Exchange-traded funds (ETFs) are becoming increasingly popular investment instruments in the modern financial market. Offering the benefits of both stocks and mutual funds, they provide investors with trading flexibility and exposure to larger markets while being cost- and time-efficient. In case you have decided to add ETFs to your portfolio, here is a comprehensive guide that comprises all the necessary information about this trading tool: ETF types, how to trade them, their merits and drawbacks, and more.
An exchange-traded fund or an ETF is a collection of underlying assets that can be traded on the exchange. This instrument combines the features of both stocks and mutual funds. Like individual stocks, ETFs are speculated during the trading day within the market hours providing investors with higher liquidity. Like mutual funds, they are considered to be efficient tools to diversify the investment portfolio due to numerous securities on its basis. An ETF can consist of many different assets such as commodities, stocks, bonds, a mixture of them, etc. When it comes to underlying stocks, they can represent one particular industry (e.g. energy, technology, services, etc.) or be a combination of shares from different spheres, be territory limited (e.g. stocks of the US companies) or have global coverage.
An ETF is formed by fund managers or investment companies who own the underlying assets and want to keep track of their behavior. Once created a fund they offer its shares to investors who can buy and sell them on the exchange during trading hours. Here are key ETF characteristics to remember:
A strong technological boost along with high investor demand has contributed to the exchange-traded fund development and its increasing popularity. A big variety of ETFs can be divided into two large groups:
ETFs can also be grouped by type of investment. Let’s have a closer look at the six main components of this classification.
Bond ETF holds a basket of bonds as an underlying asset. It can include various types of these securities such as corporate bonds, convertibles, Treasuries, and others. Bond ETFs like any other type of exchange-traded funds are sold and bought on exchanges when the market is open. In contrast to individual bonds, they are more liquid and don’t have a maturity date, so it’s possible to sell them immediately after purchasing without any fees. This type of ETF is used by many traders to gain a fixed income which comes from the interest accumulated from the individual bonds in the basket. Some examples of bond ETFs include SPLB (a corporate bond ETF), ICVT (a convertible bond ETF), SCHO (a Treasury bond ETF), etc.
Stock ETF (also known as equity ETF) consists of various stocks commonly representing one industry (for example, technology, energy, etc.). In contrast to individual stocks, it allows investors to get exposure to the whole market sector by opening one position, thus, with significantly lower expenses. Stock ETFs are considered to be efficient long-term investments. The majority of them monitor the performance of industry benchmark indexes, thus, are referred to as indexed-stock ETFs. One of the most actively traded stock ETFs in the market nowadays is SPDR S&P 500 (SPY). It tracks the performance of the S&P 500 index.
Industry or sector ETF concentrates on investing in a particular industry. Global Industry Classification Standard (GICS) has defined 11 key sectors that can be widened to numerous industries and subindustries. Here are some of them:
This ETF type provides investors with an opportunity to enter a certain area of their interest while carrying significantly lower risks in contrast to investing in an individual company. Industry ETF examples include the XTN (Transportation ETF), XLE (the Energy ETF), the SMH (Information Technology ETF), etc.
Commodity ETF, as its name suggests, monitors the performance of a certain commodity or a combination of them such as precious metals (gold, silver, etc.), agricultural products (coffee, cotton, etc.), natural resources (crude oil, natural gas, etc.), and others. ETF investing in commodities offers traders a set of benefits. It’s cost-effective since investors don’t need to take ownership over the physical assets, meaning that they don’t have to pay for its storage and insurance. Moreover, they can still take advantage of commodity hedging abilities, protecting them from market downturns. The most popular commodity ETFs focus on precious metals and natural resources. The largest commodity ETF with $65.5 billion in assets is SPDR Gold Trust (GLD).
Currency ETF monitors the price fluctuations of a particular currency or basket of currencies on the foreign exchange (Forex). Like any other type of ETF, it lets investors get exposure to the whole market without having to open numerous positions. What's more, it has proven to serve effectively various investment objectives: be it speculating, diversification, or hedging. Some of the popular currency ETFs include Invesco DB US Dollar Index Bullish Fund (UUP), Invesco CurrencyShares® Euro Currency Trust (FXE), and others.
Inverse ETF (also called short ETF) allows investors to potentially profit from market downturns. Trading this type of exchange-traded fund is very similar to shorting. Inverse ETFs make use of derivatives (e.g. futures) to let investors make their predictions about the possible asset price movements. If the asset price goes down, inverse ETF is going to rise in value proportionally, excluding the brokerage commission and some fees. This type of ETF is mostly used for short-term investments. The list of top inverse ETFs involves:
ETF is a quite easy-to-implement trading instrument suitable for both newbies and seasoned investors. Once you decided to try it out, all you need to do is to follow these steps.
ETF investing is much similar to trading individual stocks. ETFs can be bought and sold on exchanges during market hours. However, one of their biggest advantages, making these assets appealing for new investors, is that they carry a lower level of risk due to the diversification feature. As mentioned above, the first thing you need to do before starting trading ETFs is to choose the platform and open the brokerage account. Then, the process of buying ETF is quite the same as buying stock.
