What is an ETF?
Exchange-traded funds (ETFs) are among the most popular financial instruments that investors add to their portfolios for exposure and diversification.
In this guide:
- What is an ETF?
- How is an ETF created?
- What are the different types of ETFs?
- ETFs vs. mutual funds and index funds
- Popular ETFs
- Advantages and disadvantages of ETFs
- The ETF tax advantage
- Should you invest in an ETF?
- Buying ETFs on margin
- ETF investment strategies
- Investing in ETFs for beginners
- How to trade ETFs with CFDs
- Trade SPDR S&P 500 ETF - SPY CFD
- Why trade ETFs CFDs with Capital.com?
ETFs are baskets of stocks, commodities or other assets that pool investors’ money and track a benchmark to measure their performance. These are typically based around an index, industry or theme. They can track a particular group of shares, bonds, commodities, currencies or other assets.
According to Blackrock, there are now more than 8,000 ETFs available globally, driven by investor demand and improvements in technology that have made ETFs easy to trade. Traded on stock exchanges, ETFs can be bought and sold instantly throughout the trading day, allowing investors to react quickly to market trends – whereas mutual funds are bought directly from the fund manager and prices are settled only once a day.
What is an ETF designed to do? Exchange-traded funds were developed as index investing became increasingly popular in the 1980s and 1990s. The first ETF launched in the US in 1993, as an instrument to track the S&P 500 Index (US500).
Investing in exchange-traded funds provides a way for investors to gain exposure to assets that were not so easy for them to trade previously, such as physical commodities or stocks on international exchanges. For example, commodity ETFs give access to the oil, precious metal and agricultural markets. The first commodity ETF for gold bullion was launched in 2003 on the Australian Securities Exchange. In 2004, State Street Corporation (STT) launched SPDR Gold Shares (GLD), the first US ETF backed entirely by physical gold – it surpassed $1bn in assets within its first three trading days.
Global investment in ETFs and exchange-traded products (ETPs) reached a record high of $8.56trn at the end of the first quarter of 2021, according to research firm ETFGI. Net inflows of money invested in ETFs was at an all time high of $359.17bn during the quarter, beating the previous record of $197.2bn, achieved over the first quarter of 2017.
How is an ETF created?
So, how are ETFs created? New ETFs must be approved by the financial regulator in the market where they will be listed. For example, in the US, the sponsor files a plan with the Securities and Exchange Commission (SEC).
The creation and redemption process allows authorised participants, such as market makers or trading desks at large institutional investors, to place shares of the securities listed in the ETF in trust and create ETF units, which are then sold as shares on the stock market in the same way as company shares.
The process of creating and redeeming shares ensures the ETF price remains in line with its net asset value (NAV).
The shareholders indirectly own the fund’s securities, and typically receive an annual report. Shareholders are entitled to a share of the profits in the form of dividends or interest, and they may get a residual value in the event that the fund is liquidated.
What are the different types of ETFs?
There are many different types of ETFs, covering a range of asset classes and investment approaches.
Equity ETFs track indices covering groups of stocks, such as large companies, small businesses, dividend-paying stocks, companies based in certain countries or specific sectors. For example, technology, consumer, banking and pharmaceutical ETFs allow investors to gain exposure to a variety of stocks in a sector, without the risk of investing in an individual stock that might underperform.
Bond ETFs provide investors with fixed income to diversify away from equity ETFs, which carry a higher risk.
Commodity ETFs allow investors to gain access to liquid and volatile commodity markets, like oil, gold, copper or coffee, which were previously limited to commodities traders registered with exchanges. Commodity ETFs are often based on derivatives rather than the physical asset, so can carry a higher risk.
Currency ETFs track a single currency or a basket of currencies, such as the US Dollar Index (DXY). Some ETFs trade a currency directly, while others trade derivatives or a combination. Currency ETFs allow investors to hedge their portfolios against currency volatility.
Speciality ETFs, such as leveraged ETFs and inverse ETFs, are speciality funds designed for short-term trading with a higher risk/reward potential. Leveraged ETFs borrow money to invest additional funds to maximise returns, typically two or three times the initial investment. Inverse ETFs move in the opposite direction to the benchmark index, allowing investors to make money if an asset falls in value.
Factor ETFs focus on specific market drivers and are often used by institutional investors and active managers. For example, value ETFs are biased towards stocks that represent good value and the potential for share price growth, while momentum ETFs hold stocks that demonstrate rising volume on an increasing share price.
Sustainable ETFs focus on investing in stocks that demonstrate high environmental, social and governance (ESG) standards. Sustainable ETFs aim to eliminate exposure to controversial business practices that do not align with an investor's values.
