Everything You Need to Know About Exchange Traded Funds (ETFs)

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Exchange traded funds (ETFs) are almost like mutual funds but somewhat different. While exchange traded funds are bought and sold from other owners and traded on an exchange throughout the day (stock exchange time), mutual funds are bought from issuers and sold at the close of the day- at the price of the commodities at the close of the day.

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ETFs are designed to track underlying assets from various industries like the technology industry, replicating their index. What this means is that most ETFs are index funds or index trackers, that is, they are mutual funds and ETFs designed to follow certain guidelines that enable them to track a basket of underlying investments. For instance, in the US, popular Exchange Traded Funds (ETFs) track the S&P 500 indexes, stock exchange indexes, commodities such as good and oil, stocks and bonds, securities and replicate their indexes.

Exchange traded funds operates on an arbitrage mechanism  that enables it to keep it trading close to the net asset value of the underlying assets its trading.

Defining Exchange Traded Funds (ETFs)

Exchange Traded Funds (ETFs) basically refer to a pool of assets or securities that can be traded on an exchange. It is a pool of tracked related or unrelated securities and assets such as stocks, bonds and loans, shares, commodities like gold etc. All collectively traded on an exchange.

Simply put- Investment Funds pooled from trading a pool of exchanged assets such as products and securities. What makes this different from stock is the singularity of trading stock on an exchange. ETFs provides a variety.

Understanding Certain Financial Terms

In order to aid a comprehensive understanding of Exchange-Traded Funds (ETFs), it is essential to have an understanding of certain financial terms.

What is a Security?

Security is a financial instrument that can be traded between parties in the open market. There are four types of securities. These are; debts, equity, derivative and hybrid securities.

Debts Securities

Also known as fixed-income securities, represent money borrowed which must be paid back based on contractual agreement that includes the interest and maturity date.

Equity Securities

It represent the ownership interest held by a shareholder in a company.

Derivative Securities

These are financial instruments whose value solely hinges on basic variables such as assets like stocks, bonds, currencies, interest rates, market indices, and goods. Its main purpose is to put risks at par by controlling it and minimizing it.

There are 4 types of Derivative securities. These are; Futures, Forwards, Swaps and options.

  • Futures

It simply means an agreement between two-party to buy and deliver an asset on an agreed upon date in the future.

  • Forwards

Forwards, also known as forward contracts are similar to Futures. The only difference is that unlike Futures, they are not traded on an exchange. They are limited to retail.

  • Swaps

Swaps refer to an exchange of 2 different kinds of cash flow.

  • Options

Options contracts also refer to the agreement between two parties on the purchase or sale of an asset on a predetermined date. Although, there is a clause or option that the buyer is not required to complete the action of buying or selling.

Hybrid Securities

This type of security combines characteristics of both debt and equity securities. Many banks and organizations turn to hybrid securities to borrow money from investors.

The Exchange Traded Funds (ETFs) are a popular choice for diversification among investors. This is because of its underlying multiple assets unlike stock which is a single asset.

An ETF can own hundreds or thousands of stocks across various industries, or it could be isolated to one particular industry or sector. While some funds are US-centric, others focus on a global scale.

There are thousands of ETFs available for investment purposes around the globe. They all offer various stocks, assets, markets and investment strategies. It is not possible to list and discuss all of them in this article but the common ones will be discussed.

The Common Types of Exchange Traded Funds  (ETFs)

Commodity ETFs

These types of ETFs are difficult to access compared to stocks. Although, the commodity ETFs provide the fantastic opportunities for the investor to come in contact with such commodities like gold, silver or Crude oil. These commodities are an attractive alternative to stocks in the case where the investor is looking to diversify his portfolio and risk. However, commodity ETFs can be less transparent than index or stock ETFs.

Investors often don’t directly own the underlying assets like gold and crude oil, but rather use derivatives instead. Derivatives track the price of the underlying commodities but can carry more risk, such as counterparty risks compared to ETFs that own the underlying assets directly.

