ETF trading: what you need to know
Exchanged Traded Funds (or ETFs) are a type of security that tracks assets listed on the stock exchange. These include financial instruments such as bonds, currencies, futures contracts, and stocks; or physical commodities such as precious metals and agricultural goods.
Interested in trading ETFs? Here is an overview of what you need to know to get started.
How do ETFs work?
ETFs are listed on the stock exchange and replicate the performance of a stock market index. They can be traded throughout the day under instant market conditions, and for the same brokerage fees as stocks. To either buy or sell ETFs, simply place an order through your usual broker.
There are various types of ETFs available on the market. For the purpose of diversification, you may want to invest in a few:
- Stock ETFs provide exposure to a set of equities within a specific sector or specific index, with a basket of stocks from high performing companies, or new ones with interesting potential for growth.
- Bond ETFs include government, corporate, state and municipal bonds, and provide regular income to investors – depending on performance of course.
- Industry or sector ETFs focus on a single industry or sector (energy, tech…) and enable investors to track the performance of companies within that industry.
- Commodity ETFs invest in assets such as crude oil, precious metals, and agricultural goods. They are an interesting asset to hold if there is a slump in the stock market, and are also cheaper than having physical possession of these commodities.
- Currency ETFs track the performance of domestic and foreign currencies, either to speculate on the outcome of political and economic events, or simply to add some diversification to a portfolio.
- Inverse ETFs are a way to make a profit from stock declines, simply by shorting stocks.
Why trade ETFs?
There are several benefits to trading ETFs. Here are the main ones:
- Ease of use
ETFs are marketable securities, which means they can be sold, bought and traded on public exchanges. This makes the trading process quite straightforward and can be carried out through your usual broker.
Also, each ETF has an international securities identification number (ISIN) which makes them universally recognisable and facilitates international trading.
- Cost effectiveness
As always when one decides to trade, costs need to be taken into account. The simple reason for this is that high costs and fees will eat away at any profit you may make. This is why investors should always calculate their expense ratio.
Because brokers charge a commission for each transaction, investing in ETFs is more cost-effective than buying all these stocks individually. Trading ETFs only involves one transaction to buy, and another to sell. Therefore, there are far fewer broker commissions than if an investor were buying and selling several stocks.
Additionally, management fees are lower for ETFs than they are for other types of funds.
Indeed, ETFs are “passively managed” because they mirror a market index and therefore require less management, brainpower and research than mutual funds. These will typically require more active management and have significantly higher costs because fund managers need to actively strategize to “beat the market”.
Finally, tax efficiency should also be considered. ETFs are more tax-efficient than mutual funds because ETF sponsors do not need to redeem or issue new shares each time they want to buy or sell. Therefore, they are not liable to pay tax each time they trade ETFs, unlike mutual funds.
- Diversification and risk management
ETFs can hold many underlying assets, either across multiple industries or specific to a single sector or investment strategy. This makes them a popular choice for investors wishing to diversify their portfolio. In fact, because traders can access hundreds of stocks with only a handful of ETFs, they can achieve the same level of diversification as the largest portfolios out there – by investing only a few dozen or hundred pounds. This is a significant benefit to trading ETFs as all traders know that diversification is key to managing risk.
Therefore, if you only have a small budget to invest, ETFs can be the way to go.
Unlike accumulation ETFs, income ETFs pay out dividends to holders in cash either once or twice a year depending on the fund manager. This is what we call distribution. Accumulation ETFs still pay out dividends; however, these are reinvested directly into the fund (and therefore the index). This is what we call capitalisation.
Careful considerations when trading ETFs
Here are a few things to think about before investing in any ETF.
- Actively managed ETFs
While ETFs are usually passively managed, some are actively managed. In these cases, fund managers have a great involvement in buying and selling company shares. This inevitably leads to higher management costs. Therefore, investors must be sure to know exactly how an ETF is managed in order to calculate the resulting expense ratio.
- Industry-specific ETFs
As we mentioned previously, investors can choose among a wide range of ETFs. These can hold assets from several industries or be specific to just one. The issue with the latter is that they limit diversification and can put your portfolio at risk. This is something to consider as it could seriously hurt the money you invested.
- Tracking errors
Finally, we need to mention tracking errors. These are the difference in performance between a position and its corresponding benchmark at the same point in time. These can be due to a number of factors that investors must research before investing in an ETF. While this discrepancy is usually quite low (and often overlooked as a result), it is worth checking an ETF’s tracking error history in order to assess its risk level and therefore anticipate future performance.
ETFs are a great way of gaining diversified exposure to the stock market without investing too much. They can also save you money in brokerage fees, management fees and tax, which makes them more cost-effective than other types of funds. As always, there are risks to take into account before investing, so make sure you do enough research before you get started.
Last Update on 16/12/21