ETF Trading – How Exchange Traded Funds Work

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An exchange traded fund (ETF) is a type of investment security that can be traded on exchanges. This type of security is structured like a fund that comprises a specific group of assets, such as stocks, bonds, commodities, and others. The main aim of an ETF is to follow the performance of a specific set of assets.

In most cases, ETFs are tracking an index or a single industry. For example, the ETFs can follow stock indexes such as the FTSE100 and S&P500, but also more specific activities, such as the mobility companies in the US, like Uber and Lyft.

Table of Contents

How to get into ETF Trading

Pros and Cons of ETFs

Types of ETFs

Closing Thoughts

How to get into ETF trading

ETFs are trading on the stock exchange and can be bought and sold at any time. An ETFs price is fluctuating depending on the price of the assets that it is made of. For example, if the FTSE100 is going up, an ETF replicating this index will follow the upward movement.

Additionally, traders should keep in mind that ETFs are different from mutual funds, that can only be traded after the markets close.

European investors that wish to buy ETFs domiciled in the US are generally blocked by doing so because US ETFs miss the Key Information Document (KID). This is part of the Packaged retail investment and insurance-based products (PRIIPS) regulation that came into force in early 2018. As a result, European traders should instead look at similar ETFs located within the EU. However, there are a few brokers that allow Europeans to buy US-domiciled ETFs, but only for professional clients.

Pros and Cons of ETFs

Pros:

  1. Portfolio diversification

ETFs provide investors with good risk management through portfolio diversification. They represent an economical and easy way to rebalance any portfolio. For example, the Vanguard FTSE 100 UCITS ETF offers diversification that is spread over an entire FTSE 100 index, covering a wide range of stocks and business sectors.

  1. Cost-effective

Investors that purchase ETFs pay lower management fees as compared to those practised by mutual funds. Generally, the overall expenses of an ETF are around 0.1% and below, while with mutual funds they can be as high as 1-2%. For example, BlackRock’s iShares Core FTSE 100 UCITS ETF has a total expense ratio of 0.07%.

  1. Tax friendly

ETFs are tax-efficient, as they do not generate capital gains taxes if the investments are not sold. This is because they have a low turnover of the securities they invest in. In addition, taxation makes them more appealing to investors compared to mutual funds, where the fund must sell its holdings to meet client’s redemptions.

  1. Buying and selling flexibility

Investors can buy and sell ETF at current market values at any time during the trading day. as compared with unit investments and mutual funds, that can be traded only at the end of the trading day. In addition, ETF investors benefit from the same trade types that are available for stocks: stop-loss, limit, take profit, market, trailing stop loss, and others.

  1. Transparency

ETFs clearly show on a daily basis what their holdings are, so investors can make an informed decision before purchasing them. As a result, they are more transparent than mutual funds, which do not show their entire positions.

Cons:

  1. Illiquidity

Less traded ETFs can have liquidity issues, since they are traded occasionally, rather than on a daily basis. This means that they have a large bid/ask spread, with investors buying at a premium and selling at a discount.

  1. Tracking errors

ETFs should generally be in line with the investments that they are tracking. However, this is not always the case, as they can stray from these indexes. This issue represents a tracking error that can lead to extra costs for investors.

  1. Settlement dates

Traders that sell ETFs must be aware that the transaction is settled two days after it is completed. As a result, the money from that sale is not available for making other investments for two days.

  1. Management fees

Investors should properly inform themselves about an ETF’s overall expenses before buying it. Even though most of them have low annual expenses, some ETFs which are actively managed or have large amounts of money invested in marketing can exceed 1% in fees.

  1. Trading costs

The ETF purchasing commission for a broker is generally a lump sum on the transaction, without considering the amount invested. As a result, traders that want to constantly invest smaller amounts in ETFs will pay higher fees overall, than those that make a large transaction at once.

Types of ETFs:

  1. Stock ETFs – tracks a basket of equities in a selected sector or index. This offers traders an easy portfolio diversification, without the need to make individual share purchases.
  2. Bond ETFs – invest only in bonds. They offer traders an effective means to increase their exposure over the bond market in an inexpensive way.
  3. Commodity ETFs – made to follow the price of a commodity, such as gold and oil. This ETF type offers investors an easy, low risk, and cost-effective way to invest in commodities. These ETFs can track various commodities, such as agricultural goods, base metals, energy, rare earths, and precious metals.
  4. Sector ETFs – track securities and stocks from a specific sector or industry. For example, a sector ETF can track an index of technology stocks from the UK, including companies such as Just Eat (JE) and Ocado (OCDO).

Sector ETFs are available for any of the 11 broad Global Industry Classification Standard (GICS) sectors:

  • Financials: XLF
  • Industrials: XLI
  • Energy: XLE
  • Information Technology: SMH
  • Health Care: XLV
  • Real Estate: IYR
  • Utilities: XLU
  • Consumer Discretionary: XLY
  • Consumer Staples: XLP
  • Telecommunication Services: XTL
  • Materials: XLB
  1. Currency ETFs – are financial products that offer exposure to foreign exchange currencies (forex). They facilitate traders access to a challenging market, without the risks of making individual trades.
  2. International ETFs – invests in foreign securities. Typically, international ETFs spread their investments either globally, in multiple countries, or in just a single country. For example, The Vanguard Total International Stock ETF is comprised of global stocks, except from the US.

Closing Thoughts

So, is ETF trading worth it? Well, successfully investing in an Exchange Traded Fund depends on the trader’s expertise and market volatility. The main advantage of investing in ETFs is the portfolio diversification, as you can invest in various assets from different sectors for a relatively low price. Check out the list below to discover all the online brokers that allow ETF trading.

 

We’ve compiled a list containing some brokers that offer ETFs or ETF CFDs below:

4.8 rating
75% of retail investor accounts lose money when trading CFDs
4.3 rating
Plus500 is a CFD broker. 76.4% of retail CFD accounts lose money
4.0 rating
75% of retail investor accounts lose money
4.0 rating
80% of retail CFD accounts lose money

Reference list:

https://www.investopedia.com/terms/e/etf.asp

https://en.wikipedia.org/wiki/Exchange-traded_fund

https://www.fidelity.com/learning-center/investment-products/etf/what-are-etfs

https://economictimes.indiatimes.com/definition/ETF

https://capital.com/etf-definition

https://www.vanguardinvestor.co.uk/investments/vanguard-ftse-100-ucits-etf-gbp-distributing

https://www.ishares.com/uk/individual/en/products/251795/ishares-ftse-100-ucits-etf-inc-fund?switchLocale=y&siteEntryPassthrough=true

https://www.fidelity.com/learning-center/investment-products/etf/drawbacks-of-etfs

https://www.ecb.europa.eu/pub/financial-stability/fsr/special/html/ecb.fsrart201811_3.en.html#toc5

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