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.

Financial spread trading comes with a high risk of losing money rapidly due to leverage. You should consider whether you can afford to take the high risk of losing your money.

Education feed

Editors’ Picks

EUR/USD hits three-week highs after the Fed, dismal US growth figures

EUR/USD approaches 1.1900, hitting the highest in three weeks. The dollar is falling across the board after the Fed refrained from pre-announcing tapering and sees inflation as transitory. German CPI beat estimates with 3.8% YoY in July. US GDP misses expectations.

EUR/USD News

GBP/USD soars above 1.3950 on Fed dovishness, Brexit optimism

GBP/USD is trading above 1.40, extending its gains after the Fed seemed reluctant to taper bond buys. The EU's suspension of legal action over the NI protocol supports sterling. UK scraps quarantine rules for fully vaccinated EU, US travelers.

GBP/USD News

USD/JPY: Risk-on limits declines

USD/JPY consolidates gains on Thursday in the initial trading session. Lower US Treasury yields undermine the demand for the US dollar. The yen remains unchanged after the BOJ summary of opinions suggests a longer accommodative monetary policy.

USD/JPY News

Editors’ Picks

EUR/USD hits three-week highs after the Fed, dismal US growth figures

EUR/USD approaches 1.1900, hitting the highest in three weeks. The dollar is falling across the board after the Fed refrained from pre-announcing tapering and sees inflation as transitory. German CPI beat estimates with 3.8% YoY in July. US GDP misses expectations.

EUR/USD News

GBP/USD soars above 1.3950 on Fed dovishness, Brexit optimism

GBP/USD is trading above 1.40, extending its gains after the Fed seemed reluctant to taper bond buys. The EU's suspension of legal action over the NI protocol supports sterling. UK scraps quarantine rules for fully vaccinated EU, US travelers.

GBP/USD News

XAU/USD climbs to two-week tops, beyond 200-DMA post-US GDP

Gold built on the previous day's post-FOMC rebound from the vicinity of the $1,790 horizontal support and gained strong follow-through traction on Thursday. 

Gold News

SPY up, GDP down, China goes green, FB goes red, RobinHOOD launches

China stocks went green for the day on Wednesday and no it wasn't St. Patrick's day but perhaps a dead cat bounce? The Fed certainly helped the green shoots as it continued its doveish stance saying there was no sign yet of dialing back ultra-loose policy.

Read more

XRP in a league of its own as BTC and ETH  pull back

Bitcoin price is setting the stage for a pullback after a 40% upswing. Ethereum price is following BTC but might undergo consolidation. Ripple price defies its run-up, suggesting a minor correction might be enough before another rally begins.

Read more

RECOMMENDED LESSONS

7 Ways to Avoid Forex Scams

The forex industry is recently seeing more and more scams. Here are 7 ways to avoid losing your money in such scams: Forex scams are becoming frequent. Michael Greenberg reports on luxurious expenses, including a submarine bought from the money taken from forex traders. Here’s another report of a forex fraud. So, how can we avoid falling in such forex scams?

What Are the 10 Fatal Mistakes Traders Make

Trading is exciting. Trading is hard. Trading is extremely hard. Some say that it takes more than 10,000 hours to master. Others believe that trading is the way to quick riches. They might be both wrong. What is important to know that no matter how experienced you are, mistakes will be part of the trading process.

Strategy

Money Management

Psychology