When you start becoming interested in asset management, ETF is a term you will almost certainly encounter. If you open a securities company’s app, you will see countless products lined up, ranging from Nikkei 225-linked, global stock, US stock, high-dividend, and bond types, to those linked to gold or real estate. However, surprisingly few people can accurately explain how ETFs actually work, how they differ from regular mutual funds, or who they are suitable for.
ETF stands for “Exchange Traded Fund.” As the name suggests, it is a financial product that is a type of mutual fund but is listed on a stock exchange just like a stock. This point—that it is a mutual fund but can be bought and sold like a stock—represents the essence of an ETF.
In this article, we will carefully explain step-by-step everything from the basic definition of an ETF, the mechanism by which its price is determined, the flow of creation and redemption, its types, pros and cons, differences from regular mutual funds, how to think about taxes and costs, and points on how to purchase and choose them. We aimed to create content that serves as useful decision-making material for both those who have just started investing and those who already own mutual funds and are considering a comparison with ETFs.
Basic definition of an ETF
An ETF is a mutual fund that is listed on a stock exchange and is managed with the goal of tracking the price movements of a specific index or asset. Representative tracking targets include Japanese stock indices such as the Nikkei Stock Average and TOPIX, US stock indices such as the S&P 500 and NASDAQ 100, and the MSCI All Country World Index. Furthermore, there are types linked to government and corporate bond indices, commodity prices such as gold and platinum, and real estate investment trust indices.
What is important to note here is that many ETFs adopt an investment policy called “passive management.” Passive management is an investment method that aims to replicate the same price movements as an index rather than aiming for performance that exceeds the market average. For example, an ETF linked to the Nikkei Stock Average achieves almost the same price movement as the Nikkei Stock Average by holding the 225 stocks that make up the Nikkei Stock Average in the same ratio as the index.
In recent years, “active management” ETFs, where the investment manager selects stocks based on their own judgment, have also appeared. However, they are still a minority when looking at the market as a whole, and it is common for the term ETF to refer to index-linked types.
Also, ETFs are legally positioned as a type of mutual fund. Therefore, buying an ETF means participating in a mechanism where experts manage funds collected from many investors, and you receive the results according to your share. It is thanks to this mechanism that you can invest in dozens to thousands of stocks at once instead of buying individual stocks one by one.
ETF mechanism: Why can they be bought and sold like stocks?
Differences in price formation from general mutual funds
The most important point in understanding the characteristics of an ETF is how its price is determined. Regular mutual funds are bought and sold at a “net asset value” (NAV) that is calculated once a day after the market closes. At the time you place an order, you do not know at what price you can buy, and the execution price is determined after the NAV is finalized on the next business day or later.
On the other hand, like stocks, ETFs can be bought and sold at real-time prices at any time while the exchange is open. Because transactions are executed at a price where the buyer’s and seller’s orders match, you can check the price before buying, and you can also use the same order methods as stocks, such as limit orders and market orders. Being able to buy and sell at your preferred timing while watching price movements is a major feature of ETFs.
Relationship between exchange price and net asset value
ETFs also have a net asset value, just like mutual funds. This is what can be called the “original value of the ETF,” calculated by subtracting liabilities from the market value of the assets held by the ETF and dividing by the number of units issued. On the other hand, the price at which it is actually bought and sold on the exchange is determined by supply and demand.
Normally, these two prices are almost identical, but a slight discrepancy can occur temporarily. A state where the exchange price is higher than the net asset value is called a “premium,” and a state where it is lower is called a “discount.” The discrepancy can become large when the market is significantly shaken or when trading an ETF linked to overseas assets during hours when overseas markets are closed. However, due to the mechanism described below, this divergence naturally works in the direction of shrinking.
Creation and redemption: The mechanism by which ETFs are born
What keeps the price of an ETF from deviating significantly from its net asset value are large financial institutions such as securities companies called “authorized participants.” Authorized participants are in a special position where they can be directly involved in the new issuance and redemption of ETFs.
When they want to increase the number of units of a new ETF, authorized participants provide the constituent stocks of the index that the ETF tracks to the management company as physical stocks. Then, in exchange, the beneficiary rights of the ETF are issued. This is called “creation.” Conversely, when an authorized participant returns the ETF to the management company and receives the constituent stocks in return, it is called “redemption.”
This mechanism creates a flow that corrects price distortions. If the exchange price of an ETF exceeds the net asset value (NAV) and becomes a premium, authorized participants can buy up the undervalued constituent stocks in the market to create the ETF, and then sell the overpriced ETF on the exchange to earn the difference. This action creates selling pressure on the ETF, bringing the price closer to the NAV. Conversely, if it becomes a discount, profit can be made by buying the undervalued ETF, exchanging it, and selling the acquired constituent stocks in the market, which creates buying pressure on the ETF and returns the price to the NAV.
