The ChoosaBroker Trading Academy

2.9. Basics of ETFs

As the name suggests, Exchange Traded Funds (ETF) are investment vehicles that can easily be bought and sold on stock exchanges. An ETF owns assets such as stocks or bonds, and the ownership of these assets is divided into shares that are held by shareholders. These shareholders are entitled to dividends or interests, and may also get a residual value in the event of the fund liquidating.

ETFs are similar in structure to mutual funds in that each share of an ETF that an investor acquires represents partial ownership of an underlying bunch of securities. However, unlike mutual funds, which can be brought or redeemed only from the asset management company after the close of trading, ETFs can be traded on an exchange throughout the day. This gives investors not just the benefit of diversification, but also better liquidity.

Types of ETF

Exchange traded funds can be broadly classified in to five categories.

  • Equity ETFs – The majority of ETFs track market indices. Some simulate the index in its entirety, while others utilize representative sampling. The rapid expansion in the number of ETFs has provided investors with an inexpensive way to achieve diversification. Whether an investor wants to buy a country fund, or an emerging markets fund, the choices available are plenty. In addition to geographic diversification, funds are also available based on the different styles of investing – value, growth, dividend or momentum.
  • Fixed Income Funds – Most investment advisors recommend that a portion of portfolio be directed towards fixed income assets like bond ETFs. Bonds have been shown to reduce the volatility in a portfolio, while also providing an additional income stream. Bond ETFs outperform during economic recessions when investors pull their money out of stocks and into federal and local government bonds
  • Commodity Funds – Investors can either buy an ETF that tracks a particular commodity like gold or silver, or invest in stock ETFs that focus on commodity producing stocks. Historically, commodities have had very little correlation with equities, providing investors with a hedge against stock market correction.
  • Currency ETFs – Currency ETFs invest in a single currency or basket of currencies. They aim to replicate the movements in a foreign exchange market by either directly holding the currency or through currency denominated short term debt.
  • Real Estate Funds –Real estate investment trust ETFs invests in a specific kind of real estate or can be broader in nature. Their biggest attraction is the fact that these funds are required to pay out 90% of their taxable income, making them extremely lucrative in terms of yield, especially when interest rates are low.

ETF Trading & Investing Strategies

Exchange Traded Funds (ETF) are ideal investment vehicles for beginners to financial markets. Their relatively lower costs, wide range of underlying assets, abundant liquidity and greater transparency are some of the key benefits. The standout feature of ETFs is that they can be used for both long term investing and shorter time frame trading. We look at 4 such time tested market beating strategies. There is a useful article on the leading brokers for beginners.

Systematic Investment

  • Systematic investment through dollar cost averaging is the most basic ETF strategy. It stipulates buying a fixed dollar amount of an underlying asset during regular time intervals without paying any heed to the ongoing market conditions. Beginner investors don’t have the requisite knowledge to time the markets. For them, the best option is to take out a couple of hundred dollars every month and invest in an ETF or a bunch of ETFs. Systematic investing has two major benefits. The first is that it inculcates a certain discipline to the entire investing process. The second is that by investing a fixed-dollar amount every month, an investor accumulates more units when price is low and lesser units when the ETF is at higher price. This averages out the cost of holdings, and is an excellent long term wealth generation strategy.

Diversified Portfolio Allocation

  • Asset allocation is defined as an investment strategy by which an investor allocates his capital to the different asset categories. Financial assets can be divided in to four broad classes – equities, commodities, bonds and cash. Each asset has its own inherent risk to reward profile. Equities are by far the riskiest asset, but they also yield the maximum returns. Commodities also fall in to the high risk, high return segment; but their low correlation with equity markets make them a perfect hedge against stock market corrections. Bonds lend stability to a portfolio due to their lack of volatility. What percentage of each asset should be in your portfolio is dependent on many factors. Typically, the younger an investor is, the more should be his exposure to equity ETFs. For example, an investor in his 20s may decide to invest 100% in to equities because of his long investment horizon and higher risk appetite. But as he gets into his 30s and 40s, he should opt to shift to a more stable investment mix – 60% in equity funds and 40% in fixed income ETFs.

