What are ETFs?
Exchange Traded Funds (ETFs) are financial products that combine the pooled asset features of a mutual fund with the trading capabilities of common stocks. As with mutual funds, a trader buys shares/units in an ETF at the Net Asset Value to own a proportional interest. But unlike mutual fund units, ETF units have high liquidity and can be bought and sold in global exchanges through brokerage accounts throughout the trading day. ETFs are continuously priced in the market and can be margined, lent, shorted or could be used as the underlying asset for derivative contracts.
ETFs are generally designed to meet particular investment objectives, mostly passive in nature. Initially ETFs were designed to track the price movements of major equity market indexes and such ETFs continue to be predominantly popular among American traders. However multiple ETF varieties have emerged that track sectorial indices, global indices, bond and commodity prices. According to ETFGI, the global assets in ETFs were valued at $2.9 trillion in 2015. In July 2017, assets in European exchange-traded funds were valued at $662 billion, with around 6000 listings on 26 exchanges, and over 1500 ETFs in total. They are a very popular product among institutional and retail traders alike.
Types of ETFs
The major varieties of ETF are outlined below:
Broad based Equity Index ETFs: These ETFs track popular market indices such as S&P500, NASDAQ composite, NASDAQ-100 etc.
Sectorial Equity Index ETFs: These ETFs track the movement of industry specific indices and allow the investor to take exposure to particular sectors such as finance, technology, consumer goods etc.
Global Equity Index ETFs: These ETFs track movements of global market indices and allow traders to get easy exposure to promising equity markets beyond the boundaries of their native country.
Bond index ETFs: These ETFs track index movements of federal and corporate bond markets.
Commodity ETFs: Commodity ETFs track prices of a wide range of commodity products such as precious metals, agricultural products etc.
Benefits of Trading ETFs
Cost: The annual fees for an ETF fund is much less than actively managed funds because of the lower churn rate of the portfolio, which leads to reduced incidences of capital gains taxes.
Diversification: As ETFs invest in all or a representative sample of securities in a particular index, the portfolio base becomes highly diversified.
Liquidity: Liquidity of a good ETF is comparable to that of a common stock. ETF units can be continuously traded at the listed price, just like stocks.
Transparency: The ETF issuer provides information to the market regarding the ETF portfolio and the NAV value is continuously updated on the exchange as the market price of an ETF unit. This makes ETFs a very transparent investment vehicle.
Speculative contracts: Market indices provide a good representation of overall market trends. Hence, Index ETFs serve as an excellent asset base for speculators and hedgers to take a position based on their market view, and provide a conducive environment for the development of a healthy derivative market around them.
ETFs Trading Strategies
Core & Satellite Strategy: A common asset allocation strategy in which a large chunk of the portfolio (core) is invested in a passive product like a Market Index ETF, benefiting from systematic risk of the index, while actively trading the remainder of the assets. Because of the low tracking error that ETFs offer, they have become a popular product to be used in the core of an investment portfolio.
Cash Equitisation: Due to the high liquidity of ETFs they can be used to reduce cash drag in case of sudden capital inflows. Funds can be directed to the index while more suitable avenues are considered. When the right opportunity comes up, ETFs can be liquidated easily to purchase new assets.
Shorting ETFs: ETFs trade just like shares, this make it possible to short the whole index and take a pessimistic speculative stance on the market. SB& L markets around ETFs are constantly growing which ensures that ETFs are abundantly available for borrowing to meet shorting obligations.
Pairs Trading: Due a wide spectrum of ETF varieties available in the market that follow various global indexes, they can be utilised for pairs trading. For example, if it is predicted that Indian stock markets could outperform the emerging markets index, then it's possible to go long on Indian NIFTY50 and short on the MSCI emerging markets index.
Trading Using CFDs: ETF indexes provide an excellent asset base for CFD trading, where an agreement is made with a counterparty to exchange the difference in NAV between the start date and the closing date of the contract. Traders can take a speculative stance on the whole market by either going long or short on the broad index, and take an exposure much greater than the amount paid by utilising leverage. ETF CFDs provide hedging benefits by balancing out price movement. For example, if crude oil prices go down then the stock price of downstream oil companies in the energy ETF goes up and net losses are minimised.
ETF Trading with Regulated Brokers
Trading ETFs with regulated brokers provide multiple advantages such as:
Regulated brokers are well supervised by authorities which makes trading with them much more secure
Many varieties of ETFs are available for CFD trading, such as equity, global equity, sectorial equity, commodity etc.
Spreads offered are quite competitive
Online and telephone customer support
Summary
Among the recent innovations in financial instruments, ETFs have been of great significance. They have provided traders with new opportunities to fine tune their trading strategy. At the same time, they have given the retail trader a vehicle which is well diversified, liquid and cheaper than mutual funds. Index ETFs that track broad markets have opened up many speculative opportunities for market participants.
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