In other words, the price of an ETF is kept close to its NAV through a mechanism called arbitrage. Individual investors do not need to be directly involved in this creation and redemption process; they can simply buy and sell on the exchange just like regular stocks.
Market makers supporting market liquidity
Even though they are listed on an exchange, not all ETFs are traded actively. In ETFs with low trading volume, the spread between the bid and ask prices tends to widen, making it difficult to trade at the desired price. To improve this situation, a market making system has been introduced in Japan.
A market maker is a financial institution that plays the role of creating an environment where trades are easily executed by constantly placing both sell and buy orders on the board. Thanks to this system, trading opportunities are more likely to be secured even for less popular ETFs. However, it is important to note that ETFs with small total net assets and low trading volume can be difficult to keep stable in price.
Types of ETFs
Equity index-linked
The most common type is an ETF that tracks a stock index. For Japanese stocks, there are those that track the Nikkei 225, TOPIX, JPX-Nikkei 400, or indices focused on high-dividend stocks. For overseas stocks, there is a wide range of products that track various indices such as the S&P 500, NASDAQ 100, Dow Jones Industrial Average, all-country stocks, developed market stocks, and emerging market stocks.
There are also sector-specific ETFs that focus on particular industries. These are used when you want to invest with expectations for growth in specific fields such as semiconductors, healthcare, finance, or energy. However, keep in mind that because the range of diversification is narrower, price movements tend to be larger.
Bond-type
These are ETFs that track indices of government or corporate bonds. They are a type often included for the purpose of increasing the stability of the entire portfolio, as their price movements tend to be milder compared to stocks. There are various types, including Japanese government bonds, US Treasuries, developed market bonds, corporate bonds, and high-yield bonds. Since bonds have the property that prices fall when interest rates rise and prices rise when interest rates fall, it is necessary to understand that they are affected by interest rate trends.
Real Estate Investment Trust (REIT) type
These are ETFs that track indices showing the price movements of listed real estate investment trusts. The results of diversified investment in office buildings, commercial facilities, logistics facilities, housing, etc., are reflected in the form of dividends and price fluctuations.
Commodity-type
These are ETFs that track commodity prices such as gold, silver, platinum, and crude oil. Gold ETFs are popular as a means of asset diversification because their prices tend to rise when the stock market becomes unstable. Among commodity-type ETFs, there are types that store physical assets to track prices and types that use futures trading, and the characteristics of costs and price movements differ depending on the mechanism.
Leveraged/Inverse type
Leveraged types move at multiples such as 2x or 3x the price movement of an index. Inverse types are designed to generate profit when an index falls. They are designed for the purpose of targeting short-term price movements and are not suitable for long-term holding. The reason is that these products are managed to maintain a constant multiple against daily price movements, so the longer they are held, the more likely they are to deviate from the long-term price movement of the index due to the effects of compounding. If beginners get involved too easily, it can easily lead to unexpected losses, so careful understanding is required.
Active/Thematic type
Instead of tracking an index, this type involves the management company selecting stocks based on its own policy. There are also thematic types that collect stocks along specific themes such as artificial intelligence, renewable energy, and cybersecurity. While the range of choices expands, there are aspects that depend on the skill of the management or the popularity of the theme itself, so it is necessary to carefully check the contents of each product.
Advantages of ETFs
Allows for diversified investment with small amounts
By buying just one unit of an ETF, you achieve the same effect as investing in dozens to thousands of stocks. While achieving the same level of diversification with individual stocks would require enormous capital and effort, ETFs allow you to invest in the entire market with just a few thousand to tens of thousands of yen. However, since ETFs are purchased in trading units determined for each product rather than in single-unit increments, the required amount varies by product. Some units cost from a few hundred to a few thousand yen, while others cost tens of thousands of yen or more, so it is necessary to check in advance.
Diversified investment has the effect of mitigating the impact of poor performance or scandals at specific companies. It is easier to suppress the risk of price fluctuations compared to concentrating funds in a single company, making it suitable for long-term asset formation.
Low management costs
Since ETFs are primarily passively managed to track an index, they require less management effort, and the costs incurred while holding them, known as trust fees, tend to be set low. Trust fees are expenses deducted little by little from net assets every day while you hold the investment, and the longer you hold them, the greater the impact on investment performance. Even if it seems like a small difference, it leads to a large difference in the final asset amount over decades.