Seasonal Trends Investing

  • ETFs are excellent tools to take advantage of seasonal trends in financial markets. Let us look at two widely known seasonal tendencies. The first is called the “sell in May and go away” strategy. Historically, equities have tended to underperform during the six months starting May, when compared to the November to April period. This general market weakness can be exploited by shorting a broad based equity index ETF around the beginning of May, and covering the short position by the end of October. The other notable seasonal trend is seen in gold, which has a tendency to appreciate in price during the months of September – October, buoyed by robust demand from top consumer India ahead of the peak wedding season. A beginner can thus take advantage of this seasonal strength in gold by acquiring units of a popular gold ETF during the end of summer and closing out the long position before the year ends. Investors should however remember that seasonal trends may not always play out as predicted. This demands the use of stop losses to prevent the risk of big erosion in capital in the event of market turning against you.

Momentum Strategies

  • Momentum traders seek to benefit from sharp short term price movements in an underlying asset. Momentum strategies and can be based on pure price action or a technical indicator signal. Such methods can be applied in both up and down markets. During quiet and non-trending phases, momentum traders prefer to sit on the sidelines and wait for higher potential setups. When trading price momentum, the gains can be big, but so can be the losses as momentum can shift very swiftly. Controlling risk with a mandatory stop loss, and always having an exit plan in place, are the two keys to profit from this strategy. A highly successful momentum strategy is to take advantage of the concept of relative strength. Relative strength refers to how one ETF performs when compared to another. In the event of a market dropping, shorting the weaker ETF increases the likelihood of your trade turning profitable. Similarly, during bull markets, betting on the best performing ETF stacks the odds of success in your favour.

Advantages of ETFs

There are numerous advantages of investing through an ETF, the most notable among which are listed below:

  • Portfolio Diversification – A single ETF can give an investor exposure to a diverse group of equities and market segments. In comparison to a stock, the ETF tracks a broader range of equity assets, or even tries to mimic the returns of a single index or a cluster of indices.
  • Lower Fees – Compared to managed funds, ETFs charge lower fees on account of lower expense ratios. A mutual fund has a relatively higher expense ratio due to costs such as management fee, accounting expenses, marketing fees, and sale and distribution expenses.
  • ETF Trades Like a Stock – Just like stocks, ETFs can be bought on margin and sold short. Their prices are updated throughout the day, enabling traders to initiate short term positions. On top of that, the availability of derivative assets like futures and options makes ETFs a handy tool for managing risk.
  • Dividends are Reinvested Immediately – In open ended ETFs, the dividends disbursed by companies are immediately reinvested. In contrast, dividend reinvestment in index mutual funds can vary depending on the stated objectives of the fund under consideration.
  • Tax Benefits – Due to the differences in structure, ETFs typically incur less capital gains taxes than mutual funds. Moreover, capital gains tax on an ETF is attracted only on sale by the investor, whereas mutual funds regularly pass on capital gains taxes to the investors.

Disadvantages of ETFs

The three main drawbacks of ETF are stated below:

  • Not Widely Available – Barring the United States and some other developed economies, investors in most other countries don’t have a wide variety of ETFs to choose from.
  • Low Trading Volumes – When ETFs don’t have sufficient trading volumes, the advantages of ETFs over indices or equities diminish. The bid-ask spread can get too wide to provide any cost benefit to the investor.
  • The Risk of Loss in Leveraged ETF – Double or triple leveraged ETFs can result in substantial loss even when the adverse market movement is relatively small.

Final Thoughts

ETFs first entered the investment horizon in 1989. Since then they have proliferated, tailoring to an increasingly specific array of assets and regions. Their ease of use and lower costs have seen a boom in investor interest, with the U.S. alone reporting ETF assets worth $3.40 trillion as of December 2017.

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