Exchange-traded Funds (ETFs) is a highly popular asset class among investors and traders. In 2021, the global exchange traded fund (ETF) market hit a high of USD 10 trillion, with the number of ETFs reaching nearly 8,600 .
Particularly impressive, considering this growth continued unabated even in the face of strong global macroeconomic headwinds sparked off by the COVID-19 pandemic, and sustained by the Russia-Ukraine war.
But what lies behind the enduring popularity of ETFs? And how can traders and investors trade them?
What are Exchange Traded Funds (ETFs)?
ETFs are a type of investment fund that typically track a broad range of securities or assets. They are so-named because they are traded on an exchange, just like stocks; this allows the ETF price to change throughout the day as trades are made.
Just like mutual funds, ETFs are pooled investment vehicles. This structure affords investors with lower fees and lower capital to start. Buying into an ETF allows you to gain exposure to every security in its portfolio, making for a convenient way to diversify your investment portfolio.
The key difference between mutual funds and ETFs is the frequency of trading. As mentioned, ETFs can be traded several times throughout the day at market price, which may be higher or lower than the net asset value (NAV); meanwhile, mutual funds are only traded once per day, after the market closes.
As such, ETFs have comparatively more flexibility and liquidity, making them suitable for beginner investors and seasoned traders alike.
What are the different types of ETFs?
ETFs can follow any of a myriad collection of compositions, drawn from across the entire universe of securities and investment assets. This vibrant variety is also a major reason for ETFs’ popularity.
Some common types of ETFs include:
- Equity ETFs, which focus on company stocks and shares. Equity ETFs may also be further subdivided according to market capitalisation, business life cycle, or other lines.
- Bond ETFs, which focus on government bonds, corporate bonds and other fixed-income instruments. One of the most popular bond ETFs is the iShares Core U.S. Aggregate Bond ETF.
- Index ETFs, which provide exposure to an entire stock market index, such as the S&P 500, or the Nasdaq. Index ETFs aim to replicate the performance of the respective indices they are benchmarked against.
- Sector ETFs, which are a grouping of ETFs centred on specific industries or market sectors. ETFs that focus on geographical areas may be considered a variant of this type of ETF.
- Commodity ETFs, which aim to track the movements of the commodities markets, such as oil, gold, copper or coffee. Note that commodity ETFs are often based on derivatives, which could create higher risk to investors.
- Currency ETFs, which track a single currency or a basket of currencies. Such ETFs may trade a currency directly, derivative, or some combination of both. Currency ETFs may be deployed to hedge against currency volatility.
- Inverse ETF is designed to profit from a decline in the value of an underlying benchmark or index. Inverse ETFs are typically used by investors who are looking to hedge against a potential downturn in the market or to generate short-term profits from market volatility.
- Emerging Markets ETF, which focus on investing in companies and markets of developing countries, such as China, India, Brazil, or South Africa. These ETFs can provide investors with exposure to high-growth economies and diversify their portfolios geographically.
How to trade ETFs?
ETFs may be traded in multiple ways, with each suited to different investment objectives, investment strategies, budgets and risk appetites.
Contract for Difference (CFD)
CFDs allow an inverter to speculate on the price movements of an ETF without actually owning shares of the fund.
The aim is to create trading opportunities from the difference in the price of the ETF between the opening and the closing of the trade. If the price moves against the trade, a loss will be incurred.
Note that with CFDs, a trader may make trades in both directions; this allows more advanced strategies to be used.
Options and futures
Like CFDs, ETF options are financial derivatives that also allow you to speculate on the price movements of an underlying fund. Using options, you can take a position, without the obligation to buy or sell the contract by its expiry date.
On the other hand, ETF futures allow investors to speculate on the price of the underlying fund on a future date. Unlike options, futures carry an obligation to take ownership of the asset – if this is not desired, the futures contract may be rolled over to a later date.
ETFs can also be traded directly on stock exchanges, through a brokerage firm or online broker.
You can buy, hold and sell ETFs just like you would a stock; doing so will allow you to buy and own ETFs at their current price, instead of speculating on future price movements.
What are the different ETF trading strategies?
Dollar-cost averaging (DCA) is a basic ETF trading strategy that involves investing a fixed sum into an ETF or group of ETFs on a regular schedule, perhaps weekly or monthly.
Doing so will allow you to start with a small budget, and gradually increase your holdings over time. Another advantage is that by investing a fixed amount regardless of fund price, the cost of your holdings will be averaged out as you go along.
Swing trading is a strategy that seeks to benefit from substantial swings in price movements over a relatively short time period, such as several days or weeks.
ETFs are well-suited to swing trading strategies due to their inherent diversification. As an ETF is essentially a basket of many different securities or assets, investors attempting a swing trade gain a degree of protection when prices move against them. Of course, this works the other way too – during an upswing, an ETF may not make as large a gain compared to a single stock.
Still, ETFs are better-suited to beginners who are testing out swing trading, as well as traders who have a lesser appetite for risk.
In short selling, or shorting, a trader borrows a security or asset, with the promise to pay for it at a later date. If the price of the security falls by the agreed date, the trader needs only pay back the lower price, and pocket the difference as a profit. However, if the price has risen, the trader will have to make up for the increase out of their own pocket as a loss.
Clearly, shorting is an advanced trading strategy that is unsuitable for inexperienced traders, especially given the risk of running into a “short squeeze”, where a security that has been heavily shorted spikes dramatically in price. However, short selling through an ETF (instead of shorting an individual stock) can lower the risk of a short squeeze.
Sector rotation allows investors to move in tandem with business and macroeconomic cycles inherent in the market, so as to limit losses and maintain a favourable position. The basic idea is to rotate out of security or assets that are in decline, and into instruments that are experiencing an uptrend.
ETFs offer a convenient and relatively easy way to practise sector rotation, given their sector-specific composition. For instance, during a market downturn, an investor may choose to trade a growth-stock ETF and rotate into an ETF focused on defensive stocks.
Seasonal trend trading
A related trading strategy to sector rotation is season trend trading, where inventors attempt to follow seasonal trends in the market.
Once again, ETFs are well-suited to this strategy, as you need only manage one or a few ETFs, instead of several individual stocks and shares.
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- “Development of assets of global exchange traded funds(ETFs) from 2003 to 2021 – Statista”. https://www.statista.com/statistics/224579/worldwide-etf-assets-under-management-since-1997/. Accessed 14 Nov 2022.