In recent years, costs for mutual funds have also been decreasing, and there are an increasing number of products that are comparable to ETFs. However, the reality is that many ETFs, especially those tracking large and popular indices, are still managed at extremely low costs.
Can be traded in real-time
Just like stocks, you can buy and sell at any time during trading hours. The flexibility to respond quickly when the market changes suddenly or to place orders at a desired price is an appeal not found in regular mutual funds. Some ETFs support margin trading and can also be used for advanced transactions such as short selling.
Easy to understand and highly transparent
For many ETFs, the holdings and composition ratios are disclosed daily. Because it is easy to see what is being invested in, investors can easily grasp the contents of the product. If it is an index-linked type, the composition of the linked index is published, so you can hold it with a clear understanding of what you are investing in.
Can receive distributions
ETFs are structured to pay distributions based on dividends from stocks or interest from bonds held. Many ETFs pay distributions once to four times a year, or even more frequently. ETFs targeting high-dividend stocks or REIT-type ETFs are also used for investments aimed at distributions.
Easy access to a wide range of assets
Normally, for an individual to invest directly in overseas stocks, bonds, or commodities, there are many hurdles such as opening accounts, foreign exchange procedures, and gathering local information. By using ETFs, there are many products available that allow you to invest in assets around the world in Japanese yen through a domestic securities account. The abundance of choices and the ease of creating a combination that suits your goals is a major advantage.
Trust assets are managed separately
Even if the management company operating the ETF or the securities company handling the transaction goes bankrupt, the ETF’s assets are managed by a trust bank separately from the assets of the management company or the sales company. Therefore, the structure is such that it is unlikely that investors’ assets will be directly lost due to the bankruptcy of a management company or similar entity.
Disadvantages of ETFs
Principal is not guaranteed
ETFs are financial products with price fluctuations, and if the price drops, there is a possibility of losing the principal. If the linked index falls, the price of the ETF will also fall accordingly. It is necessary to understand as a prerequisite for investment that the principal is not guaranteed like in savings accounts. Just because it is diversified does not mean you are exempt from losses. In phases where the entire market falls significantly, ETFs will also decline in value without exception.
Fees are incurred every time you trade
When buying and selling ETFs, you will incur trading commissions paid to your brokerage firm. While the number of brokerage firms offering free or very low commissions has increased in recent years, there are still many cases where fees are charged for each transaction. In particular, if you want to engage in a savings-style investment where you frequently purchase small amounts, paying a commission each time can cause costs to accumulate, which may be disadvantageous.
Also, you need to be aware of the difference between the selling price and the buying price, known as the spread, as a practical cost. For ETFs with low trading volume, this spread tends to widen.
May not be suitable for automatic savings plans
Regular mutual funds have established systems for automatic savings plans where a fixed amount is purchased on a fixed day every month. Because ETFs have set trading units, it is difficult to purchase them with an exact fixed amount, and support for automatic savings plans is limited. Recently, some brokerage firms have started supporting ETF savings plans, but they are not as easy to use as regular mutual funds.
Dividends often cannot be automatically reinvested
For many mutual funds, there are products that allow you to choose a plan to automatically reinvest dividends. With ETFs, it is common that you must manually reinvest the dividends you receive yourself. If you want to maximize the compounding effect, it takes time and effort to purchase them manually each time.
Prices may deviate from the net asset value
As explained earlier, the exchange price of an ETF can temporarily deviate from its net asset value. This discrepancy can become significant, especially when the market drops sharply, during hours when overseas markets are closed, or for products with low trading volume. There is a risk of buying at an overpriced level or being forced to sell at an underpriced level.
Risk of delisting or early redemption
If the total net assets fall below a certain level, an ETF may be delisted and redeemed early. If it is redeemed, it will be cashed out at the price at that time, which could result in the same outcome as selling at a time the investor did not want. For investors who intended to hold for the long term, this can be a factor that disrupts their plans.
Currency risk and risks specific to overseas markets
ETFs linked to overseas assets are affected by fluctuations in exchange rates. If the yen strengthens, gains in local currency may decrease when converted to yen. Additionally, ETFs that invest in assets of emerging countries are more susceptible to the effects of political and economic instability.
Complex products have their own specific risks
Leveraged, inverse, and commodity-based ETFs that use futures have complex mechanisms, and holding them with the same mindset as regular index-linked ETFs can lead to unexpected losses. You should avoid purchasing them without fully understanding how they work.
