What are ETFs
When it comes to trading financial instruments, most people will have heard of trading stocks, bonds, or mutual funds. But aside from those, there are plenty of other financial instruments that traders can take advantage of. One such financial instrument that a few reputable brokers such as Saxo Bank provide includes an exchange-traded fund in Switzerland, otherwise known as an ETF.
But what exactly is an ETF, and what makes them different from other financial instruments on the market? In this article, we attempt to explain what an ETF is, in addition to the types of ETFs that are available for traders to invest in. So, for those looking to learn more about this topic, make sure to keep on reading to the very end.
What is an ETF?
So, what is an ETF, exactly? An ETF is usually a pooled investment security that functions very similar to a mutual fund. This means they will typically track a particular sector, index, commodity, or asset. However, a few things that make them different from mutual funds is that they can be sold or bought on the stock exchange in the same way that regular stocks can – hence why it is called an exchange-traded fund. The price of an ETF’s share will also fluctuate throughout the day as its assets are bought and sold on the market, unlike mutual funds, which only trade once per day and only after the market has closed.
ETFs can focus on tracking anything, ranging from the price of an individual commodity to seeing a bird’s eye view of a large and diverse collection of securities. A few ETFs can even be used to track specific investment strategies. As an ETF holds multiple underlying assets, they remain a popular choice for investors and traders who are looking to diversify their portfolios. Some of these ETFs may be focused on a particular sector or industry, whilst others may have a more international and global outlook. For instance, a banking-specific ETF may only contain assets that are related to various banks across the industry.
Types of ETFs
As mentioned previously, as ETFs hold multiple underlying assets, they can contain various types of investments, such as stocks, bonds, commodities, or even more exotic investment types. These ETFs can be used in various ways by investors, especially when it comes to speculating how prices are doing in the markets and hedging against future risks. Here are a few common types of ETFs available in most financial markets today.
Much as its name suggests, stock ETFs mainly consist of a basket of stocks usually tracking a single industry or sector. For instance, a stock ETF may specifically track either automotive or foreign stocks. The main goal of this type of ETF is to provide diversified exposure in a single industry. This means that experienced and high-performing traders as well as novices and beginners both have the potential for growth. Unlike stock mutual funds, stock ETFs tend to have lower fees, but they do not involve the actual ownership of the underlying securities.
Much like bonds, bond ETFs are also used to provide a regular pay check to investors. The income being distributed will depend on how the underlying bonds perform in the market. The bonds an ETF may consist of include government bonds, corporate bonds, as well as state and local bonds (which are called municipal bonds). However, unlike the underlying asset, bond ETFs do not have a maturity date. They also generally trade at a premium or discount from the original bond price.
Industry and sector ETFs
Again, as its name suggests, industry and sector ETFs are financial instruments that focus on a specific sector or industry. So, an energy sector ETF will focus on including companies and assets that operate in the energy sector, whereas a healthcare ETF will focus on including assets and companies that are part of the healthcare sector. The main idea behind industry ETFs is that investors can use them to gain exposure to how an industry is doing, by tracking the performance of companies operating in that particular industry.
For instance, the technology sector has witnessed a boom in recent years. However, this has also made the financial markets volatile. Fortunately, investing in ETFs instead of stocks means that investors do not have to actually own the underlying securities, meaning they are less likely to be affected by stock market fluctuations.
Commodity ETFs heavily invest in commodities. These assets can include materials such as precious metals, energy, livestock, and agriculture, to name a few. One great thing about commodity ETFs is that they help to diversify an investor’s portfolio, meaning it is easier for them to protect themselves during downturns in the market. For instance, if the stock market moves in an unfavourable direction for investors, these ETFs can help provide a cushion during these times. Additionally, holding shares in commodity ETFs tends to be cheaper than actually possessing the commodity itself. This is because actually owning the commodity involves insurance and storage costs, which ETF holders do not need to worry about.
Currency ETFs are pooled investment vehicles that track how currency pairs are doing – which are usually consisting of domestic and foreign currencies. They have multiple purposes. The first is that they can be used by investors to speculate on the prices of currencies, especially when current events and economic developments are involved. The second is that they can also be used for diversification, or as a way to hedge against volatility in the forex market. Some currency ETFs can even be used by resourceful traders to hedge against inflation.
Passive or Active ETFs
On the whole, ETFs are usually either characterised as actively managed or passive. A passive ETF aims to follow the performance of a broader index. This can either be large, diversified indices such as the S&P 500, or a more specific index targeting either a sector or trend, such as gold mining stocks.
On the other hand, actively managed ETFs are the opposite. Instead of targeting an index of securities, they have portfolio managers actively making decisions on which securities to include in the portfolio. While there are plenty of advantages to investing in an active ETF, they also tend to be more expensive to investors, which is something investors and traders need to keep in mind before investing.