What an ETF stands for and how it works

An ETF (Exchange Traded Fund) is an investment fund whose shares can be bought and sold on the stock exchange. It tracks the performance of a particular index, economic sector or other asset.

How it works:

1. A management company creates an ETF and chooses which index, economic sector or asset it will track.
2. The management company buys assets corresponding to the selected index, sector or asset. These can be stocks, bonds, commodities and other financial instruments.
3. ETF shares are issued on an exchange. Any investor can buy ETF shares just like shares of any other company.
4. The price of ETF shares depends on the value of the assets that are included in the ETF and the supply and demand in the market. If the value of the assets goes up, the price of ETF shares usually goes up. If asset values fall, the ETF’s share price may also fall.
5. Investors receive income from investing in ETFs if asset values rise. The income may come in the form of dividends or an increase in the ETF’s share price.

Now for more details

Many investors seek to diversify their assets to minimise risk and avoid significant losses, and to find profitable securities. As a result, they form balanced portfolios.

Nevertheless, some attractive securities have high prices.

If an investor does not have significant capital, he can indirectly invest in such expensive securities through units of investment funds that invest in them. These units can be purchased from the fund’s management company or on the stock exchange in the case of an exchange traded mutual fund (ETF) or its foreign analogue ETF (exchange traded fund).

An ETF is an investment fund that is managed by a foreign company and contains specific securities or assets. The fund’s assets are divided into units, which are essentially similar to investment portfolios, and these units are listed on an exchange. They are traded just like regular stocks, so exchange-traded fund units or ETFs are also called fund shares.

A management company will usually accumulate resources into a fund based on a general concept that will be attractive and understandable to investors. Funds may allocate their resources to stocks in specific industries, sectors or countries. For example, a fund dedicated to ‘Healthcare’ may include shares in pharmaceutical and healthcare organisations, while an ‘IT sector’ fund may include digital companies and technology manufacturers.

Investing in funds is considered safer than individual stocks because they provide exposure to dozens or even hundreds of securities at a time. If a few stocks in a fund lose value but the majority rise, this can lead to an increase in the value of the unit. This is a key difference from an individual portfolio with a limited number of securities, where a fall in even a couple of them can significantly affect the overall return.

How ETFs are traded on an exchange

In order for units to be freely traded on the market, management companies list them on an exchange, also known as an exchange listing (units are sometimes referred to as fund shares). Russian exchanges have additional requirements for foreign securities.

The issuers of ETFs are foreign management companies, which are required to comply with the rules of the Russian law ‘On the Securities Market’ regarding securities obligations. In particular, under Russian law, an organisation must provide information about its ETFs. In addition, the foreign exchange where the fund is principally traded must be on the list of foreign exchanges approved by the Central Bank.

If a foreign management company signs an agreement with a Russian exchange to list units and enters into an agreement with a market maker on that exchange to provide liquidity, its units will be included in the first or second quotation lists of the exchange. The existence of such agreements has a significant impact on ETF pricing, liquidity and investment risks.

The value of units is calculated as the total price of the fund’s assets divided by the total number of units, which is called the fair price. As the assets in the fund increase, the price of units increases, and vice versa.

Although ETF units are traded on the stock market, they cannot be considered a speculative instrument, as the influence of supply and demand on their price is limited. The management company is obliged to ensure that deviations of the market price from the fair (or estimated) value are minimised by maintaining the liquidity of the units through an authorised fund participant, the market maker, who is bound to the management company by obligations on these securities.

If the market price of the units is below or above the fair price, the market maker will place bids in the opposite direction to bring the price in line with the true level. According to the Central Bank’s rules, the deviation of the market value from the fair value should not exceed 3 per cent. That is why market makers are invariably on the market and monitor price fluctuations.

However, the Russian exchange may also hold units of foreign funds that do not have an agreement with the exchange and market-maker. These securities belong to a lower listing level – 3, and investing in them is associated with higher risks.

What risks ETFs may have

If ETF units started trading on a Russian exchange without an agreement with the issuer, the latter will not be interested in maintaining the liquidity of these securities. In this case, there may be no market maker for these assets, and no one will monitor the divergence of stock exchange quotation prices from their fair price and the liquidity of these units. On this basis, the fund quotes will be formed only under the influence of market supply and demand, and not as a result of fluctuations in the prices of the relevant assets that affect the fair value of the units.

Difficulties with the liquidity of these units also remain, as no one is responsible for its support on the Russian platform.

On days when a foreign fund’s main trading platform is not open, its ETFs may continue to trade on the Russian market, but their liquidity is likely to be quite low.

If the Russian exchange has allowed ETFs to trade without an agreement with the person responsible for the securities, the potential cessation of such trading and delisting of units creates additional risks for investors. In this case, neither the management company nor the authorised participant will redeem the units and investors will only be able to attempt to sell them before or after delisting if a buyer is found.

Like any other investment instruments, ETFs can be associated with certain risks. Here are some of them:

1. Market risk. The ETF’s share price can fluctuate in response to changes in the market. This can cause you to lose some of your investment.
2. Liquidity risk. If ETF shares are not popular among investors, there may be a problem in buying or selling them at the desired price.
3. Currency risk. If an ETF invests in foreign assets, currency fluctuations may affect its value.
4. Inflation risk. If inflation rises, the real value of an investment may decline, even if the ETF’s face value remains unchanged.
5. Issuer risk. Some ETFs invest in the stocks of individual companies. If these companies encounter problems, the ETF’s share price may be adversely affected.
6. Managerial risk. Poor decisions by the manager of an ETF can lead to a decline in share price.
7. Low diversification risk. Some ETFs invest in a small number of companies or assets, which can increase risk.
8. Regulatory risk. Changes in laws or regulatory actions may affect the ETF’s share price.
9. Taxation risk. Investments in ETFs may be subject to taxes, which may reduce investment returns.
10. Fraud risk. As with any investment, there is a risk of fraud or dishonest behaviour on the part of ETF managers.

It is important to remember that ETFs, like any other investment instruments, do not guarantee a profit. It is advisable to consult a financial adviser before making a decision to invest in ETFs.

Taxation of ETF gains

In the stock market, a broker or management company acts as the tax agent for buy and sell transactions. This means that the investor does not need to complete a tax return or pay taxes on such transactions himself.

When it comes to foreign funds, in order to determine the income, it is important to take into account the ratio between the ruble exchange rate and the currency in which the calculations were made.

The profit received depends not only on fluctuations in the value of the securities themselves, but also on the exchange rate. Since all transactions are carried out on the Russian market, the income is translated into roubles at the exchange rate set by the Central Bank.

Let’s look at specific examples.

An investor bought an ETF share for $100 last year and sold it for $120 this year. During this period, the dollar exchange rate changed, increasing from 50 roubles to 75 roubles. To calculate the taxable base it is necessary to multiply the value of the share by the dollar rate of the Central Bank and deduct the initial investment: (120 × 75) – (100 × 50) = 9 000 – 5 000 = 4 000 rubles.

Let’s consider another case, when the value of the unit in currency remained unchanged, but the dollar rate increased. In this situation, the investor will also have to pay tax.

Suppose that the investor bought an ETF share for $100 and also sold it for $100. However, during this time, the ruble depreciated, and the dollar’s exchange rate against the ruble increased from 60 rubles to 66 rubles. To determine the taxable base, multiply the unit price by the Central Bank dollar rate and deduct the initial investment: (100×66) – (100×60) = 6600 – 6000 = 600 rubles.

Thus, although the transaction did not actually benefit the investor, the increase in the dollar exchange rate resulted in a taxable basis.