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ETFs might look similar to mutual funds, but they both are run by several investors who invest in a basket of securities, and they are considered a safer investment for beginners as they are less volatile.
An exchange-traded fund (ETF) works just the same way as any other tradable instrument in the financial market. However, rather than buying and selling ownership of a security, ETF traders can buy shares in a basket of securities including stocks, commodities, indices, and many more.
This way, a trader can track the performance of several companies that operate in the same or in different industries, which may help balance out the risk they are taking by diversifying their portfolio.
However, not all investors trade ETFs because some prefer other securities which provide higher rates of return. In the following, we will discuss how ETFs are created, how they are traded, and what ETF trading looks like.
“There shall be an ETF for every asset class, and it shall be virtually free to own.” – Matt Hougan
Some traders prefer investing their money in a collection of different stocks and other securities in one basket. Depending on the performance of the securities, the basket or the fund’s price can go up and down, and this is how traders make money from investing in ETFs.
ETF traders enjoy lower volatility compared to other financial instruments in other markets. It is somewhat rare for ETFs to make the headlines of an investing platform or a trading brokerage website. So, with less of a buzz about them, ETFs generally don't see rapid price fluctuations.
It might seem like a safer choice for traders because ETFs have less volatility than ordinary financial instruments such as crypto or fiat currencies. On the other hand, it is common to conclude that lower volatility might mean lower rates of return, and some investors prefer putting their money in securities that generate higher gains.
An exchange-traded fund basket may include different securities, for example, stocks of different companies, or different currency pairs in one basket, which is intended to diversify the risk. Classically, a basket balances itself when one currency pair in the basket declines, there is an opportunity for another currency pair in the same basket to increase.
“ETFs are fundamentally a technology. They are mechanisms to achieve a certain goal, like phones. Traditional mutual funds were rotary phones. ETFs are smartphones: They do the same thing but are in a better package.” – Dave Nadig
The SPDR S&P 500 and QQQ are examples of publicly traded ETFs and probably the biggest two funds that trade securities of different industries such as information technology, healthcare, financial services, and communication services. The stocks in these ETFs have different weights from the overall basket and depending on the performance of each stock, the price of the ETF goes either up or down.
Traded funds include securities that share some common characteristics. For example, stocks of companies in the same industry or several Forex currency pairs that vary between common, uncommon, and exotic. All in all, traders can find different types of ETFs in the market.
Stock exchange-traded funds provide traders with stocks of different corporations that perform in different industries, or in the same industry. Investors who trade in stock ETFs can track the performance of different companies’ stocks, and therefore benefit if these companies perform well in the market.
Since stock ETFs use a basket of different stocks that have different weights in the basket, it provides affordable trading opportunities. Especially when it comes to expensive stocks that can be out of reach for traders with a limited budget.
Investing in such ETFs can be a good idea for traders who understand the stock price movements, and enjoy the thrill of watching stock prices change as the result of a public report or a global event. Additionally, some stock traders invest in a stock ETF because it can be cheaper than buying and holding several stocks.
Stock ETFs have different types as well - they can be oriented around stock volatility, market capitalization, or stock value, giving the traders more of a selection when it comes to trading in stock ETFs.
Exchange-traded funds may offer different stocks for companies that operate in the same market. These ETFs are also called Sector ETFs. It might be the most logical option because choosing several stocks from the same industry enables market participants to better predict the upcoming price movement.
Additionally, investing in a basket of stocks in the same industry makes sense because if the whole industry is going up, investing in an ETF that is focused on that sector can bring great returns from the market momentum. This way, traders are less likely to have contradictory stock performances.
There are some industries that are commonly traded in several ETFs because they provide more promising returns than other industries. For example, for a long time now, the tech and financial industries along with communication services have been performing very well in the market.
Commodity ETFs enable traders to invest in a basket of several commodities. These commodities can share similar characteristics such as the oil market which can include crude oil, WTI oil, and brent oil, and traders who are interested in the oil market can make money in ETF investment if the oil market is moving upwards.
Investing in a commodity-based ETF does not mean that you are physically owning the commodities. Rather you are trading on contracts backed by these commodities, which can be futures, forward, or swap contracts.
Future contracts are the most common way of trading with commodity ETFs, but they carry the risk of a rollover fee which is the difference between the commodity’s profit and loss, and the price change in the on-spot commodity price.
Forex-based ETFs enable traders to invest in a basket that contains several currency pairs. This way, traders do not need to invest in several currency pairs at the same time, because it can be overwhelming given the different levels of volatility and events that can affect a currency pair's price.
