Exchange Traded Funds (ETFs), or traded funds, are one of the most important and versatile investment products of the last few decades. With almost 30 years of existence, ETFs offer many advantages, and if used correctly with the right strategy, they can be a good vehicle to achieve your investment goals.
What is an ETF?
Exchange Traded Funds (ETFs) are an investment vehicle hybrid between investment funds and stocks that try to replicate a reference index, but that can be bought and sold on the stock exchange like a normal and current stock, which does not happen in investment funds, since they are subscribed and liquidated at liquidation value after the close of each session. Also, like stocks, ETFs have a quotation symbol (ticker).
On the other hand, similar to investment funds, they invest in a basket of assets (stocks, bonds, currencies, etc.), which favors risk diversification, but one must be careful because some ETFs suffer from concentration risk due to having exposure to only one industry or niche even though they are diversified within it.
In the beginning, all ETFs were passively managed—that is, they followed an index. Recently, a new generation of actively managed ETFs has been created that do not follow any index but are rather managed discretionally by managers, but they have the benefits of the ETF structure, which is more transparent and efficient in terms of operational and tax costs.
In this article, we will focus on talking about passively managed ETFs.
It should be noted that there are ETFs for physical replication and others for synthetic replication. In the first one, the manager, using different statistical methods, buys the underlying values of the index to be replicated, while in the synthetic one, the manager buys a swap contract with an investment bank that will pay him the return of the index.
Many investors prefer those of physical replication, since they have real ownership of the underlying, while in those of synthetic replication, this is not the case. In addition, synthetic or swap replicas add counterparty risk.
Within physical replication, there are different methods:
- Complete Replication: They buy all the underlying securities of the index.
- Optimized Replication or Sampling: They only buy a selection that is representative of the total portfolio of the index. It is usually done to save operational costs when the index is too wide and/or many of its underlying have little liquidity.
ETFs can have exposure to a huge variety of markets, regions, sectors, subindustries, and even strategies within them. For example:
- We can find the most classic ones that replicate the S&P500 such as the SPDR S&P500 ETF (SPY), which is the first ETF launched to the market by State Street Global Advisors.
- There are others that replicate more thematic indices: Lithium & Battery Tech ETF (LIT), Cannabis ETF (POTX), Uranium ETF (URA), etc. In this sense, Global X ETFs is the pioneering manager in thematic ETFs, on its website you can find a wide list of products.
Advantages of ETFs
ETFs can be very useful for investors, as they combine the strong points of funds and stocks, all at a low cost. In addition, we have a wider variety of exposures than with Investment Funds.
By investing in baskets of stocks, usually of stock indices, ETFs are diversified and support a lower risk than individual stocks. With an ETF of a market, we will have a portfolio of many different stocks buying a single product.
But here it is important to clarify that although an ETF has a diversified portfolio of different stocks, it could also fall into the concentration risk if the number of stocks is low and/or if they are concentrated within a single sector, industry, or niche.
That is why it is important to know the index they follow and the volatility of it. For those interested in a guide on ETF portfolio diversification, check out this article.
- Transparency, Flexibility, and Simplicity in Negotiation
Being a hybrid, it benefits from the flexibility and ease of negotiation of stocks, being able to carry out buy-sell operations in real-time. This is an advantage over index funds, where the operation is slower. Therefore, we can know the value of our investment at all times thanks to the fact that the liquidation value and the price are constantly updated, something that does not happen with investment funds, where we have to wait for the closing of the markets to know the value of our positions.
- Efficiency in Costs
ETFs are characterized by having reduced commissions compared to investment funds since their management is much easier, with lower operating costs and they do not need a team of analysts for decision-making, since they follow an index. Therefore, its final return is very similar to the indices or sectors that they replicate.
But here are two important nuances:
- Sometimes it is believed that indexed ETFs are managed automatically and that there is no human being in front of them. They are partially automatic, but some operational decisions are made by a manager or management team and traders who plan and execute rebalances, securities lending, and synchronization with authorized participants so that the entire ETF operation has the lowest possible friction and with them reduces costs.
- The recent generation of actively managed ETFs does use analysts and a manager in the making of discretionary decisions, but they are taking advantage of the ETF structure to reduce operating costs and thus give lower commissions than Investment Funds. This is mainly due to the process of creating and redeeming units, which is much more efficient fiscally and operationally than the sale and purchase of fund shares.
Another point in favor is that the minimums to access this type of products are very reduced, which makes them a very accessible product for investors with less wealth.
- Performance is very similar to indices in the long term
By replicating an index, they seek to have a performance very similar, exactly lower than the commissions charged. Therefore, when buying an ETF there is a high probability that our long-term return will be very similar to the market or with less tracking error than in many Investment Funds.
However, we must always review the tracking error and the spread to avoid surprises.
- Possibility of Leverage or Short Investments
ETFs give the investor the possibility of leveraging with respect to the index and even investing in the same in the opposite direction, which is complicated to do in investment funds. Therefore, it gives new alternatives for speculation, more related to stock investment than to investment funds.
