ETF trading offers an assortment of benefits and, when done wisely, is an excellent way for investors to achieve their investment goals. Exchange-traded funds (ETFs) are some of the most valuable and important investment products created for traders in recent years. Understanding what ETF trading is, how it works, and what type of ETF product meets your risk tolerance and goals are important steps to having profitable success.
- ETF trading is buying or selling baskets of assets from a brokerage firm.
- ETFs have ticker symbols and intraday price information readily available during the ETF trading day.
- There are several types of ETFs, including broad-market, sector, dividend, style, commodity, currency, and bond.
- ETFs give traders the flexibility to be any kind of investors they would like to be.
What Is ETF Trading?
ETF trading is buying or selling a basket of securities via a brokerage firm on the stock market. Virtually every conceivable class of assets offers ETF trading, from traditional investments to alternative assets such as currencies or commodities. Innovative ETF trading also enables traders to short markets to avoid short-term capital gain taxes and gain leverage.
After a few false starts, ETF trading began in 1993 with SPDR ETFs, routinely known as spiders. The SPDR S&P 500 trust remains the highest-volume ETF in history. Currently, over $1 trillion is invested in ETFs, with nearly 1,000 ETF trading products on U.S. stock exchanges. ETF trading provides many advantages, including:
- Investors can buy and sell at any time of the day, unlike with mutual funds, which settle once the market closes.
- Fees are lower due to no sales load, while brokerage commissions do still apply.
- It’s more efficient for taxes since traders have more control over when they pay capital gains tax.
- Since ETF trading is done similarly to other stock trading, traders can place several types of orders, including stop-loss orders, limit orders, and buy on margin, which isn’t possible with mutual funds.
While superior in many aspects, ETF trading does bring with it some drawbacks, including:
- Trading costs can be high, especially for individuals who frequently invest small amounts. Investing directly with a fund company in a no-load fund may be a lower-cost alternative.
- The underlying index usually tracks ETF trading, but discrepancies can occur due to technical issues.
- It takes sales two days to settle after a transaction with ETF trading, meaning individuals can’t reinvest funds during this time.
How ETF Trading Works
As with stocks, ETFs have a ticker symbol and intraday price information that can be easily found during the course of the ETF trading day. Unlike traditional stocks, the number of outstanding ETF shares often changes daily due to new shares being created and existing shares being redeemed. This ability to issue and redeem ETF shares continually keeps ETF market prices in line with their underlying assets.
While ETF trading is designed for individual traders, institutional traders also play an essential role in maintaining the tracking integrity and liquidity of ETFs. By purchasing and selling creation units, institutional traders can exchange blocks of ETF shares for baskets of underlying assets. When ETF prices deviate from the underlying security value, institutions use the arbitrage mechanism to restore the ETF price in line with the underlying security value.
Types of ETFs
There are thousands of ETFs available to choose from. With so many ETF trading options available, it can be challenging for traders to determine which kind of ETFs are best for their investing goals. It’s important to understand the different types and what each offers to make an educated decision before purchasing.
Broad-Market ETFs for Full Market Exposure
Broad-market ETFs are the largest and most popular type of ETFs. They track indexes covering all or a significant portion of the stock market. The SPDR S&P 500 (NYSEMKT: SPY) is the largest ETF tracking the S&P 500 index of U.S. stocks.
Investors can find broad-market ETFs covering an array of various indexes. Some provide exposure to all the global stock markets while focusing on a specific geographic region or the size of the company. The least expensive investment options are often cheap broad-market ETFs that work well as one-stop solutions for asset allocation.
Sector ETFs for Industry-Specific Investing
Sector ETF trading enables individuals to purchase stocks within specific sectors of the markets. Sector SPDR ETFs divides the market into 10 different sectors, with other ETF groups using different types of classifications for specific industries.
The main advantage of sector ETFs is that investors get pure-play exposure to a very attractive industry. Broad-market ETFs have small fractions allocated to specific sectors, but when a chosen sector does very well, sector ETFs enable investors to benefit completely without having returns minimized by stocks performing less favorably.
Dividend ETFs for Solid Income
A dividend ETF focuses on stocks that pay dividends and have the objective of paying significant current income to individuals. Dividend ETFs can take several different approaches moving toward this objective.
Some dividend ETFs attempt to maximize current yield resulting in maximum income distribution opportunities. Others select stocks not just based on yield but also on the ETF’s history of consistent dividend growth. ETF trading following these two strategies can result in returns that vary significantly from one another. For this reason, investors need to know what kind of dividend ETF they’re interested in and which option is the best fit for their investing style.
Style ETFs for Growth or Value Investors
Many investors choose to focus on either value or growth stocks. Some ETFs separate popular stock indexes into two sections, one looking at value stocks and the other at growth stocks. These style-based ETFs can be found for various types of stocks, from small, mid-sized, and large domestic companies to international stocks of varying sizes from all over the world. Growth and value styles go in and out of favor with investors, but both can be profitable ways to invest.
Commodity ETFs for Uncorrelated Returns
Commodity ETFs give investors exposure to commodity markets, providing returns that aren’t always linked to those of stock markets. This is especially useful for traders interested in true diversification across various asset classifications. The majority of commodity ETFs use derivatives such as futures to gain exposure in respective markets. However, some purchase the physical commodity itself. In this case, each share would represent a corresponding portion of the commodity.
Because commodity EFTs use derivatives, investors must be familiar with future market vagaries to avoid traps. Owning physical commodities does include costs that slowly erode the value, yet most investors feel getting a different type of asset exposure is worth this downside.
Currency ETFs for Foreign Exchange Exposure
Currency ETFs are similar to commodity EFTs. Both are designed to let the investor profit from moves in foreign currency in relation to the U.S. dollar. Most currency ETFs have conventions where an ETF share corresponds to the value of a specific amount of a particular foreign currency. Other currency ETFs track broad benchmarks of currency moves, such as the U.S. dollar index.
Investors can use currency ETFs to protect against downward currency moves for top companies in their portfolio or hedge personal exposure on things such as a vacation trip. By mimicking a cash investment in foreign currencies, currency ETFs act similarly to cash in an asset allocation strategy.
Bond ETFs for Fixed Income
Finally, bond ETFs provide individuals with exposure to the bond market. Investors can find broad-market bond ETFs covering the whole market and bond sector ETFs focusing on specific kinds of bonds, such as international sovereign obligations of foreign nations, Treasury bonds, or corporate debt.
When investing in bond ETFs, investors need to know whether the fund rolls over maturing bonds to purchase new ones or is focusing on a specific maturity. Each type has different interest-rate risks, so matching your specific needs to the EFT is important.
ETFs provide investors with the flexibility to be any type of investors they want to be. After investors determine their investment goals, they can use ETFs to increase exposure to any industry sector or market in the world. Individuals can traditionally invest their assets using bond ETFs and stock indexes, adjusting the allocations according to changes in their risk tolerance and goals. They can also add alternative assets, including emerging stock markets, commodities, and gold. They can quickly move in and out of markets, hoping to catch shorter-term swings similar to a hedge fund.
To learn more about ETF trading, consult our expert team for guidance today. Take advantage of free ebooks, webinars, and many other resources from Raging Bull that can help you get the most out of your investments.