Country ETFs allow investors to diversify into stocks in other countries that their broker does not offer for trading individually. This has become particularly attractive with the growth of emerging markets.
ETFs vs. mutual funds and index funds
What are the differences between an ETF vs a mutual fund vs an index fund? 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.
Some of the world’s most actively-traded and popular ETFs to invest in include the ProShares UltraPro Short QQQ (SQQQ), SPDR S&P 500 ETF (SPY), SPDR Financial Sector ETF (XLF), Invesco QQQ Trust (QQQ) and iShares MSCI Emerging Markets ETF (EEM).
The SPDR S&P 500 ETF, for instance, provides investors around the world with access to the US stock market and as of August 2021, sees an average daily trading volume of more than 65 million shares. On 9 August 2021, it had more than $384bn assets under management (AUM).
Advantages and disadvantages of ETFs
There are advantages of ETFs over mutual funds that make them a popular choice. ETFs offer stock-like features, tax efficiency and lower transaction and management costs.
There are many reasons why traders and investors choose investing in ETFs rather than other financial instruments.
Portfolio allocation. Traders and investors manage portfolio allocation by buying and selling ETFs to balance targets for certain types of holdings. Moreover, they can trade ETFs to diversify their long-term portfolio holdings.
Diversification. ETF investment provides exposure to sometimes hundreds of stocks spread across different industries and sectors. Building a diverse portfolio with individual stocks or other assets can take more time and require larger sums of money. If an investor is missing exposure to a key market sector or type of asset, they can simply invest in an ETF to fill the gap.
Spread risk. Instead of buying shares in a few individual companies, an investor gains exposure to a large number of companies. This limits the impact on the portfolio if the share price of one of the companies collapses or it goes bankrupt.
Ease of portfolio management. A small number of ETFs is easier for investors to manage than a large portfolio of individual stocks.
Decreased volatility. As diversified assets, ETF prices can be less volatile than individual stocks and make for a more stable portfolio.
Risk management. ETFs can be used to mitigate risk and hedge portfolios, for example against currency volatility or commodity prices.
Tactical positions. ETF trading provides an easy opportunity to trade assets and profit from a particular short-term market trend, such as rallying technology sector stocks or emerging market growth.
Tax efficiency. Capital gains taxes are lower on ETFs than individual stocks and mutual funds and are payable only when the fund is sold.
Lower expenses. Holding a small number of low-cost ETFs will result in traders and investors paying fewer trading commission charges than buying and selling individual stocks. Some ETFs charge an annual management fee of 0.40%, while some large passive index funds charge 0.10%.
Liquidity and cash management. ETFs trading enables investors to maintain exposure to highly liquid assets to be able to manage cash flow and put cash to work.
Transparency. Most ETFs publish their holdings daily so you can see which stocks the fund holds, their weighting and whether the fund has changed its holdings.
While there are benefits to investing in ETFs, there are also drawbacks that investors should be aware of before buying them.
Higher fees than stocks. ETFs have lower management fees than mutual funds, but buying individual stocks carries no fees beyond the commission charged on the trade. And niche ETFs tend to have wider bid/ask spreads and higher management fees, which may make it more profitable to invest in the component stocks individually.
Lower dividend yields. Yields from ETFs that distribute dividends from their holdings can be lower than owning a group of dividend stocks. Investors can select which dividend-paying stocks to invest in, whereas a dividend ETF could hold stocks with lower yields that bring down the average pay out.
Higher risk from leveraged ETFs. Leveraged ETFs are highly speculative assets that use financial derivatives and borrowed funds to multiply returns compared to the benchmark. Some double or triple leveraged ETFs can shed more than two or three times the value of the benchmark. These assets are not designed to be held for long periods and positions must be actively managed.
Lack of control. Unlike choosing when and which individual stocks to buy and sell, investors have no control over the holdings in an ETF, or if and when they are rebalanced. An investor may want to gain exposure to some of the stocks in an ETF but not others.
The ETF tax advantage
As mentioned above, there is an ETF tax advantage over mutual funds and stocks. The creation and redemption model means that ETFs are often reset as they buy and sell securities, so they generate lower capital gains than mutual funds, reducing an investor’s capital gains tax liability.
If a mutual fund manager sells a security for a profit, they must distribute the capital gains to the shareholders. This incurs capital gains tax even if the overall value of the fund falls. Passive ETFs in particular have fewer transactions and portfolio turnover than an actively managed fund.
Should you invest in an ETF?
