Exchange-traded funds, more commonly referred to as ETFs, first made their debut in 1993 as obscure financial securities, of which extraordinarily little was known. Over the years, they have grown to be essential tools for both professional as well as retail investors. They are also driving substantial changes in the field concerned with investment management.
What is ETF Trading
- ✔️What are ETFs
- ✔️How do ETFs Work?
- ✔️Types of ETFs
- What is the difference between ETF and ETN?
- ETFs and Mutual funds
- ETFs and Index Funds
- The risks involved with trading ETFs
- How to start trading ETFs
- Pros and Cons of Trading ETFs
As a type of investment, ETFs have their own set of pros and cons to consider before investors add them to their portfolios. But before exploring this, it is crucial to explore more about ETFs, how they compare to similar investment vessels, and how they work.
What are ETFs
At its core, an ETF is a fund that can consist of a variety of assets such as stocks, bonds, commodities, and other assets, which are designed to track a specific index. As with stocks, ETFs are traded daily on stock exchanges, with their prices experiencing fluctuations throughout the day.
How do ETFs Work?
ETFs are created by large money managers who bundle the underlying instruments of the fund together. After a series of regulatory steps have been completed, an ETF is offered for sale to the public and it can then be purchased through a broker.
ETFs are liquid assets and for this reason, traders and investors can purchase and sell them throughout the trading day, as with stocks.
There are a variety of ETFs available, suiting any taste, style, asset class, or industry. Many track a popular index and as the value of the index increases, so does the value of the ETF.
While stock ETFs track stock indexes, other ETFs track indexes for commodities, currencies, and bonds. There are also ETFs that invest in precious metals such as gold and other esoteric offerings which can be specifically designed to mimic fluctuations of something intangible for instance market volatility.
There are also leveraged ETFs that are specifically designed to multiply a particular index or asset class’s daily returns. Leverage, however, comes with increased risks as it can serve to multiply returns as easy as it can multiply the risks and losses that the investor or trader can experience.
The tell-tale sign of a leverage ETF is when words such as ‘enhanced’, ‘ultra’, ‘3x’, or ‘2x’ are coupled with returns that are either better or significantly worse than the overall market.
Types of ETFs
There are several types of ETFs, the following are the most common types:
- Stock ETFs – These hold stocks and are designed for long-term growth. They also carry more risk than any of the other types of ETFs.
- Bond ETFs – These hold government bonds, corporate bonds as well as municipal bonds.
- Industry ETFs – These hold stocks within a specific industry such as technology, mining, or manufacturing.
- Commodity ETFs – These ETFs invest in commodities such as crude oil, precious metals, or others.
- Currency ETFs – These invest in foreign currencies such as the US Dollar or Euro.
- Index ETFs – These hold stocks within a specific market index. They are the most popular as they provide investors with the diversification, security, and reliability of an index fund.
Apart from these types, there are a few others that investors should know about such as an inverse ETF. These ETFs attempt to earn gains through shortening stocks. When a stock is shortened, it is sold with the expectation that the price will decline in value. The stocks are then repurchased at a lower price.
Most inverse ETFs, however, are not actual ETFs, they are exchange-traded notes, or ETNs, which are not a popular investment option for beginners.
Investors may also occasionally stumble upon actively managed ETFs. These, like mutual funds, have an investment manager who constantly oversees the fund. These ETFs may see strong gains over a brief period, but their expense ratios are also higher, and they may not be worth holding over the long-term.
What is the difference between ETF and ETN?
Exchange-traded notes, or ETNs, are related to ETFs but when looked at closely, there are distinct differences between the two assets. Both ETNs and ETFs track benchmarks, often an index, and both trade like stocks. But this is where the similarities begin and end abruptly.
The main difference between ETNs and ETFs comes down to how they are designed. ETNs are products that are structured and form part of both a bond and a derivative. The bond portion provides principal protection while the derivative portion offers upside potential.
Such as with bonds, banks and brokerage firms issue ETNs with maturity dates. However, ETNs do not pay regular interest. Instead, the owner of the ETN will receive a repayment at maturity which is based on the value of the underlying benchmark.
Repayment is guaranteed by the issuer, which means that the money of the investor is only as safe as the issuer. When the issuer experiences bankruptcy, the ETN will disappear. This characteristic makes ETNs inherently riskier than ETFs.
Once they have been issued, ETNs come with annual fees and trade on exchanges just like ETFs. Investors can hold their note until it matures or sells it earlier on the stock market.
Structurally, both ETFs and ETNs work in separate ways. An ETF is a fund that means that the owner holds shares of the stocks, bonds, or other securities in the portfolio. When buying an ETF, the trader or investor becomes a fractional owner of the securities.
An ETN does not involve direct or partial ownership of securities. There are no shares of the index in the ETN, instead, it makes use of derivatives, such as futures and options, to speculate on the price of the index.
Some ETNs are secured against an asset that the investor can claim should the issuer default. However, most ETNs in some countries, such as the United States, are unsecured. So, investor returns will solely depend on the ability of the issuer to repay them.