Differences between ETFs and mutual funds
Listing status and trading methods
The biggest difference is whether or not they are listed on an exchange. Because ETFs are listed, they can be bought and sold at any time during exchange hours, just like stocks. Mutual funds are not listed and are traded through distributors such as brokerage firms and banks at the net asset value calculated once a day.
Timing when the price is known
With ETFs, you can confirm the price at the time you place an order. On the other hand, with regular mutual funds, you do not know the execution price at the time you place the order, and the transaction is completed at the net asset value determined later. If you want to make trading decisions by watching price movements during the day, ETFs are more suitable. Conversely, for those who do not want to be swayed by daily price fluctuations, some view mutual funds, where the price is determined only once a day, as easier to manage with peace of mind.
Amounts and methods for purchasing
Many mutual funds are products that can be purchased by specifying an amount from a small sum, such as 100 or 1,000 yen, making them suitable for monthly automatic savings. ETFs must be purchased in trading units determined for each ticker, so they cannot be bought for an exact amount. The capital required also varies depending on the product and price.
Differences in costs
Trust fees, which are the holding costs for ETFs, tend to be low for many products overall. However, the number of mutual funds that have reduced their trust fees to the same level as ETFs is increasing. Therefore, it cannot be said unconditionally that ETFs are cheaper, and it is important to compare the trust fees of individual products.
On the other hand, while ETFs incur trading commissions and spreads, many mutual funds are ‘no-load’ types with no purchase fees, and additional costs associated with buying and selling tend to be small. However, some mutual funds have a fee called a trust asset retention fee when selling.
Operational mechanisms and product types
Most ETFs are passively managed, tracking an index. On the other hand, mutual funds offer a wide range of products, including not only passive management but also active management where the investment firm actively selects stocks. If you want to aim for performance that exceeds the market average or choose products based on unique investment policies, mutual funds offer a wider range of options.
Handling of distributions
Many mutual funds have a mechanism to automatically reinvest distributions, making it easier to take advantage of compound interest effects. With ETFs, you must receive the distribution and then reinvest it yourself.
Flexibility of trading
ETFs have the advantage of allowing the same trading methods as stocks, such as limit orders, stop-loss orders, and the use of margin trading. Mutual funds cannot use such detailed order methods and are basically limited to buying and selling at the net asset value.
Which one should you choose?
For those who want to save steadily over the long term and those who want to invest without much hassle, mutual fund accumulation is suitable. On the other hand, for those who want to buy and sell at their own timing while watching market movements, those who want to keep costs as low as possible, and those who want to invest a lump sum at once, ETFs are suitable. However, neither is absolutely superior, and it is practical to use them differently depending on your purpose and investment style.
Costs associated with ETFs
Trust fees
This is a cost deducted from the net assets little by little every day while you hold the investment. Since it is reflected in the ETF price, investors do not pay it directly from their accounts, but in effect, they are bearing a certain percentage of the investment balance every year. If there are multiple ETFs tracking the same index, the basic approach is to choose the one with the lower trust fee.
Trading commissions
This is the commission paid to the securities company when buying and selling ETFs. The fee structure varies by securities company and may change depending on the transaction amount or be free up to a certain amount. While fee reductions are progressing, mainly among online securities companies, you should check the fees of the securities company you use in advance.
Spread
This is the difference between the price offered by buyers and the price offered by sellers. In ETFs with high trading volume and active trading, the difference tends to be small, while in ETFs with low trading volume, the difference tends to be large. Although often overlooked, it is one of the actual transaction costs.
Other expenses
In addition to the trust fee, other costs such as audit fees, brokerage commissions, and securities transaction taxes may be deducted from the trust assets. These are reflected in indicators such as the total expense ratio and actual costs. You can make more accurate comparisons by checking the actual costs rather than just the stated trust fee.
Taxes on ETFs
In Japan, profits earned from ETF transactions are subject to taxation. For ETFs listed on domestic stock exchanges, both capital gains from sales and dividends received are generally taxed at a rate of approximately 20%. This tax rate is the sum of income tax, special reconstruction income tax, and resident tax.
If you use NISA (Nippon Individual Savings Account), these profits and dividends can be tax-exempt within a certain range. You can purchase ETFs in a NISA account using the growth investment quota. If you are aiming for long-term asset formation, actively utilizing NISA can reduce your tax burden and increase investment efficiency.
However, the details of the system and the tax-exempt quotas may change due to legal revisions or other factors. Please check the latest information before using the system for specific details.
Also, when purchasing ETFs listed on overseas exchanges, tax treatment may differ, and procedures or calculations may become complex, such as being subject to foreign taxation on dividends. When investing in overseas ETFs, it is important to confirm the tax treatment in advance.
