Exchange-traded funds (ETFs) can be a useful way to diversify your portfolio, speculate on markets and track the value of given assets. But what are ETFs, and how can you use them in your trading? Here are the essentials on ETFs, to help you make the most of your trading operations.
What is an ETF?
An exchange-traded fund (ETF) is a type of investment fund that can be traded on an exchange, much like a stock. ETFs are similar to mutual funds in that both are investment funds, but where ETFs are bought and sold throughout the trading day, mutual funds are not traded on an exchange and only trade once a day when the market closes.
ETFs are created by the fund providers who own the underlying assets, who design funds to track their performance, then sell shares in that fund to investors. Shareholders own a portion of an ETF, but don’t own the underlying assets in the fund.
Types of ETF
Being a tool used by a number of different traders on the stock market, there are many different types of ETF. Some examples include:
- Bond ETFs- these differ from regular bonds due to their lack of a maturity date, and are commonly used to generate regular cash payments generated by the individual bonds to investors.
- Commodity ETFs– these invest in physical commodities, such as agricultural goods, natural resources, and precious metals. A commodity ETF is usually focused on either a single commodity or investments in futures contracts.
- Currency ETFs– these track the relative value of a currency or a basket of currencies. They can be used to speculate on forex markets, diversify a portfolio or hedge against currency risks.
- International ETFs- these specialise in foreign securities, and may track global markets or track country-specific benchmark indexes. Investors can use them to diversify the geographic and political risks associated with their portfolios.
- Sector ETFs- these provide a way to invest in one of the 11 sectors that comprise the stock market rather than the broad market, which can be useful to investors tracking business cycles.
- Stock ETFs- these, appropriately enough, comprise stocks and are primarily meant for long-term growth. They are typically less risky than individual stocks, but carry more risk than other types of ETF.
How to buy and sell ETFs
ETFs trade through online brokers and traditional broker-dealers, just like regular stocks. They are also unique compared to other types of fund as they can be bought and sold at any time during the day.
Like stocks, ETFs can be traded on exchanges and have unique ticker symbols that let you track their price activity. However, it is important to keep in mind that they represent a basket of assets, while a stock represents just one company.
Pros and cons
While ETFs can be a useful tool in a trader’s arsenal, investing in them does not come without risks, and it is important to understand how they work before you start using them in your trading operations. With this in mind, here are some pros and cons of exchange-traded funds:
- Diversification- ETFs allow investors to diversify their portfolios across industries quickly and easily, with a single ETF delivering the benefits of multiple baskets at once.
- Easy to trade– as ETFs can be bought and sold at any time during the trading day, they are easier to trade than similar funds such as mutual funds, which can only be bought and sold at the end of the trading day.
- Liquidity- as a result of their unique qualities on the stock market, ETFs tend to be more cost-effective and liquid than mutual funds.
- Lower fees- ETFs, which are passively managed, have much lower expense ratios compared to actively managed funds, which mutual funds tend to be.
- Transparency- anyone with internet access can search the price activity for a particular ETF on an exchange. A fund’s holdings are also disclosed each day to the public, whereas that only happens monthly or quarterly with mutual funds.
- Tax benefits- with ETFs, investors are typically only taxed upon selling the investment, while mutual funds are taxed over the course of the investment.
- Illiquidity- Some thinly-traded ETFs have wide bid/ask spreads, which means you’ll run the risk of buying at the high price of the spread and selling at the low price of the spread.
- Potential risk- Investing in any security puts you at the mercy of current market prices when it comes time to sell, but ETFs that aren’t traded as frequently can be harder to unload.
- Risk of shuttering- if a fund hasn’t brought in enough assets to cover administrative costs, there’s a risk that it could close down. This means that investors must sell sooner than they may have intended, possibly at a loss. In addition, an ETF shuttering presents the frustrating prospect of having to reinvest the money, as well as the risk of potential tax burdens.
- Trading costs- Because ETFs are exchange-traded, they may be subject to commission fees from online brokers- while many brokers have decided to drop their ETF commissions to zero, not all of them have.