Are you wondering, should I invest in ETFs? ETFs are a way for an investor to gain exposure to stocks and other securities without requiring extensive research into individual companies.
Buying and selling ETFs through brokerage platforms gives investors real-time control over their portfolios. Some individual investors choose to predominantly trade ETFs rather than individual stocks, to reduce risk in their equity exposure. They can avoid heavy losses if a single company encounters problems or even goes out of business. The rise of dividend ETFs is especially attractive for retail investors, as they can spread their risk across markets and receive regular income in the form of dividend payments.
By providing simple access to previously hard-to-access markets, ETFs open up trading opportunities to more investors. For example, trading gold on an exchange involves navigating premiums on the bid and ask spreads, rolling over futures contracts and dealing with storage requirements, while buying and selling shares in a gold ETF is rather straightforward.
According to Greenwich Associates, ETFs are the go-to index investing vehicle for 78% of institutional investors. They are also increasingly used by individual retail investors for portfolio diversification and exposure to global markets.
It is important to remember, however, that there is still high risk that comes along with all investments. Whether ETFs are a good investment vehicle for you depends on your personal circumstances, risk tolerance and portfolio allocation.
Buying ETFs on margin
If you’re wondering, can you buy ETFs on margin, the answer is yes. As ETFs trade like stocks, they can be bought on margin in the same way.
A broker can lend an investor up to 50% of the value of an initial purchase on margin. Regulations from the Financial Industry Regulatory Authority (FINRA) state that “the current maintenance margin requirement for any long ETF is 25% of the market value, and for any short ETF, the current maintenance margin requirement is generally 30% of the market value.” Leveraged ETF margin requirements are commensurate with the amount of leverage, not exceeding 100% of the value of the ETF.
If an investor’s account balance falls below the margin requirement, they receive a margin call. They must deposit funds in the account to bring the balance back up or sell assets in the account to provide the funds.
Buying ETFs on margin allows investors to open larger positions with the funds they have available and pay back what they borrow with their trading profits.
Before starting, it’s crucial to understand the increased risks – and not just the potential rewards – of trading on margin. It’s best to do a thorough research and educate yourself on how leverage and margin work before trading.
ETF investment strategies
Once you’ve decided to invest in ETFs, you need to decide on an ETF investment strategy. There are several different approaches you can take to investing in ETFs.
Dollar cost averaging. By purchasing an asset like an ETF on a regular basis, you can average out the price you pay for shares over time as the price fluctuates. Rather than making a single investment at a certain price, some purchases will be at higher prices and others at lower prices. This can reduce your average purchase price over time, allowing you to take advantage of dips in the market.
Swing trading. Swing trades capitalise on large swings in the price of an asset. ETFs are ideal for this because they have tight bid and ask spreads, so the difference in price does not get lost in the spread. Investors can choose to swing trade an ETF that covers a specific industry or asset class that they have particular knowledge of that allows them to identify drivers for large price movements.
Asset allocation and sector rotation. ETFs make it easier for investors to construct their portfolio when starting out and rebalance over time. Investors can allocate a portion of their portfolio to a specific sector, such as technology or consumer staples, or a specific asset class, such as bonds or commodities. If their portfolio becomes overweight in a specific sector, they can sell some of their ETF holdings to invest in a different sector so that the portfolio does not become overly concentrated.
Hedging. ETFs offer investors a simple way to hedge their portfolios against downside risk. ETFs are one of the easiest ways of investing in commodities, like precious metals, which provide a hedge against economic uncertainty, rising inflation and low interest rates. While advanced investors can trade put options on specific securities to hedge their portfolios, ETFs make it straightforward to take a short position on a certain sector or the broader market.
Depending on your circumstances, you can choose a combination of ETF strategies.
Investing in ETFs for beginners
Are you wondering how to invest in ETF funds? In some ways, investing in ETFs for beginners is easier than investing in individual stocks, commodities or other securities. They offer broad exposure to major markets and require less time spent on research.
How to trade ETFs with CFDs
Are you wondering about how to invest in exchange-traded funds? Today, one of the most popular ways to trade ETFs is with contracts for difference (CFDs).
A CFD is a contract between a broker and a trader, where one party agrees to pay the other the difference in the value of an asset or security. The trader aims to make a profit from the difference between the price of the asset when they open and close the trade. When you trade an ETF using CFDs, you speculate on the direction of the underlying asset’s prices without actually owning it.
Using CFDs to trade ETFs allows you to try to capitalise on market fluctuations in both directions:
Long – if you think the price will rise, you can take a long position.
Short – if you believe the price will fall, you can take a short position.
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