How to purchase ETFs
To purchase an ETF, you first need to open an account with a securities company. If you use an online brokerage, you can complete the account opening process from your smartphone or computer, and transactions can be completed entirely online. There are different types of accounts, such as specific accounts (tokutei kouza), general accounts, and NISA accounts. If you want to simplify tax procedures as much as possible, it is common to choose a specific account with tax withholding.
Once you have opened an account and deposited funds, choose the ETF you want to purchase. Search by ticker symbol or name, and check the current price, trading unit, and trading volume. Then, choose your order method. Use a limit order if you want to buy at a specified price, or a market order if you want to buy immediately. Once the order is executed, the ETF will be reflected in your account.
If you are purchasing for the first time, it is recommended to start with a small amount to get used to price movements and the flow of transactions. Please note that for Japanese exchanges, trading hours are limited to daytime on weekdays. Also, be aware that you cannot trade outside of these hours.
Points for choosing an ETF
Underlying index or investment target
The first thing you should check is what the ETF tracks. Is it Japanese stocks, US stocks, global stocks, or bonds? You need to choose based on your investment goals and the balance with the assets you already hold. The characteristics of price movements and the level of risk vary greatly depending on the investment target.
Level of trust fees
If there are multiple ETFs tracking the same index, those with lower trust fees tend to be more advantageous in the long term. However, it is important to judge comprehensively based not only on the difference in trust fees but also on the stability and scale of the fund’s operation.
Total net assets and trading volume
ETFs with large total net assets and high trading volume tend to be easier to trade and have smaller spreads. Also, if the total net assets are small, the risk of early redemption increases. If you want to hold an investment stably for a long time, products with a large scale and popularity are safer.
Dividend policy
The ETF you should choose depends on whether you prioritize dividends or capital gains. While high-dividend ETFs offer large dividends, they may have limited room for price appreciation. Choose a product with a dividend policy that suits your life plan.
Presence or absence of currency hedging
Among ETFs that track overseas assets, there are “currency-hedged” types that suppress the impact of exchange rate fluctuations. This is effective if you want to avoid currency risk, but it is important to keep in mind that hedging incurs costs.
Tracking accuracy
While ETFs aim to track an index, they do not match it perfectly. Due to trust fees and operational errors, slight discrepancies arise between the ETF and the index. The extent of this discrepancy is one of the factors to consider when choosing an ETF.
Points to note and risk management for ETF investment
ETFs are convenient and diverse products, but they are not a panacea. No matter how well-diversified they are, losses are unavoidable if the entire market falls, so it is important to fully understand the risks and invest within your means.
First, make sure to invest with surplus funds. If you invest money needed for living expenses or for the near future, you may be forced to sell at a time you do not want to when the market falls.
Next, instead of investing all your funds at once, diversifying the timing of your purchases is also an effective strategy. By buying at different times, you can mitigate the risk of buying at a high price and smooth out your average purchase price.
Furthermore, diversifying your investment targets, regions, and asset types is essential. By combining not only stocks but also bonds, real estate, gold, etc., you can mitigate the impact when a specific asset declines in value.
Also, products with complex structures, especially leveraged or inverse types, are intended for short-term trading and are not suitable for long-term asset formation. It is important to adopt a stance of not touching products whose contents you cannot fully understand.
Finally, review your portfolio regularly. Check about once a year to see if your asset allocation has deviated significantly from your initial plan, and adjust it as necessary.
Summary
An ETF is a financial product that has the structure of a mutual fund but can be traded in real-time on an exchange just like a stock. It has many advantages, such as the ability to invest in a diversified manner with a small amount of money, a tendency for lower management costs, the ability to trade while watching prices, and high transparency of its contents. On the other hand, there are also disadvantages, such as the principal not being guaranteed, the incurrence of trading commissions and spreads, the difficulty of automatic accumulation and reinvestment of dividends, and the possibility that the price may deviate from the net asset value.
The differences from regular mutual funds appear in whether they are listed, the timing when the price is determined, the purchase method, the cost structure, and the breadth of investment styles. It cannot be said unconditionally which is superior; suitability depends on your investment style, such as whether you want to invest steadily with a focus on accumulation or whether you want to trade at your own timing.
The important thing is to correctly understand the mechanics and characteristics of the ETF product and choose one that matches your purpose, time horizon, and risk tolerance. Comparing trust fees, total net assets, trading volume, and the underlying index, while making good use of tax-advantaged systems like NISA, and continuing long-term within your means can be said to be the basics for successful ETF investment.
Speaking of side income methods that even employees of companies that prohibit side jobs or civil servants can do openly (click image)