Various types of ETFs may come with different expenses. In general, ETF investing is known to have a lower expense ratio, in comparison to other types of trading (for example, mutual funds). However, to clear up how much it may cost, it’s necessary to pay attention to the following elements:
According to Statista, in 2020 there were around 7602 ETFs worldwide, 2204 of which were in the US. As of 2022, State Street’s SPDR S&P 500 ETF Trust is considered to be the largest ETF globally by market capitalization (about $397.9 billion). Some other popular examples of exchange-traded funds include, but are not limited to:
ETFs attract the attention of many traders mainly due to their cost-effectiveness, simple learning curve, and diversification ability. However, like any trading tool, they are prone to some pitfalls. This table will help you analyze ETF's main pros and cons.
Apart from potential trading returns, ETF investors can profit from dividends in case the underlying asset is dividend-paying. Exchange-traded funds offer two types of dividend distribution:
Depending on the ETF type, dividends can be paid monthly, quarterly, or following a different schedule.
ETF investing has proven to be tax-efficient. In contrast to mutual funds that create many taxable events when being sold, ETF managers don’t have to pay off the assets that traders sell or add new assets when traders want to buy. This way, ETF tax costs stay lower. In all the rest, ETF tax regulation is similar to mutual funds. They involve
Although ETFs are growing in popularity among traders, experts have different standpoints about their influence on the financial market. Some skeptics believe that ETFs reduce market efficiency, foster volatility, and hinder diversification. However, this point of view is refuted by other experts and market researchers, insisting that ETFs don’t carry any harm since they still have quite small footprints on the market. Moreover, formed and developed in the right way, they can have a positive impact on the future market performance.
Creation and redemption is a special approach that controls ETF security supply. These processes involve Authorized Participant (AP) who can be a financial organization, financial expert, or anyone who obtains a significant buying power since the AP is the one who buys all the assets that an ETF is planned to consist of.
The process of ETF creation consists of the following steps:
ETF trading at a premium means that ETF shares value at the market closure exceeds the price of the underlying stock itself (called net asset value). Let’s consider an example. If the ETF monitors the performance of Nasdaq 100 and at the market close its share price is $92 in contrast to $90 of the underlying asset price, this situation will be defined as trading at a premium. To balance the ETF price to NAV, AP has to commence ETF funds creation by buying underlying securities. This process will increase the number of new ETF shares and stabilize their price.
Redemption is an opposite process. AP acquires ETF shares on the market and sells them to the ETF manager, receiving individual underlying stock that he may sell to get potential profit. The process of redemption can be presented in the following steps:
Trade at discount occurs when the ETF shares have a lower value than its basket of underlying assets. Redemption can be an efficient tool to equilibrate this situation. AP buys ETF shares, decreasing their number on the market, this way, making their price grow and get closer to the net asset value.
ETFs have much in common with both mutual funds and stocks. However, they are not the same. Let’s have a closer look at their similarities and differences.
The main similarity between these two investment instruments is that they represent the basket of underlying securities (stocks, bonds, commodities, or a mixture of them). This leads to their two other common points - greater exposure to the market and a diversification opportunity, helping investors to mitigate potential trading risks.
The differences between ETFs and mutual funds are as follows:
The key feature that unites ETF and stock is that they are both traded on the open market. What’s more, an ETF, having in its basket dividend-paying assets, like stock, may also provide investors with extra income from dividends.
When it comes to differences, here are the most significant ones.
Although ETFs have already achieved widespread popularity on the financial market, according to many specialists, they will continue gaining more influence following rapid technological development. They stand out with lower costs, tax efficiency, liquidity, easier management, diversification abilities, and more. However, when considering adding ETFs to the portfolio, it’s crucial to remember that like any trading instrument they imply risk. Therefore, before doing any investment steps it’s necessary to conduct thorough preliminary research and learn more about exchange-traded fund features and their types.
While ETFs represent a basket of underlying assets, stocks are shares of one particular company. This provides exchange-traded funds with a diversification advantage over individual stock investments. Moreover, ETF trading is known to be less risky and more tax-effective. When it comes to similarities, both stocks and ETFs are traded on exchanges during market hours.
ETF is a type of investment instrument that includes a pool of underlying securities, such as stocks, bonds, commodities, currencies, etc. Like stocks, they are traded on the open market, providing investors with more liquidity in contrast to mutual funds. Moreover, consisting of several assets they allow for a greater market exposure without opening numerous positions.
ETF investing fits both beginners and experienced traders. It comes with a high level of liquidity, a wide choice of ETF types (stocks, bonds, currencies, commodities, etc.), diversification, tax efficiency, etc. However, like with any other investment tool, it’s recommended to first educate yourself, learn more about ETF features, benefits, and possible challenges. This will help you develop a strong investment strategy and reduce potential trading risks.
ETFs may pay out a dividend distribution if the basket of the underlying asset includes dividend-paying securities. The payment is usually done on a monthly or quarterly basis, depending on the asset type.
Every type of investment carries a particular risk. If managed correctly in compliance with a robust trading strategy and risk management plan, it can be mitigated. Since ETFs hold a basket of securities at their core, investors can take advantage of their diversification and hedging features while trying to protect their funds from unexpected market fluctuations.
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