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What are ETFs

14 minutes
intermediate
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Miguel A. Rodriguez
Miguel A. Rodriguez
05 December 2023
Trade ETFs to get diverse exposure to a range of markets – including indices, sectors, commodities and currencies. Find out what ETFs are and how to open your first position.

ETFs are one of the most popular investment products in the world today. Like traditional managed funds or mutual funds, they give investors access to a diverse range of securities, but they are much more cost-effective. Unlike traditional funds, they can be traded like any regular stock, which puts more control in the hands of the investor. Let’s look at how ETFs work and examine some of the pros and cons.

There is quite a bit you should know before you dive in. If you want to invest in ETFs right away, here is a quick guide: 

How to Trade or Invest in ETFs - Quick Guide 

  • Choose your strategy - Trading lets you speculate on prices using derivatives; investing lets you take direct ownership of ETF;
     
  • Select your ETFs - Buy or trade an ETF to track a sector, an index, stocks from a specific country, a commodity, a currency or fixed income markets;
     
  • Take your position - Create an account with us to open your trade or investment.

For more info about what is an ETF and how it works, you can discover everything you need to know in this guide. 

What is an ETF 

An exchange-traded fund (ETF) is a basket of securities — stocks, bonds, currencies, commodities, indexes, even cryptocurrencies, or some combination of these — that you can buy or trade through a broker. The fund will either physically buy the assets it is tracking or use more complicated investments to mimic the movement of the underlying market. 

ETFs offer the best attributes of two popular assets: They have the diversification benefits of mutual funds while mimicking the ease with which stocks are traded. 

An ETF gives you a way to buy and sell a basket of assets without having to buy all the components individually. The ETF provider owns the underlying assets, designs a fund to track their performance, and then sells shares in that fund to investors. Shareholders own a portion of an ETF, but they don’t own the underlying assets in the fund. Even so, investors in an ETF that tracks a stock index get lump dividend payments, or reinvestments, for the stocks that make up the index.  

While ETFs are designed to track the value of an underlying asset — be it a commodity like gold or a basket of stocks such as the USA500 — they trade at market-determined prices that usually differ from that asset. What’s more, because of things like expenses, longer-term returns for an ETF will vary from those of its underlying asset. 

How to trade or invest in ETFs 

ETFs trade through both online brokers and traditional broker-dealers. 

Trading ETFs with derivatives 

Trading ETFs is a way to get exposure to shorter-term price movements within certain sectors. When you trade ETFs with CFDs, you can use leverage to get amplified exposure to the ETF of your choice. 

As a result, CFDs enable you to open a position for just a fraction of the cost of traditional investing. This means that, while leverage can magnify your profits, it can also magnify your losses. This is because loss is calculated based on the full size of the position rather than the cost of opening that position and can far outweigh any initial deposit, so it is important to create a risk management strategy before you trade. 

ETF Trading Strategies

Below are some strategies you may want to learn more about before taking a long or short position on an ETF. 

Day Trading

Day trading is a technique used by traders rather than investors. It involves buying and selling financial instruments within a single trading day. Day traders attempt to take advantage of small market movements by executing many trades for a relatively small profit each time. 
Markets suited to day trading include forex, indices, commodities, cryptocurrencies and shares

Swing Trading

Swing trading aims to benefit from short-term price patterns, and assumes that prices never go in only one direction in a trend (ie even in a trend, prices will both rise and fall). Swing traders look to make money from the up and down movements that occur in a short timeframe. 
Essentially, traders employing this strategy will attempt to profit from the small reversals in a market’s price movement.

Short-Selling

Short-selling, also known as ‘shorting’ or 'going short’, is a trading strategy used to take advantage of markets that are falling in price. The traditional way to short sell involves selling a borrowed asset in the hope that its price will go down and buying it back later for a profit. 
Using derivative products, such as CFDs, is an alternative way to execute the trade, since these products do not require the exchange of an underlying asset. You are agreeing to exchange the difference in price of your ETF from when the position is opened to when it is closed. 

Hedging

Hedging could be compared to taking out an insurance policy on your securities and is a way to mitigate your losses should the market turn against you. It’s achieved by strategically placing trades so that a gain or loss in one position is offset by changes to the value of the other.
Typically, to hedge a position, you would either take an opposite position in a closely related market, or the same position in a market that moves inversely to your original investment. Although hedging could lessen your risk, please take note that you’ll still incur fees on both positions. 

