Exchange-traded funds (ETFs) are all the rage right now and chances are you’ve already put your money in one or two of them. Maybe a Spider or a commodity-focused fund that you trade from your trading account? Well if you aren’t already in ETFs you might want to think about adding one of these investment vehicles to your financial plan soon.
What are Exchange Traded Funds?
ETFs are commonly known as securities that track an index or a basket of assets the way an index fund does, and trades on a stock exchange just like companies listed stock does. ETF shares can be bought on Margin, Sold Short, or Options contracts can be bought, in the same manner, that exists when buying and selling stocks.
Exchange-traded funds regularly track the stock index value as well as the market climate. These are a good investment if you would like to invest in liquid funds that can be easily bought or sold. What usually attracts investors to ETFs is the fact that this investment opens the door to more options. You can, in effect, create a diversified portfolio of personal financial investments.
Since these trade funds constantly monitor market changes, your risk is significantly reduced. Traders in ETFs are usually investing in funds that are performing well in the market.
Why Investors Choose ETFs
Now that we’ve briefly answered the question, What Are ETFs – let’s explore reasons that investors choose them as investment choices. First off, ETFs offer a way for investors to gain entrée into narrow or obscure markets such as companies based in Belgium or stocks in a particular sector such as the Healthcare Sector.
As mentioned above, some ETFs offer broader exposure to international indexes such as the Nikkei 225 index in Japan, or the FTSE 100 index in the U.K.
ETFs by their nature, provide easy diversification and are attractive to investors because they offer many of the same features of ordinary stocks, such as trading throughout the day on a Stock Exchange, the ability to use limit and stop-loss orders, and the capacity to short sell ETFs, buy futures and options contracts, and even buy ETFs using Margin Accounts.
There are occasions in which an ETF tracks an index that comprises thousands of underlying securities. ETFs created to track these particular indexes, usually invest only in a small percentage of the underlying securities found in that index but still have the goal of matching the performance of the index it tracks.
An Edge over Mutual Funds
So, what are the advantages of investing in exchange-traded funds? Is this better than mutual funds? Traders generally consider ETFs as slightly better than mutual funds.
Mutual funds can be saturated. It may start with a good performance, but it could reach a period where it will not perform as well as you would want it to. On the other hand, ETFs are constantly and regularly tracking the market. The investment, therefore, is dynamic. It will continue to perform well, and it will continue to reduce your financial risks.
ETFs – Know what you’re buying
The terms ETP and ETF are often used interchangeably by the public, although regulators make distinctions between them. Essentially, though, the concept is the same. But ETNs are a whole different animal.
Exchange-traded funds (ETFs) are generally used to provide traditional index exposure. When you buy an ETF, you own a single security that represents a basket of other securities. It generally tracks an index and fluctuates with the underlying assets.
Commodity ETPs that use futures contracts are structured as limited partnerships, while those that hold the physical commodity are structured as grantor trusts. As with an ETF, when you buy an ETP, you own a single security that represents a basket of something else — in this case, a basket of commodities.
Exchange-traded notes (ETNs) are technically debt obligations from a backing bank. They do not necessarily hold the index’s underlying constituents. They can be used to provide traditional index exposure similar to what an ETF offers, but they can also provide two and three times leveraged and inverse and commodity strategies.
Both ETFs and ETPs own an underlying basket that’s what you’re buying, and someone is going to arbitrage. When someone sells you a share of an ETF, they’ve bought something in relation to that to hedge that. So if they sell you the S&P 500 ETF, they’ve bought the S&P 500 stocks. If they buy a share of the S&P 500 ETF from you, they sell the S&P 500 stocks. It’s instantaneous. It provides liquidity and price visibility constantly to investors.
Investors should not confuse ETNs with an ETF, an ETP
There are legal nuances between the latter three, but basically, they are the same. ETNs, however, are generally unsecured debt obligations of the issuer. So you can buy oil ETNs, but all you’re getting is the promise of the issuer to pay you based on some oil index. The issuer doesn’t have to own that oil index. ETNs are not visible. They are not transparent. they are unsecured debt obligations.
The issuer of an ETN tells you what the ETN is based off of, so you know what you’re buying, but you have no idea if they’re hedging that. They don’t have to hedge it. It’s a credit exposure. If that bank or issuer goes bankrupt, you stand in line with the other unsecured creditors. You have substantial risk there.
Know what your ETF or ETP holds. “What is the underlying benchmark?” The level and type of risk may vary significantly from one ETF to another. It is important to understand the underlying benchmark or portfolio of securities the ETF is designed to replicate in order to evaluate the risks of investing in it.
Know the liquidity of the underlying benchmark and when it trades. For an ETF like the S&P 500, this is simple, because if you trade it between 9:30 a.m. and 4:00 p.m. Eastern Time, New York Stock Exchange hours, all those stocks are trading. If you buy the S&P 500 ETF, there’s a market maker who can hedge his position with you, so you always have a very tight bid-ask spread and almost infinite liquidity, because no one is going to put in a big enough order on an ETF to nuke the underlying market.
But some ETFs trade things that aren’t that visible or aren’t that liquid, like an ETF on foreign security. It might be a great ETF.
But if it’s in a different time zone and you’re trading during New York Stock Exchange hours, the person hedging his buy or sell to you, which is usually a market professional, authorized purchaser, or arbitrager, may not have as efficient a hedge, because the markets in that location are closed.
So the price and liquidity may not be as good as if you traded that ETF when its underlying markets were open.
Understand that liquidity and price are at their best when the underlying markets are open. “Trade when the markets are open! Trade your ETF, ETP, or ETV when those underlying markets are open because that’s when you’re going to get the best pricing and liquidity. Now, this matters less to retail investors than institutional investors, but it is still worth noting.”
Never trade a market order on any ETF – Ever
Every ETF is priced by these professionals. There’s a bid and an ask. When the markets are open, that professional will sell you your ETF and buy the underlying to hedge. Machines do that work. There aren’t people anymore. There aren’t floor specialists. It all happens lightning fast on multiple exchanges with machines, and those machines do a two-step process to give you that bid or ask on your ETF.
If they’re offering some shares of an ETF, they are simultaneously bidding in the underlying market. It’s a two-step process. So when you buy an ETF from them, they simultaneously sell to you — step one — and buy the underlying — step two. If you hit a market order, a simple little 100-lot eTrade order, the machine lifts that order.
It’s a one-step process. The machine knows someone just looked at what it was offering. It is instantly programmed to now back up its offer a little, No. 1, for safety, because you can’t ask them to lose money, and No. 2, it knows when you’re bargaining with it.
And if you’re not bargaining with it and just coming at it, it’s going to back away from you. It’s programmed to do that. And it’s basically like a circuit breaker programmed by these computer specialists. It keeps backing up, and the market order keeps chasing. Investors should never, ever, ever use a market order.”
Use a limit order on stops, regular buys and sells, and anything you do. Put a price limit if you are trading an ETF because ETFs are all run electronically by necessity. I don’t mean anything disparaging by that. But machines don’t understand market orders. They just know they are under attack, and they back up unless you are trading all but the most liquid ETFs.
Suggestion: If you’re buying, just go to the ask price. If you’re selling, go to the offer price. And just let the order sit there. The machine knows its value and will keep buying or selling to you at those levels.