETFs that do not track an index, but instead have managers select stocks based on their own judgment to aim for returns that outperform the index, have also emerged.

7. Thematic and Sector ETFs

• Thematic ETFs
  There are also many ETFs that focus on specific themes or industrial sectors, such as biotechnology, AI, clean energy, and fintech.

• Sector ETFs
  There are many ETFs that allow you to invest by industry, such as finance, high-tech, energy, and healthcare, making it possible to diversify sectors according to the economy and trends.

Summary

ETFs (Exchange Traded Funds) are financial products that combine the
diversification benefits of investment trusts with the
real-time trading convenience of stocks.

They track various indices such as the Nikkei Stock Average and the S&P 500, and have many advantages such as low costs, high transparency, and ease of diversification.

On the other hand, it is also necessary to understand the disadvantages, such as trading commissions, liquidity risk, and the divergence between market price and net asset value.

ETFs are an attractive option for a wide range of investors, from beginners to advanced users.

Let's aim for asset formation by utilizing ETFs wisely, in accordance with your own investment objectives and risk tolerance.

※This article explains the general mechanisms and characteristics of ETFs. For specific product selection and investment decisions, please refer to information from each financial institution and official documents.