Buying shares of ETFs directly 

You can also typically purchase ETFs directly. A brokerage account allows investors to buy shares of ETFs just as they would buy shares of stocks. 

This is a longer-term form of gaining exposure to the movements of a specific market or sector. 

Investors may opt for a traditional brokerage account, while traders may opt for derivatives featuring. 

Traders can not only open the more traditional ‘long’ position, but they can take advantage of markets that are falling in price too – known as going ‘short’. This opens a whole other avenue of potential profit while increasing the risk. 

ETF investing strategies

Below are some strategies you may want to learn more about before buying shares in an ETF.

Buy and Hold

A buy-and-hold strategy involves a long-term investment horizon and holding onto your investment despite any fluctuations in the ETF’s value. The theory behind a buy-and-hold strategy is straightforward. Buy an asset and hold it until you need to sell it, during which time you could have benefited from years of capital appreciation and income payments.

Sector Rotation

To diversify your investments, you may want to build a portfolio that profits from different stages of the business cycle. ETFs are a possible way to implement a sector-based strategy. Their relatively low fees allow them to be ‘rebalanced’ when necessary, and their transparency means that you’ll know exactly what the fund is investing in.

Dollar Cost Averaging

Dollar cost averaging involves investing smaller amounts of capital over a period rather than a large sum in one go. When using this strategy, you’ll be averaging out the peaks and troughs of price movements over time. Because prices rise and fall, spreading your investments out means you’ll likely achieve a lower average cost of buying each investment unit. 

Types of ETFs 

Distinct types of ETFs are available to investors that can be used for income generation, speculation, and price increases, and to hedge or partly offset risk in an investor’s portfolio. Here is a brief description of some of the ETFs available on the market today. 

Stock ETFs 

Stock ETFs comprise a basket of stocks to track a single industry or sector. For example, a stock ETF might track automotive or foreign stocks. The aim is to provide diversified exposure to a single industry, one that includes high performers and new entrants with potential for growth. Unlike stock mutual funds, stock ETFs have lower fees and do not involve actual ownership of securities. 

Stock ETFs

Industry/Sector ETFs 

Industry or sector ETFs are funds that focus on a specific sector or industry. For example, an energy sector ETF will include companies operating in that sector. The idea behind industry ETFs is to gain exposure to the upside of that industry by tracking the performance of companies operating in that sector. One example is the technology sector, including Artificial Intelligence, which has witnessed an influx of funds in recent years. At the same time, the downside of volatile stock performance is also curtailed in an ETF because they do not involve direct ownership of securities. Industry ETFs are also used to rotate in and out of sectors during economic cycles. 

Industry/Sector ETFs

Geographic ETFs 

Geographic ETFs enable you to track assets in a specific region. For example, you can trade in a US ETF that grants you exposure across all the US indices, an MCSI ETF that includes Taiwan companies, or an international ETF such as iShares Saudi Arabia ETF (KSA) if you are looking to invest in the Saudi Stock Market or iShares Frontier and Select EM ETF (FM) if you want to gain exposure on the Bucharest Stock Exchange and diversify your portfolio with emerging markets. 

Geographic ETFs

Commodity ETFs 

As their name indicates, commodity ETFs invest in gold, oil, and other commodities. Commodity ETFs provide several benefits. First, they diversify a portfolio, making it easier to hedge downturns. For example, commodity ETFs can provide a cushion during a slump in the stock market. Second, holding shares in a Gold ETF or Oil ETF is cheaper than physical possession of the commodity. This is because the former does not involve insurance and storage costs. 

Commodity ETFs

Currency ETFs 

Currency ETFs are pooled investment vehicles that track the performance of currency pairs, consisting of domestic and foreign currencies. Currency ETFs serve multiple purposes. They can be used to speculate on the prices of currencies based on political and economic developments in a country. They are also used to diversify a portfolio or as a hedge against volatility in forex markets by importers and exporters. Some of them are also used to hedge against the threat of inflation. 

