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What are ETF’s?

Jeff BishopJeff Bishop ·

Exchange traded funds, shortly known as ETFs, are a great alternative to stocks or mutual funds. Many traders find ETFs more attractive because they involve less risk compared to individual stocks and are more flexible than mutual funds.

First of all, let us discuss what an ETF is. As the name suggests, the ETF is a fund. This fund tracks and simulates a basket of stocks, generally representing a market sector or an index, and can be traded like a stock. Thus, the ETF price can move up and down the same as a stock price does within a day.

For example, SPDR S&P 500 (SPY) is an ETF that tracks and mirrors the performance of the S&P 500 index, which means it invests in the companies included in the S&P 500 index. Now, if you would invest in one or two companies included in the S&P 500 index, the volatility will be higher and the risk of being out of money would be more realistic, especially because of different unexpected events and reports. Yet, when you trade an ETF, you are exposed to less risk since ETFs are well diversified, offering more protection against unexpected events.

Let’s use a simplistic example.

As you can see in the image above, the ETF considers the composite performance of its basket of shares, so this is an instant diversification instrument that you can benefit from. You can only lose when the whole market drops rather than a single company from the traded ETF.

Generally, ETFs can track their indexes with great precision. For example, here is the already mentioned SPDR S&P 500 ETF compared to S&P 500:

As you can see, in the longer-term, the ETF could not outperform the S&P 500 index, but the short-term changes and movements are very similar.

Accordingly, the ETF gives you the opportunity to invest in whole sectors and indexes. Do you find tech companies attractive? You can invest in tech ETFs. Do you think gold demand will increase amid the upcoming uncertainty? You can invest in ETFs that track gold mining companies or other gold related stocks. It’s a great diversification chance that you should not ignore. In fact, your portfolio will look steadier if it has some ETFs included. However, the important thing to know is that it all depends on your risk profile and target. We view lower volatility as a great benefit and stability which is typical for ETFs, but some traders want more potential profits based on higher short-term volatility, meaning that they are ready to take more risk which the ETFs cannot offer.

The ETFs has very similar principles with the mutual funds, since they basically operate the same, but there are some important differences:

  • ETFs generate intra-day price changes, while with mutual funds, there are single quotes for the whole day, and the change happens after the session ends (Net Asset Value – NAV).

  • ETFs fees are much lower when compared to mutual funds;

  • Mutual funds can be actively managed, which means they can outperform their index, while ETFs try to just simulate an index price, and because of this, as you could see in the chart above, they don’t generally outperform the tracked index;

  • The ETFs can be easily shorted, which is not true about mutual funds;

  • The minimum investment requirement is much lower with ETFs – for example, you can buy single ETF shares. With mutual funds, minimum investment can range from $1000 to $2500 and may go even higher.

  • The ETFs cannot automatically re-invest the gains from dividends, which is one of the drawbacks.

  • ETFs are more transparent than mutual funds. Generally, everyone can get familiar with the stocks involved in an ETF.

There are more such nuances that seem to put the ETFs in a better perspective, especially for beginners and traders with lower investment potential.

Since ETFs are traded very much the same as individual stocks, ETF investing is done via brokerage services. Basically, the feeling of buying ETF shares and company stocks is quite the same. The only difference is that in the later case you automatically get diversified. Thus, you will need a brokerage account for buying ETFs.

There are also leveraged ETFs, but don’t get confused – these are much riskier instruments and they are not traded in the long term. Leveraged ETFs track indexes, other ETFs, bonds, etc., but they try to amplify the daily performance of the tracked asset price by two or three times, depending on its leverage. For example, a 3:1 leveraged ETF will generate a price change three times higher or lower compared to the asset it tracks. For example, NUGT is a leveraged ETF that tracks GDX, which is another ETF, and whenever GDX goes up 1%, NUGT rises 3%.

In conclusion, if you want to feel more protected when it comes to your investment, ETFs should be considered first. However, make sure you understand the difference between typical ETFs and leveraged ETFs, because the latter can ‘eat’ your investment in the long-term.

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