However, for this same reason, there could be an amplification of movements where there are leveraged and inverse ETFs. Also, be careful of those whose underlying assets have little liquidity or whose ETF price has very high spreads.
Disadvantages of ETFs
- Less favorable taxation than investment funds
ETFs are taxed as stocks, so they do not have the tax advantage of investment funds, which allows transfers between different funds without having to pay taxes on capital gains.
- Transaction costs
Here, we also have to take into account the costs charged by the broker platforms when making purchase and sale transactions.
- Most Complex Product
Due to the great variety that exists, several ETFs could be more sophisticated and not suitable for the general public, and therefore it is necessary for the investor to be well informed about their operation before starting to invest in them. For example, it is necessary to know that ETFs are not settled the next day as funds can be, but they take about two days. That means that if you liquidate an ETF to invest the capital in an ETF or action the next day, you cannot do it unless you have a margin account.
On the other hand, ETFs have an offer price (bid) and a demand price (ask). If the differential, fork, or spread is large, it can be said that the ETF or the market in which it is quoted is illiquid or that its underlying ones are, so it will be more difficult for the investor to sell at a target price. Therefore, it is important to be well-informed before investing.
Types of ETFs
Below is a list of the main types of ETFs you will find in the market according to the assets they replicate:
- Stock ETFs: iShares Core MSCI World UCITS ETF (SWDA), iShares NASDAQ 100 UCITS ETF (CSNDX)…
- Fixed Income ETFs: EUR Corporate Bond UCITS ETF (VECP), Emerging Markets Bond ETF (EMBD)…
- Sectorial ETFs: Video Games & Sports ETF (HERO), Artificial Intelligence & Technology ETF (AIQ), SPDR MSCI World Health Care UCITS ETF (WHEA LN)…
- Commodity ETFs: Invesco DB Commodity Tracking (DBC), First Trust Global Tactical Commodity Strat ETF (FTGC)…
- Currency ETFs: Invesco DB US Dollar Index Bullish Fund (UUP), Invesco CurrencyShares® Euro Currency Trust (FXE), Invesco CurrencyShares Japanese Yen Trust (FXY)…
- Inverse ETFs: ProShares UltraPro Short QQQ (SQQQ), ProShares Short S&P 500 (SH)…
- Leveraged ETFs: Direxion Daily Semiconductor Bull 3x Shares (SOXL), Direxion Daily Financial Bull 3X Shares (FAS).
- Regional ETFs: IWDA – iShares Core MSCI World UCITS ETF, EMIM – iShares Core MSCI Emerging Markets IMI UCITS ETF, VanEck AFK Africa Index ETF
- Strategy ETFs: Global X XYLD S&P 500 Covered Call ETF, Global X QYLG Nasdaq 100 Covered Call & Growth ETF, VanEck MOAT Morningstar Wide Moat ETF
- Thematic ETFs: Global X RNRG Renewable Energy Producers ETF, Global X AIQ Artificial Intelligence & Technology ETF
As ETFs have become more popular, a variety of ETFs have emerged that use all kinds of strategies to attract more investors. Two of the most interesting are inverse ETFs, which benefit when a particular index performs poorly, and leveraged ETFs, which can double or triple the returns of a particular index through the use of leverage, as the name implies. However, these two products are not recommended for long-term investors or those just starting out.
Here you can find the best ETFs to invest this year.
How to invest in ETFs
ETFs are mainly traded through broker platforms and banking entities. Here it is especially important to look for an intermediary with low commissions, since as we have seen before, one of the drawbacks is that sometimes the purchase-sale commissions can be high, so it is important to analyze which is the cheapest broker to buy ETFs. Here we offer a list of some that commercialize ETFs:
- Interactive Brokers
- Click Trade
- Renta 4…
ETFs are very versatile, so they can be a good alternative for:
- Investors who don’t believe it is possible to beat the market, with indexing being the best alternative. In the long run, we ensure a return similar to the indices, but always lower than the same.
- For traders with intraday or swing strategies.
- For those with rotation strategies.
- For those looking for coverage.
- For those who want to leverage without the risks and costs of derivatives,
- For top-down or macro investors looking for exposure to certain themes, sectors, or countries.
We’ve compiled this detailed guide that teaches both beginner and intermediary investors how to master the art of choosing ETFS.
How to create an ETF portfolio
Once we have clear concepts of what ETFs are and where they can be acquired, it is also important that we are aware of the type of ETF portfolio we want to create. This will depend on our investor profile and our needs.
Investing in ETFs is not your only roadmap to wealth. Many people have made a fortune out of index funds and you can easily join the cue as soon as you’re ready.
How can I start investing in ETFs?
You can start investing in ETFs through broker platforms and banking entities. It’s important to choose a platform with low commissions to minimize costs.
How do ETFs differ from investment funds?
Unlike investment funds, which are bought and sold at the end of a trading day, ETFs are traded throughout the day like stocks. They offer diversification by investing in a basket of assets, but some ETFs may still have concentration risk if they focus too narrowly within a sector.
Are there different methods of ETF replication?
Yes, ETFs use two main methods: physical replication, where the manager buys the actual assets in the index, and synthetic replication, where they use swap contracts with investment banks.