Currency ETFs

Cryptocurrency ETFs

A cryptocurrency exchange traded fund (crypto ETF) is a fund consisting of cryptocurrencies. While most ETFs track an index or a basket of assets, a cryptocurrency ETF tracks the price of one or more digital tokens. They are either backed by physical cryptocurrencies (the investment firm managing the fund makes purchases of cryptocurrencies, and ownership of the coins is represented as shares) or a synthetic variant that tracks cryptocurrency derivatives like futures contracts (for example the only listed Bitcoin ETF).

Cryptocurrency ETFs

Bond ETFs

Bond ETFs are exchange-traded funds that invest in various fixed-income securities such as corporate bonds or Treasuries. Unlike individual bonds, most bond ETFs don't have a maturity date and they trade throughout the day on a centralized exchange, like stocks, so you can buy or sell them at any time during the trading day. The structure of traditional bonds makes it difficult for investors to find a bond with an attractive price. Bond ETFs avoid this issue by trading on major indexes, such as NYSE. 

Bond ETFs

Inverse ETFs 

Inverse ETFs attempt to earn gains from stock declines by shorting stocks. Shorting is selling a stock, expecting a decline in value, and repurchasing it at a lower price. An inverse ETF uses derivatives to short a stock. They are bets that the market will decline. When the market declines, an inverse ETF increases by a proportionate amount. Investors should be aware that many inverse ETFs are exchange-traded notes (ETNs) and not true ETFs. An ETN is a bond but trades like a stock and is backed by an issuer such as a bank. Be sure to check with your broker to determine if an ETN is a good fit for your portfolio. 

Inverse ETFs

Leveraged ETFs 

A leveraged ETF seeks to return some multiples (e.g., 2× like SQQQ or 3× like TQQQ) on the return of the underlying investments. For instance, if the S&P 500 rises 1%, a 3× leveraged S&P 500 ETF will return 3% (and if the index falls by 1%, the ETF will lose 3%). These products use derivatives such as options or futures contracts to leverage their returns. There are also leveraged inverse ETFs, which seek an inverse multiplied return. 

Leveraged ETFs

Examples of popular ETFs  

The first ETF was the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index, and which remains an actively traded ETF today. 

Other popular ETFs to watch are: 

  • The SPDR Dow Jones Industrial Average (DIA) (“diamonds”) represents the 30 stocks of the Dow Jones Index. 
  • The iShares MSCI World ETF (EEM) seeks to track the investment results of an index composed of developed market equities. 
  • ProShares Bitcoin Strategy ETF (BITO) is the first U.S. bitcoin-linked ETF offering investors an opportunity to gain exposure to bitcoin returns in a convenient, liquid, and transparent way.
  • Sector ETFs track individual industries and sectors such as energy (XLE), technologies (XLK), utilities (XLU), or financial services (XLF).
  • Commodity ETFs represent commodity markets, including gold (GLD), silver (SLV), or crude oil (USO). 

The Big 5 ETF Issuers 

The types of ETFs are endless, ranging from bond ETFs and market ETFs to inverse ETFs, foreign market ETFs, and alternative ETFs. 

Vanguard‘s portfolio passed the $1 trillion mark in ETF assets under management (AUM). BlackRock (BLK), which sponsors the iShares ETFs, is the only other firm at that elite level. 

There are five issuers with $100 billion or more in ETF assets under management: 

  • BlackRock: $2.117 trillion 
  • The Vanguard Group: $1.619 trillion 
  • State Street Corp., the sponsor of SPDR ETFs: $881 billion 
  • Invesco Ltd.: $308 billion
  • Charles Schwab: $214 billion 

The Biggest ETFs 

All 50 of the biggest ETFs, which range from $23 billion to $329 billion in AUM, are offered by these five top issuers. The five largest funds are: 

  • SPDR S&P 500 ETF Trust (SPY) from State Street: $329 billion 
  • iShares Core S&P 500 ETF (IVV) from BlackRock: $249 billion
  • Vanguard Total Stock Market ETF (VTI): $213 billion
  • Vanguard S&P 500 ETF (VOO): $194 billion
  • Invesco QQQ Trust (QQQ): $152 billion 

Among the 50 largest ETFs, BlackRock offers 21, Vanguard sponsors 19, State Street issues six, and Invesco has one. 

