Exchange-traded funds are quite mutual funds. It is a pooled investment fund, which replicates and tracks the performance of various assets like indexes, commodities, stocks, etc.
These ETFs can track either one type of securities or asset class or can be a culmination of various types of assets and securities. Also, unlike mutual funds, you can buy and sell ETFs on the stock exchanges as its name suggests.
They will have a price, which will go up and down based on the market. They can be bought and sold multiple times in a day and can be sold short as well. Here is a complete guide to exchange-traded funds, their types, benefits, etc.
How do Exchange Traded Funds Work?
Exchange-traded funds are created by the fund providers. Fund providers tend to own the assets which are part of the funds. By adding various such assets, they create a fund.
The investors will own a part of these funds. One thing to keep in mind is that they are not owners of the assets, but only the share of the ETF. The traders can, therefore, trade their share of ETFs on stock exchanges.
As per many traders, these funds are much more liquid, cost-effective, and also easy to trade. You can also trade these funds to have a much more diversified portfolio and well-mitigated risks, as these funds tend to have multiple types of assets.
These funds can have hundreds of assets under them, which can be from various industries or a single sector. Some of the ETFs tend to target the national market while others are more global with assets from across the world.
Now, not all ETFs are the same. Each one of them has its own set of features like investment quality, risk; market they track, fund provider fees and commissions, diversification, etc. You should do complete research to make the right decision about trading ETFs.
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Types of ETFs
Here are some of the types of ETFs that you should know of:
Commodity ETFs
These ETFs invest in commodities that can range from gold to crude oil. They are quite beneficial when it comes to hedging market downturns. They are also comparatively cheaper when compared with the commodity itself.
Leveraged ETFs
These ETFs chase a gain with the help of leveraging. This means they seek returns on the assets by multiple (2x, 3x, etc.). To leverage these returns, the fund tends to use derivatives like futures contracts and options.
So if the underlying assets rise by 1 percent, then the 2x leverage ETF will rise by 2 percent.
Stock ETFs
Stock ETFs have stocks of various companies in a sector or from various sectors in the basket. These stocks can be from high-performing companies or new entrants with huge potential. This help in diversifying one’s portfolio effectively.
Bond ETFs
If you are in search of ETFs that will provide regular income, then bond ETFs are a perfect choice. The underlying assets in these ETFs are various bonds like corporate bonds, government bonds, local bonds, etc.
Sector-based ETFs
These ETFs are built on assets from certain sectors. The stocks or bonds of the companies that operate in the industry are part of these ETFs. This helps in speculating and chasing the upward movement of a certain industry and gaining from it.
Currency ETFs
As the name suggests, these ETFs work on the underlying assets of currency pairs. These funds track the performance of the currencies.
This can useful in hedging against the volatility of foreign exchanges, speculating currency prices, or diversifying the portfolio.
Inverse ETFs
Inverse ETFs take advantage of the falling price of a stock. Therefore, you can say that they take benefit from shorting.
Shorting is a market process, in which the stocks are sold when they are about to fall in value and bought back at a lower price. When the market falls, the Inverse ETFs will rise in value.
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Pros and cons of Exchange Traded Funds
Here are some of the pros and cons:
Pros
- Tax effective: one of the major benefits of exchange-traded funds that almost every trader should know is, that they are more tax efficient than mutual funds. This is because; the exchange-traded funds have comparatively low capital gain distribution.
- Easy to trade: exchange-traded funds can be bought and sold at any time of the day, unlike mutual funds which can be traded at the end of the day.
- Easy transactions: You can easily place orders on stock exchanges just like trading stocks and bonds on the stock exchanges. You can choose to place stop orders or limit orders as per the requirement, unlike mutual funds.
- More transparent: if you are in search of a fund that is more transparent and carries less risk, then exchange-traded funds are the perfect choice for you. These funds need to report their overall holdings daily, making them much more reliable.
Cons
- Less liquid comparatively: when compared to other investment options, exchange-traded funds are less liquid. It is common in less traded funds, as in them the, ask and bid spreads are quite large. This means you will have to buy the Funds at higher bid prices and sell them at lower prices, making these a comparatively illiquid asset class.
- Trading costs: most of the time ETF fund managers can charge heavy trading costs and commissions. This can be quite a disadvantage for those investors whose portfolio is not that extensive and if they are planning to invest smaller sums. Therefore, it is better to find a no-load fund, if you are planning to invest less amount of money.
- Settlement costs: one of the major issues with ETFs is that there is a time limit of two days for settlement. This means the sale of the ETF will not settle for two days, and that means one cannot reinvest their money for two days minimum.
- Variances: the variances are pretty common in these exchange-traded funds. This is because technical difficulties can take place due to various underlying assets. Since these funds closely follow the assets, any type of change can cause variances.
How to Choose an ETF?
There are a few factors that one should pay attention to while choosing an ETF, like:
- Expenses: This is one of the very first things that most ETF investor looks for in an ETF. Look at the expense ratio of the ETF. The higher the expense ratio, the more you will have to pay the fund manager from one’s earnings. However, keep in mind that, not all the cheaper ETFs will have good performance in the market.
- Volume: Look at the trading volume of the ETF. More trading volume means easier it is to trade them on the stock exchange.
- Performance: Always check the performance of the ETFs. Look at the past trends and the earnings investors could rake in. Though they may not be the best indicator, as the market will always change, still it is a good start nonetheless.
- Commissions: You will have to trade ETFs by paying a certain amount as the commission. But, if possible look for an ETF that can be traded for free without any fee involved.
Conclusion
So, there you go! ETFs are quite an effective tool to invest in. however, you should do complete research beforehand to find a profitable ETF for one’s investment and risk appetite. Always look for a reliable ETF trading platform and have a trading strategy up your sleeve.
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