As a trader or investor, it is really important to know the different vehicles available to you. Most everyone knows about Stocks, Futures, and Forex but there is another vehicle that has gained popularity over the years and that is Exchange Traded Funds or ETF’s for short.
What is an ETF?
The question now is what an ETF is but if you understand vehicles like mutual funds, you already have some basic idea of exchange traded funds. A mutual fund is a diversified pool of instruments all under the umbrella of names like Vanguard Prime Cap or Nicholas Fund.
An ETF is also a pool but instead of purchasing from a fund company, you would use a brokerage that deals with ETF’s.
Diversification: A strategy used to offset the risk of one sector or instrument skewing the value, negatively or positively of a group of instruments.
The common mistake people make is thinking a group of instruments traded together is a mutual fund. One way to differentiate is to understand that the ETF is traded on the open market. A mutual fund is accessed through a mutual fund broker.
An ETF has the ability to be focused on strict criteria for its makeup. For example, you may want to be involved in an ETF that is strictly focused on the alternative energy sector. Given the push that is happening worldwide to move away from fossil fuels, many investors may find this to be an attractive bundle of stocks.
Other investors may have great success with the financial market and focus solely on the ETF’s that follow bank stocks. Perhaps emerging or foreign markets pique your interest and you would seek out an ETF that suits your needs.
Think of your interest and there is probably an exchange traded fund that can give you laser focused exposure to the markets, regions, or even currencies of your choice. As you can see, the ETF is usually an index fund made up of several stocks and the price depends on the underlying portfolio. Fluctuations are determined by the volatility of each interest in the ETF so having some education of the sectors in the ETF would be prudent.
Types of Exchange Trade Funds
Whatever your interest, there is probably an ETF that will satisfy your needs. Being able to focus in on exactly what your needs are, is a plus in the books of many traders.
- Interested in the energy sector because your research has shown it to be a good addition to your portfolio? You can jump into an energy focused ETF that hold stocks of companies focused on that industry.
- Bond ETF’s would carry various bonds in their holdings.
- If you have a long or short bias in the market, you can be involved in an ETF that focuses on that direction by taking the appropriate position on the underlying indexes.
Benefits of an Exchange Trade Fund
- As mentioned, since an ETF is like the wrapper around a select group of stocks, you have the power of diversification which can be a good thing if one sector is underperforming.
- ETF transactions take place through a brokerage. Unlike mutual funds, you don’t have the same type of fees and often you will see the mutual fund that tracks the same index as the ETF be a more expensive venture. You may still pay brokerage commissions with the ETF but often, there are cheaper than a similar mutual fund. There are no-load mutual funds that don’t come with fees and that may also be of interest.
- There is not a problem with liquidity of the ETF. Unlike stocks that have a finite supply available and ETF does not have that issue and lack of supply is corrected through the creation and redemption process.
For all the good that comes with being involved in trading ETF’s, nothing is without drawbacks.
- ETF’s are treated like stocks so if you are active with buying and selling of an ETF, commission fees will add up. If your plan is to be active, ensure you calculate the cost of doing business. You may find yourself better off in the mutual fund market.
- While diversification is a selling point, it can also be a negative depending on the makeup of the ETF. An ETF tracking the S&P 500 covers such a broad range of sectors that extreme volatility will probably not be an issue. A narrow focused ETF such as one in the energy sector may experience intense volatility depending on issues that directly affect that sector.
- Like stocks and other instruments, an ETF does have a spread which can also add to your trading costs.
Spread: The price difference between the bid and ask price.
While it is easy to get involved in an ETF, you should be using them as part of the plan of an overall portfolio strategy. Keep in mind that fees will add up if you actively trade them so the benefits you think you have may be overshadowed by fees and spread costs.