What is ETF? How to Trade them

What is ETF

Let’s say you want to buy an apartment. You made a visit to an apartment that is well furnished, decently lavish and within your budget also but doesn’t have proper ventilation with the required number of balconies and green space. And you visited another apartment that is less lavish but has greater outer space for natural air ventilation. But what if you want both facilities in an apartment that suits your budget. What if you need something extraordinary from a regular deal? What is ETF? In terms of investment, an ETF can offer you something extraordinary.  

What is ETF (Exchange-Traded Fund)?

An ETF or Exchange-Traded Fund is a security that can be traded like stocks on the stock exchange. An ETF is also known as a basket of securities. Exchange-traded funds (ETFs) can be a lucrative option for investors with less experience in the stock market. With ETFs, the exposure gained by retail investors in the stock market is much better. In addition, ETFs have high liquidity because of the regular fluctuation in price due to buying and selling ETF shares throughout the day. 

An ETF represents indices, commodities and securities. Most ETFs use numerous financial resources to buy various asset classes covering shares, equity, bonds and derivatives. They are quite similar to mutual funds, but the core difference between ETFs and mutual funds is that, unlike mutual funds, an ETF can be traded at any time on the stock exchange, just like stocks. In addition, traders can buy or sell the ETF directly from a brokerage account. As a result, ETFs required less cost than required in many forms of investing.

An ETF can hold multiple underlying assets, unlike stocks. Stocks can hold only one underlying asset. Therefore, traders who want to diversify their portfolio by choosing less complex ways often choose an ETF as a great option because an ETF can hold multiple assets.

ETFs can own various asset classes, but it would be good for traders to figure out the ETF that owns the securities from a specific industry. For example, an ETF focused on the oil industry would likely contain thousands of stocks related to the oil industry.   

How do Exchange Traded Funds Work?

AS mentioned above, up to some context, ETFs are quite similar to mutual funds and stocks. At the time of equity trading, ETFs can be bought or sold on major stock exchanges. More ETFs usually come out of the mechanism called ETF creation. ETF creation is a process of buying shares from the index and exchanging them with the ETF at the same price for the return of new ETF shares.

When fund managers of an ETF provider manage assets in a good manner, that will reflect the dividend value received by ETF shareholders. Generally, ETFs can be managed by two methods-actively and passively. In the case of actively managed ETFs, the role of a portfolio manager increases as s/he has to watch the market conditions and take a detailed approach to calculate risks and invest accordingly.

In actively managed ETFs, a portfolio manager monitors the holdings within the fund. On the other hand, passively managed ETFs depend more on how the company is rising and how particular market indices are performing with trends. The expense ratio of well actively managed ETFs is typically higher than that of passively managed ETFs.

ETF share prices vary according to the variation in prices of underlying assets contained by a pool of financial resources. For example, suppose the price of petrol rises; then you can also witness a significant rise in ETF price.

Types of ETFs

ETFs can be of various types as per the industries and sectors. But here are the most common types of ETFs.

Index ETF

The ETF’s expense ratio of index ETFs is the lowest among all kinds of ETFs. By investing in an index ETF, you can benefit from the profit gain in securities of that index. They are the oldest ETFs. Index exchange-traded funds buy shares that are associated with the corresponding index. You can trade ETFs as they have decent liquidity in the financial market. 

Commodity ETF

Gold ETF is a significant part of commodity ETF. Commodity ETFs buy commodities and diversify the portfolio for several benefits. Let’s take the example of gold ETFs. They own physical gold assets. Gold ETFs provide opportunities for traders to participate as the owner of gold in the bullion market. So gold ETFs shred off the responsibility of physical gold protection for you.

It is much cheaper and convenient to hold shares in commodity ETFs without physically owning them, eliminating insurance costs. Plus, you also don’t have to store the commodity physically, which means there are no storage costs and making charges. There is an involvement of an ETF certificate just like a stock certificate as there is no physical possession of the commodity. The alternative method to buy the gold ETF is systematic investment plans (SIPs).

Bank ETF

Bank ETFs are highly volatile because of huge financial activities in banks and other financial institutions. In addition, Bank ETFs contain stocks of banks listed. As they are highly liquid, too, you can trade ETFs on margins and monitor the price movement for technical analysis and trade accordingly. 

Stock ETF

Stock ETF is known as the basket of stocks. Similar to commodity ETFs, you can hold stock ETFs without actually owning the securities. Stock ETFs contain stocks from a specific industry, and traders can get a diversified exposure of various stocks from that particular industry. This is the reason why ETF is a safe haven for investors with low capital amounts. In addition, most ETFs invest in foreign-based securities to provide opportunities for potential growth.

