ETFs: What are they and how can you trade them?

An ETF, or exchange-traded fund, is a type of security that can track a stock index, a sector within a stock market, a single commodity, or other financial assets such as government bonds. It can contain, for example, stocks of companies that operate in a particular sector, such as oil producers. Or it can be even more specific and may only contain companies that are connected to US shale oil, for instance. By grouping together different companies in a related field, an ETF can give you exposure to a specific sector while simultaneously providing diversification. It’s also cheaper and takes less time than buying all the individual stocks yourself.

ETFs are also versatile and convenient. You can trade in and out of an ETF with the single click of a mouse. You can also go short, trade on margin, and purchase small amounts if you wish. In addition, there are ETFs that have been structured to track a specific investment strategy, such as taking a leveraged short position on US stock market volatility.

ETFs versus mutual funds

ETFs are often compared to mutual funds but there are a few fundamental differences. For a start, ETFs are exchange-traded, just like a company’s stock. This means they can be bought and sold throughout the trading day, quite unlike a mutual fund. Furthermore, the holdings in an ETF are disclosed each day to the public, whereas that happens monthly or quarterly with mutual funds.

Most ETFs are passively managed investments simply tracking an index, such as the S&P 500 or NASDAQ 100. Some investors prefer the more active, hands-on approach of mutual funds which are run by a professional manager who tries to outperform the market. Although there are actively managed ETFs that mimic mutual funds, these come with higher fees.

Index ETFs

There are hundreds of ETFs in existence and new ones are created all the time. An ETF creator, or sponsor, is typically an institution that groups together baskets of assets under one banner with its own stock market identifier, or ticker. The provider then sells shares in that fund to investors who will own a portion of the ETF, but not the underlying assets in the fund. However, investors in an ETF tracking a stock index may receive dividend payments, or reinvestments, for the stocks that make up the index.

While many ETFs are designed to track the value of an underlying asset or index, typically they trade at market-determined prices that usually differ from that asset. In addition, there are usually costs involved which the sponsor covers by adjusting the price of the ETF. This means that longer-term returns for an ETF will vary compared to its underlying asset.

Inverse and leveraged ETFs

When you buy an inverse ETF on an index such as the S&P 500, you’re hoping to make a profit if the underlying index falls in price. This can be an effective way to hedge a portfolio of stocks without the expense and bother, not to mention the possible tax implications of borrowing and then shorting, or even closing out multiple positions on individual stocks.

However, many traders warn that an inverse EFT should only be used as a short-term hedging method because of the way it is structured, which can involve forwards, swaps and futures. In essence, inverse ETFs are designed for traders looking for short-term tactical trades. This may not be the right vehicle for you, so make sure to carry out thorough due diligence.

There are also many popular leveraged ETFs. These are designed to multiply your profits by a factor of two or even three, assuming you correctly identify which way the market moves. These can enhance your returns on sharp moves in the right direction, but you will also accumulate losses at a similarly high-leveraged level if you are wrong. Like inverse ETFs, they are only suitable for short-term holdings, and even if you get the overall direction of travel correct, they can still result in losses if held for more than a day or two.

Other issues

While it’s unwise to ask too many questions about what goes into making a pork sausage, you can never ask too many about the contents of an ETF. There may be stocks in there that you may not want to own, or that don’t align with the type of exposure you’d like. For instance, an ETF often has a heavy weighting towards just one or two stocks. Similarly, it could exclude smaller, potentially more interesting stocks as their market capitalisation may be below a certain threshold, thus deemed unsuitable to hold in the ETF by the sponsor. You may be perfectly happy with that, or you may feel that the ETF isn’t giving you the kind of exposure that you’re after.

Another issue is that ETFs have become victims of their own success. They have proved very popular with both investors and traders, encouraging sponsors to create new funds. Unfortunately, this means that trading volumes can be extremely light in some ETFs, which makes them illiquid and difficult to trade. So, the bottom line: make sure you know what you’re buying and that it fits your investing style.