Currency ETFs

The Currency ETFs could either be mono-centric or poly-centric. That is, it could choose to invest in a single currency like the US dollar or choose a basket of currencies in a poly-centric case. It directly invests in the currency or it uses derivative, and can mix both.

Using derivatives can potentially add more risk to the ETF, so the investor needs to be sure of what he is buying. The reason for buying a currency ETF spans from the thought that the underlying currency is likely to strengthen or wanting to protect or hedge your investment portfolio. Some ETFs that invest in offshore markets may already ‘hedge’ against currency risk.

Equity ETFs

As the name implies, the Equity ETFs track an index of equities. The intending investor can choose ETFs covering large businesses, small businesses, or stocks from a specific country. Equity ETFs also let you target sectors that might be doing well at that time, like tech stocks or banking stocks, which makes them a popular choice.

Bond/Fixed Income ETFs

It’s important to diversify your portfolio. Spreading your investment risk is an expedient practice. That’s why most professionals will also invest in fixed-income and bond ETFs that provide steady return at potentially lower risk than equity ETFs.

Specialty ETFs

The special ETFs comprise of two fund types which recently emerged to meet very specific needs. They are leveraged funds and inverse funds. These specialty ETFs offer much greater growth potential but also a much higher risk.

Inverse funds

Inverse funds go up when the target index goes down. It is similar to traders short-selling a stock as the price falls.

Leveraged funds

Leveraged funds on the other hand aims to maximize returns by borrowing more money (leverage) to invest.

The Inverse and Leveraged fund ETFs pose a high level risk, so it is paramount for the intending investor do his research before investing.

Sustainable ETFs

These range of ETFs have become an attraction for investors.  Sustainable investing combines traditional investment approaches with environmental, social and governance insights. Sustainable investing is growing across a wide range of investors. The demand is being driven by trends in demographic shifts, government policies and evolving views on risk.

Factor ETFs

This type of ETF involves targeting specific drivers of return across asset classes. Institutional investors and active managers have been using factors to manage portfolios for decades. A common way to access factors is through rule-based ETFs also known as “Smart Beta”.

Advantages of Trading Exchange Traded Funds (ETFs)

  1. Multiple options

Since the Exchange Traded Funds (ETFs) comprise of various tradable assets, bonds, securities packed in one, it offers the investor multiple options.

  1. Reduced risk

Since the Exchange Traded Funds (ETFs) comprise if diverse assets, it reduces the risk if trading a while combined compared to stocks which us a single asset.

  1. Cost Effective

The ETFs us cost effective as every Tim, Dick and Harry can afford to invest and trade. Although charges and commissions by brokerage us applicable.

  1. Stress free

The ETFs provides a variety of assets across diverse industries. It enables the trader to make his choices to the best if his satisfaction. The trader can trade ETFs at anytime during trading hiurs.

  1. It is Tax Efficient

Since ETFs can be held for a very long period of time and have no distributed capital gains, this makes it possible for the investor to pay less tax.

  1. Can be purchased in dibs and drabs

ETFs can be bought in dribs and drabs making it super affordable. This enables the investor to take small positions.

Disadvantages of Trading Exchange Traded Funds (ETFs)

  1. Diversification can be mismanaged. There are some ETFs that engage in over-diversification. This often leads to the inability to manage the over-diversified assets.
  2. Rebalancing has become a noted disadvantage in ETFs.

It has been seen that most ETFs struggle to rebalance their portfolio due to tracking indexes that decline and become a smaller percentage. Owning such ETFs will put you at a disadvantage.

To conclude, there are about 8000 Exchange Traded Funds (ETFs) globally. The reason for this increased number is largely pinned to investors’ demands and a continuous improvement in technology which has aided easy-to-trade ETFs and made them cost-effective.

The Common Types of Exchange Traded Funds (ETFs) listed in the article can serve as a guide for intending investors.

If you have any questions, kindly comment below.

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