Bond ETF

Bond ETFs track assets, including corporate bonds, government bonds and municipal bonds. A municipal bond is a term that is used to determine state and local bonds. By investing in bond ETFs, one can generate regular income by incurring profits from the underlying bonds. In addition, you can gain passive exposure to the benchmark index by investing in bond ETFs.

How well underlying bonds are performing will decide the income distribution for investors, as there is no maturity date. As a result, traders often trade ETFs at a discount on the actual price of bonds. 

Currency ETF

Currency ETFs track forex currency pairs. The price of currency ETFs fluctuates by the impact of economic reforms of a country and exchange rates. The change in diplomatic position also results in the volatility of currency ETFs. They can be traded as a hedge against volatility for the diversification of a portfolio as they are highly liquid. The exchange rate is highly responsible for the volatile conditions in the case of Currency ETFs. They buy different currencies and follow the trends to predict future performances and provide traders with higher returns.

Industry ETF

Industry ETFs are also called sector ETFs. This type of exchange-traded fund is a specific sector-focused ETF. Companies operating in a particular industry or a sector will be included in a particular ETF associated with that industry. One can monitor sector ETFs by keeping an eye on the performance of companies operating in the corresponding industry. 

How To Trade ETFs?

There are so many methods to trade in ETFs. Several ETF providers will help you to invest in ETFs by various methods. Trading in an ETF requires your attention to choose a certain broker. Brokers play an important role in the process of trading ETFs as the portfolio managers are involved in managing your Exchange Trading funds. But if you are investing in passively managed ETFs, there is no requirement for portfolio managers. But still, it is essential to be aware of the right method for trading ETFs. So here are several methods to trade in ETFs.

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  • You can contact your broker and ask the brokerage agent over a call to place the trade as per the technical analysis required to invest in a specific ETF as they are subjected to risks because of high liquidity, which creates the possibility of incurring losses. So technical analysis is a must step taken before you decide to invest in an ETF. Make sure that your broker is conducting the technical analysis if you are not able to do that.
  • The above process can be done through an online investing platform where all you need is a device, whether a personal computer, laptop or mobile and an internet connection. So you can place your trade-in ETFs by yourself, followed by a thorough technical analysis. 
  • ETFs can be traded just like stocks. As stocks are traded on an exchange through an investing platform, you can buy or sell ETFs that will contribute to the diversification of your portfolio. Choosing an investing platform also requires your attention so that you can invest and manage your ETFs smoothly. 
  • Ensure that your investing platform should be commission-free. As you can not redeem shares in ETFs just like stocks, you don’t have to pay commission for transactions. But you should also know that platform providers offer some investing products. These are not free of cost. These costs are associated with convenience and some services other than the portal for transactions. 
  • To get familiar with ETFs, some brokerages provide educational material to their clients. So that you can do well research before investing in an ETF, brokers may ask you for paperwork which is a potentially complicated process. Ensure that your broker is providing hassle-free one-click trading options with fewer complications.  
  • One of the most crucial steps in ETF investing is research. A market order followed by well research is the most basic form of ETF trade you place with your broker. It may also be the most hazardous. Most ETFs have a low investment barrier, making it simple for a beginner to adopt a basic asset allocation plan. It is important to ask yourself some practical questions before investing in ETFs. 
  • The questions can be: What is your investment’s purpose, whether it is for regular income or long-term growth? What is the time window for buying or selling ETFs? Are you attracted to a particular sector or industry, or are you planning to invest in various asset classes?
  • Answer these questions consciously, and you should be clear on what you need. It’s important to be aware of what you exactly want out of the investment in ETFs.
  • Suppose you are a novice ETF investor, dollar-cost averaging or a useful trading technique. It is also a technique of spreading out the costs of investments in a specific period of time. Market orders should be avoided at all costs by most investors. Market orders should be utilised exclusively for the largest and most liquid ETFs when assured. Very fast execution is critical to your strategy. 
  • ETF trading volumes have grown. Previously, investors were not able to sell ETF units at will. Therefore, if you want liquidity and a fair price for your units, selecting an ETF with large trading volumes is critical. This is no longer the case. However, In comparison with others, certain ETFs continue to have lower trading volumes.
  • A lower expense ratio indicates a higher possibility of making a profit. An ETF has a lower cost ratio for an actively managed fund. To entice new investors, several fund firms provide further reductions on cost ratios.
  • For stability, you may wish to allocate a modest percentage of your portfolio to ETFs. However, because these funds are handled passively, their goal is to replicate the index’s returns rather than outperform them. So it is essential to invest carefully after conducting calculated risks associated with your investment.
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Pros and Cons of ETFs 

ETFs are subjected to volatility that has both sides, positive and negative. One can earn huge profits out of this volatility, but at the same time, another one can lose out money because of it. High liquid markets are always subjected to profit and loss, so are ETFs. So here are some advantages and disadvantages of investing in ETFs.