What you need to know before you invest in ETFs 

ETFs make up 30% of all U.S. trading in terms of value, according to Barron’s. Investors have flocked to them because of their simplicity, relative cheapness, and access to a diversified product. 

Today, there are hundreds of ETFs traded regularly on major exchanges. There are both positive and negative aspects of ETFs, a smart investor should consider both elements before investing. 

Advantages of ETFs 

Since their introduction in 1993, exchange-traded funds (ETFs) have exploded in popularity. For most individual investors, ETFs represent an ideal type of asset with which to build a diversified portfolio. 

Easy diversification 

Get exposure to an entire market, country, or region with one trade.

ETFs are a cost-effective investment product 

It only takes one transaction to trade fully. diversified index. The cost of investing in ETFs attracts lower fees (lower management expense ratio) than investing in actively managed equity funds, and even some equity index funds. A low minimum initial investment of $500 (for ASX-listed ETFs)

Safety

ETFs hold the underlying securities in a trust separately from a custodian.

No maturity date

Unlike managed funds, ETFs do not have minimum holding periods or early-withdrawal fees.

Leverage and shorting  

Just like shares, ETFs can be bought or sold. They can also be traded through gearing facilities such as a margin loan or CFDs. While leverage can increase exposure and profit potential it can also increase the risk. 

Transparency

ETFs, particularly index funds, aim to disclose their holdings regularly so you can see exactly what you hold in your portfolio. 

Risks of ETFs 

It can be easy to get caught up in the hype of how great exchange-traded funds (ETF) are. Yet they still come with many of the same risks as stocks, plus some unique risks for ETFs. Here's a look at the "fine print" for ETFs. 

Currency risk 

Investing in ETFs with an international focus exposes your capital to currency risk as well as local equity returns. 

Liquidity 

Liquidity varies between ETFs, and it influences the buy/sell spread (or cost) you’ll encounter when trading. 

Tracking error 

The return on the portfolio may deviate from the return on the index or benchmark tracked. These errors are more significant when the ETF employs a strategy other than full replication of the underlying index.

Lack of price discovery 

If a preponderance of investors holds ETFs and do not trade the individual stocks that sit inside of them, then price discovery for the individual securities that constitute an index may be less efficient. In the worst case, if everybody owns just ETFs, then nobody is left to price the component stocks and thus the market breaks.  

ETFs vs. mutual funds and index funds  

What are the differences between ETFs, mutual funds, and index funds? The term ‘mutual fund’ refers to the way a fund is structured. Investors ‘mutually’ pool their resources to invest in the market. Rather than trading shares in the securities held in the fund, investors buy and sell shares in the mutual fund company.  

Index funds are a type of fund that aims to replicate the performance of a specific stock market index, while mutual funds are actively managed and aim to outperform the index. An index fund can be structured as a mutual fund or an ETF.  

ETFs were developed to provide investors with a more tax-efficient alternative to mutual funds with higher liquidity. Mutual funds are bought directly from the fund manager and prices are settled only once per day. ETFs are marketable securities that can be bought and sold on stock exchanges instantly throughout the trading session. This allows investors to react quickly to market trends.  

ETFs offer a flexible, lower-cost alternative to mutual funds, as passive index-based funds have lower management fees than actively managed funds. ETFs act like stocks in that they can typically be sold short, bought on margin, and offer options. ETFs share some common features with mutual funds – they both are made up of a diversified basket of securities – but, typically, they don’t require a minimum investment, as most mutual funds do. ETFs usually offer lower expense ratios and broker fees.  

How to trade or invest in ETFs with CAPEX.com

  • Open a live account - We offer hundreds of exchange-traded funds on our platform, including popular titles from iShares, Invesco, Vanguard and ARK Invest.
  • Choose your products - Learn about the differences between investing and CFD trading before opening a position.
  • Build an effective risk management strategy - Read about our execution and order types to see how stop-loss and take-profit orders can help to prevent capital loss.
  • Pick your ETF - Read our article on best ETFs for 2024 to discover which fund can get you the highest dividend payout.

 

FAQs about ETFs

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Miguel A. Rodriguez
Miguel A. Rodriguez
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Miguel worked for major financial institutions such as Banco Santander, and Banco Central-Hispano. He is a published author of currency trading books.