Where an ETN shines, is the taxation, or the lack thereof. ETNs do not hold securities directly and for this reason, investors cannot be taxed on dividends that are paid by the underlying securities. The only taxes that investors are subjected to are the capital gains incurred at maturity or when the investor sells.
ETFs and Mutual funds
There is some degree of similarity between ETFs and Mutual funds. Like Mutual funds, ETFs allow investors to instantly spread their risk over a variety of investments, often hundreds at a time, as opposed to buying a stock here and there.
Both provide investors with an easier way to become extremely well-diversified. This without the investor spending too much time and transaction cost to build a diversified portfolio.
Diversification is a great advantage in any portfolio. However, it is particularly important for retail investors as it allows them to participate in the upside of a market with lower risk as well as volatility than a portfolio with only three, or more, stocks.
However, Mutual funds do not possess the same liquidity that ETFs are known for. Only close-ended mutual funds trade throughout the day and even then, they are managed and can be leveraged with debt.
More traditionally, open-ended mutual funds are priced at the end of the trading session each day and when there is a shortage of funds, the shares must be sold. ETFs are more liquid and when this increases, their bid-ask spread narrows, making it easier and practical to trade in and out of them.
Another advantage that ETFs hold above Mutual funds is that they typically charge lower management fees. This is primarily attributed to how ETFs and Mutual funds are run.
Mutual fund managers are the primary custodians of the funds. These managers make daily decisions associated with buying or selling which are executed by stock, bond, or commodity traders.
ETFs, however, are exclusively passive; securities are bought in exact proportions to the index that the ETF tracks, and the fund is subsequently divided into shares that are sold. Management on ETFs is only needed on a trivial basis such as when indexing changes or when dividends are distributed.
There are also tax advantages with ETFs such as capital gains which are taxed on money made with the ETF, which does not have to be paid until the fund is redeemed.
ETFs and Index Funds
Index Funds are a subset of passive mutual funds which aim to compete with ETFs. Index funds are mutual funds that track an index. With an absence of active management, index funds tend to have lower fees than mutual funds which are active, but they are not as low as ETFs.
The lower expense is, in part, due to ETF managers not having to conduct daily accounting of both redemptions as well as purchases. These redemptions also force the index fund to trade more often within the fund, than an ETF would.
This may have direct consequences to the index fund where firstly, the commission incurred from trading is deducted from the fund’s overall return and, secondly, the need to keep cash on hand means less invested money at any given time as redemptions must be satisfied.
However, one advantage that index funds have is that they may compensate for this through automatic reinvesting of dividends as well as interest.
The risks involved with trading ETFs
As with other investments, there is no level of guarantee which can be tied to ETFs. When there are close ties to one sector or index, it could mean that a crisis may immediately affect the investor’s bottom line. Asset allocation also spreads the risk but cannot eliminate it.
One other thing to keep in mind with ETFs is how well a particular fund can achieve its goal. This means how well it replicates the returns of a particular index. The difference between the return of the index and that of the fund is referred to as tracking error.
Tracking error can be utilized to narrow down investment options. A greater tracking error translates to greater risk or less management efficiency. Ideally, investors must consider ETFs with less volatility and a narrower risk corridor.
One of the crucial trade-offs of ETFs originates from its defining nature, that indexes are diversified but may not carry the same substantial return potential as that of an individual stock.
Investors who are more risk-tolerant may want to explore instruments that can provide more dramatic returns. ETFs are therefore more suited for investors who have a smaller risk appetite.
How to start trading ETFs
Open an Account
First, investors need to register an account with a broker that offers ETFs. The broker serves as an agent to facilitate the purchase and sale of securities. Opening an account with a broker is like that of opening a bank account.
However, there are some factors that need to be considered when selecting a broker such as the investor’s needs, regulation, trading and non-trading fees, deposit and withdrawal options, trading platforms, and customer support.
To gain better insight into a broker, the investor may consider registering a demo account to explore the broker’s platform and offering in a risk-free environment.
Find and compare ETFs
Once the investor has registered an account with the broker, they can start exploring their options to find a suitable ETF in which they can invest. It should be noted that the costs associated with ETFs can vary from fund to fund, and some of the common features to compare include:
- Administrative expenses, or the expense ratio which are fees that go toward the upkeep of the fund.
- Commissions, which are transaction fees charged every time an ETF is bought or sold.
- Volume – which refers to the number of investors involved with a particular ETF. The more are involved, the easier it is to buy and sell.
- Holdings – Which stocks are contained in the fund and whether they will generate strong returns.
- Performance – The amount of profit generated by the fund, which is important especially for long-term investors but not necessary for active traders, and
- Trading prices – This refers to the price per share.
Pros and Cons
|Underlying assets offered at a fraction of the cost and only one transaction needed||Trading costs with commissions which may be charged|
|Diversification of the portfolio||Not all ETFs have high liquidity|
|Variety of markets and assets||There is always a risk of closure|
|Transparency in fee schedules||ETFs may not provide as much return potential as individual stocks|
|High liquidity||Single-industry ETFs are not always well-diversified.|
|Bond investing is made easier|