Pros

High accessibility of stocks

When you buy a share of the company, then the potential returns will depend only on the performance of that company, and the degree of risk is much higher. But buying an ETF gives you more exposure to various stocks of that particular industry, which also reduces the risk.

By trading ETFs, one can cover up losses incurred due to the performance of an asset as they get exposure to diversification. In addition, because you have invested in an ETF and contains various assets, the good performance of only one asset can cover up the amount you lose in other assets. Traders also benefit from intraday movements in the stock market by investing in ETFs.

Low fees and tax-efficient

The ETF’s expense ratio and management fees are much lower than other managed funds. Investors also benefit from dividends, as in the case of ETFs, stock prices are increasing or decreasing. ETFs are quite cost-effective. This is the reason why people are inclined towards ETFs nowadays, as it provides investors with opportunities to make higher returns with lesser capital and fewer risks.

Risks involved in stock trading are higher but in stock ETFs, as they allow you to invest in various stocks with the same capital amount that you are supposed to use to buy an individual stock of a company. As a result, even the tax associated with ETFs is much lower as compared with mutual funds.

ETFs are also subjected to capital gains tax and tax on dividends like mutual funds, but they are charged with lower fees. Because there is no facility for redeeming shares in an ETF, they are more tax-efficient. Tax liability increases as one redeems funds or shares, but ETFs are traded through an exchange.     

Diversification

Risks involved in ETFs are much lower than mutual funds because most ETFs are passively managed. In addition, to mitigate the risks of investing in mutual funds, one can invest in ETFs because ETFs invest in various shares of a specific industry for diversification. In mutual funds, risks are higher because they can invest in newly formed companies that trigger heavy losses. 

Investing in ETFs is a great way for retail investors to build a customised portfolio based on their financial goals. As asset allocation requires knowledge and expertise in financial markets, it is not easy for retail investors to build a portfolio independently. So with ETFs, you can get your hands on different asset classes of bonds, stocks and commodities.

Cons

Higher brokerage fees 

Portfolio managers manage actively managed ETFs like index ETFs, so they require higher management fees. In addition, fund managers or portfolio managers will charge you the commission for operating your Demat account and the technical process required for transactions of ETFs. This is one of the disadvantages of investing in ETFs. 

But if you compare it with mutual funds, then there will be lesser brokerage fees for ETFs. But, again, this is because mutual funds and ETFs have so many similarities in terms of the cost involved. 

But in comparison with investing in individual stocks, the costs associated with ETFs are much higher. There is no involvement of management fees for stocks, but it will be charged for investing in ETFs. 

Due to the trading flexibility offered by ETFs, one can tend to over-invest in these funds. Over investing results in rising costs and can reduce returns.       

Limited Diversification  

Market index narrows down the large-cap stocks due to which investors have limited exposure. As a result, investors can often not meet the potential growth opportunities associated with small and mid-cap companies. In this way, ETFs are subjected to limited diversification.  

This is because many ETFs are passively managed, which means they just pick top companies on charts and often newly formed ones with huge potential. 

Risks associated with high volatility

As per the market trends, assets witness high price fluctuations. This is because they are not subjected to stability like government bonds. Often volatility is seen as an advantage of higher returns. But one should be aware of the risks involved in volatile assets. The same goes with ETFs, stocks or other assets that are subjected to liquidity or often witness price fluctuation that can directly impact the corresponding ETF. 

Final Words

This was the detailed overview about what is ETF? ETFs offer the benefits of several assets without investing in them individually. So again, this is a great way to diversify your portfolio even if you don’t have enough experience trading various asset classes. In addition, with much lower costs, you can gain better exposure to a wide market arena. But before investing in ETFs, it is essential to be aware of the risks involved because of the volatility.

High liquidity often helps to gain higher returns, but it is also subjected to potential risks that you should be aware of. For example, fluctuation in prices of different classes can reflect the performance of an ETF. So it is important to remember that you have to do a brief market analysis before investing in an ETF. Nevertheless, investors who consider all the risks and invest in an ETF that matches their investment goals will likely gain larger profits.

Ensure that you earn something extraordinary by investing in ETFs.

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