There is a huge number of currencies that can be traded in a basket of currency ETFs. Different currency ETFs include different collections of currencies, which helps the trader utilize the volatility of this market in a much more affordable way.
Investing in currency ETFs can be used for hedging or arbitrage purposes, where traders can choose one currency and invest in several pairs that include one specific currency against other currencies.
This can multiply the trader’s gain if that fixed currency performs well. However, the trader’s losses can also be magnified if the currency is declining and the majority of the basket is comprised of this one currency.
“Those of you who make investments outside of any retirement accounts are absolutely crazy if you are using actively managed funds rather than ETFs.” – Suze Orman
The exchange-traded funds are created by the ETF manager or the sponsor who initiates a plan to set up an ETF. After the plan is approved, the ETF manager enters into an agreement with authorized participants.
Authorized participants in an ETF can be individual investors, market makers, or brokerage firms, who are empowered to create and redeem a security within the fund. In other words, are authorized to add securities into the fund and take securities out from the fund.
Then, an authorized participant can add shares into the ETF by purchasing them from the market and bundling them. Authorized investors usually buy shares when their stock price is increasing or has a winning potential in the near future, which makes the fund beneficial.
Additionally, an authorized participant in an ETF can sell shares from the fund and take them into the secondary market. This activity is called redemption. If some shares are decreasing in value and they do not represent a good trading opportunity anymore, an authorized participant may redeem these shares from the fund.
ETFs are traded in financial markets, and they have their own ticker symbol allowing any financial trader to buy and sell shares of the ETF. The ETF stock price fluctuates just like any stock, according to the rules of supply and demand.
In order to start trading ETFs, you are going to need to find a broker that includes ETFs in their tradable assets. Then, after you check the broker’s eligibility and set up your trading account, you can start adding funds and trading just like with any other financial instrument.
There is quite a huge number of ETFs on the market. In 2020 alone, there were 2,204 ETFs in the United States, and the number keeps growing as long as ETFs provide flexibility and affordability.
Therefore, knowing how to choose the right ETF that suits your trading style and preferences matters. If you are interested in the Forex market, you are more likely to choose currency ETFs, and so on.
These five factors need to be taken into account when it comes to picking the right ETF for you:
In order to better choose the ETF you want to invest in, you will need to know what types of securities are included in the ETF. If you are more familiar with currencies, then you might be looking to invest in currency ETFs where several currency pairs are involved.
Since an ETF is the same as any other investment in the financial market, you need to understand how the different securities in the ETF are performing and what interests you as a trader - stocks, currencies, commodities, etc.
Additionally, you might be interested in one specific industry because it is performing better than others. So you want to trade ETFs that make sense at that moment, in order to ensure your trade is going to be successful.
The number of securities in the ETFs is also important, whether they are currencies, stocks, commodities, bonds, or any other tradable asset. The number of traded assets in the ETF basket will determine the trading volume and therefore the ETF's price volatility.
If the ETF includes a huge number of assets that are being traded in the market, it means there will be more buying and selling activity, and higher liquidity.
On the other hand, if there are only a handful of assets in the basket, the ETF volatility will be relatively high because less trading volume in the fund will result in low liquidity.
Another factor that affects the volatility of an ETF, is how active the ETF is itself. Popular ETFs in the financial markets have millions of investors involved, and when many traders hear about an ETF, they are more likely to invest.
Managers of successful ETFs keep improving the fund by creating and redeeming securities constantly to keep up with market trends, and to make the ETF appealing to more investors.
Fund trading error is caused by the performance of the ETF itself, which might cause the ETF security prices to diverge from the real price in the financial markets. Such delays can make the overall process less appealing to many traders, especially for volatile assets.
Tracking divergence happens because of the expense ratio of the fund. If the trading expense is high, the ETF divergence is more likely to be high, and the ETF's overall performance will be low and not interesting to traders.
The more trendy the ETF, the more likely it is to be profitable. At the same time, the best ETFs managed to grab a huge share of the market, which makes it more difficult for newer ETFs to compete.
ETFs include a range of securities that affect the fund price, and the performance of these assets affects the fund price. ETFs are traded just like any other financial instrument in the financial markets, where traders can buy and sell stocks of the ETF.
Exchange-traded funds are considered a better choice for beginner traders because of their low price volatility. ETFs and mutual funds usually entail a slower price movement and speculation, which gives space for new investors to understand the financial market and trade accordingly.
It depends on the ETF. You may receive cash distributions as ETF dividends. If you are looking to receive dividends from ETFs, you will need to check the fund beforehand to see if it offers dividends.