ETF Trading: What Are ETFs and What Are Their Advantages?
Reading time: 19 minutes
If you're getting started in trading and investing, you might have heard the term 'ETF' being used. And you might be wondering, what are ETFs?
This article will give you an overview of what ETFs are, their origins, the benefits and disadvantages of ETF trading and our top ETFs to invest in for 2020.
What is an ETF?
An Exchange Traded Fund (ETF) is a group of securities that you can buy or sell via a brokerage company on a stock exchange. These underlying securities tend to represent an economy or a sector, so it's a way for investors and traders to invest in economies or sectors they are interested in without having to pick individual stocks and at much lower costs than mutual funds.
Some examples of ETFs include:
- iShares S&P 500 Growth ETF, which includes shares from the S&P 500
- VanEck Vectors Gold Miners ETF, comprised of gold mining companies
- iShares Silver Trust ETF, which reflects the performance of silver's price
- iShares PHLX Semiconductor ETF, which tracks US stocks in the semiconductor sector
- Energy Sector SPDR Fund ETF, which tracks companies in the energy sector
There are many more types of ETFs to choose from, including bonds, currencies and new growing markets such as biotechnology, artificial intelligence, etc.
As mentioned above, ETFs give traders and investors the opportunity to speculate on or invest in a sector, rather than choosing individual assets.
For example, you may have recently heard a lot about the growth of AI (Artificial Intelligence). However, you may not know how to find the right company to invest in since it is still a very new area.
In this case, an investor could turn to the Global X Robotics & Artificial Intelligence ETF. Below you can see the price of this fund during five days of October 2019. Source: Google Finance.
This ETF in particular seeks to invest in companies that can benefit from advances in the development of robotics and artificial intelligence. Therefore, it can provide the investor with access to a growing market, without having to choose a company individually.
This sector/economy focused approach makes Exchange-Traded Funds one of the most sought-after financial products for small investors. ETFs offer a broad array of benefits and, if selected carefully, can be an excellent way of achieving investment goals.
The Origin of ETFs
As a product, ETFs were created in the US 1993 when Nathan Most and Steven Bloom developed Standard & Poor's Depositary Receipts (SPY).
Economist Harry Markowitz was one of those who laid the first bricks in the creation of the Exchange Traded Fund. His idea was to introduce a publicly traded fund that was related to the world's most popular index: the S&P 500. Known as SPDRs or Spiders, the fund became the largest ETF in the world, now having a value of more than 43.3 billion dollars.
On US stock exchanges alone, there are nearly 1,000 ETF products with around $1 trillion invested in total.
In 1996, iShares debuted in ETFs globally, selling ETFs on a wide range of European, Asian and American indices. Thus, iShares established themselves as having the largest variety of ETFs, with more than 300 options for traders and investors. This caused a domino effect in terms of the emergence of new ETF instruments that could be traded and to which the common investor could have access.
The success of stock ETFs encouraged the industry to launch one related to gold, and in 2004 Gold SPDR (GLD) was launched. In the image below you can see the performance of this instrument over a year. Source: Etf.com
Today, the ETF market represents almost 3 billion dollars in daily transactions, competing with the liquidity offered by the Forex market. Essentially, ETFs are investment funds that aim to track the performance of a specific index or asset.
Admiral Markets offers the ability to trade on thousands of stocks and ETFs, and over 300 ETF CFDs.
How Do They Work?
Just like company shares, ETFs are listed on stock exchanges and can be bought and sold during trading hours. Also, like listed stocks, an ETF will have a ticker symbol and intraday prices.
Where they differ from company stocks is that the number of shares available in an ETF can change daily as a result of the continuous creation of new shares, and redemption of existing shares in the ETF.
The market price of an ETF is usually kept in line with its underlying securities on an ongoing basis, due to the ability of an ETF to issue and redeem shares in itself.
In summary, these are the characteristics of ETFs:
- They are traded like equities, which makes their prices visible in real time.
- They can be sold or purchased at any time during trading sessions.
- They are a single instrument that contains several trading instruments, including shares and fixed-income securities.
- They are not exclusively available to corporate investors or large participants in financial markets.
Generally, ETFs are outstanding investment choices. They can be bought and sold in real time and have lower management fees than ordinary funds. For these reasons, ETFs are also starting to replace mutual funds as the default investment vehicle.
What Are the Differences Between ETFs and Investment Funds?
If you've considered investing in investment or mutual funds, you might feel like ETFs and investment funds sound very similar. While the two instruments share some similarities, they also have some key differences:
- An investment fund includes the contributions of several savers who transfer the management of those contributions. ETFs, however, are bought or sold directly in the stock market as if they were shares.
- Investment funds can be actively or passively managed, while ETFs are passively managed and, typically, have much lower costs.
- Active investment funds try to outperform indexes while the ETFs seek to match the returns of the index they replicate.
What Are Leveraged ETFs?
A leveraged ETF is an Exchange Traded Fund that uses financial derivatives and debt to amplify the returns of an underlying index. In plain English, this means you can access a high-value ETF for a relatively low deposit.
Think of it like buying a house - you pay a 10% or 20% deposit up front, and the bank allows you to borrow the rest of the money in order to purchase the property. Similarly, some brokers offer leveraged ETFs where a trader can deposit just 20% of the ETF's value in order to trade it.
If the ETF then rises or falls in price, you will experience the full change in price, even though your deposit was just a fraction of the ETF's value. This means that if the market moves in your favour, your percentage return on investment (relative to your initial deposit) is much higher than it would be if you'd purchased the full value outright.
However, if the market moves against you, your losses will be magnified to the same extent.
Learn more about leverage in trading and investing.
What are the Benefits of ETF Trading?
Now that you know what ETFs are, here are some of the benefits of trading and investing in Exchange Traded Funds:
- Tax efficiency: Investors can have better control over when they pay capital gains tax.
- Lower fees: ETF Trading can be low cost, as there may not be any sales load. However, brokerage commissions will apply.
- Sell and buy during any time of the trading day, whereas mutual funds can settle after the market closes.
- Trading transactions: As ETFs can be traded like stocks, investors can place a variety of different orders (limit orders, stop-loss orders, buy-on-margin orders, etc.) which are not available with mutual funds.
- Diversification: Because ETFs represent a range of assets, they create automatic diversification (and lower risks) for investors, as opposed to picking individual instruments. This is one of the main reasons why ETF Trading is a good option for beginners.
- No minimum investment: This is determined by the limits established by the broker you work with.
- Ability to trade long or short: If you trade ETFs via CFDs, you have the ability to trade long and short, which gives you the opportunity to profit in both rising and falling markets.
- Trade with leverage: When trading ETF CFDs, leverage allows you to access a large position size for a relatively small deposit, which can amplify your profits and losses.
- Versatility: ETFs are suitable for all types of traders, including swing traders
If these benefits sound interesting to you, you can start trading ETFs online today with an Invest.MT5 trading account! Invest.MT5 gives you access to over 200 of the world's most popular ETFs, as well as over 4,000 shares from 15 of the world's largest stock exchanges.
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What Are the Disadvantages of ETFs?
While they have many advantages in many fields, ETFs do have some drawbacks, including:
- Settlement delays: ETF sales may not settle for two days after a transaction, which means that a seller's funds may not be available for re-investment until the two days have passed.
- Illiquidity: Some thinly traded ETFs may have wide bid/ask spreads, meaning your transaction costs could be high, although the same can be said about small company stocks that are thinly traded.
- Price discrepancies: While ETF prices track their underlying asset class reasonably well, there can be discrepancies.
- Trading costs: If the investment value is small or less frequent, there could be lower-cost alternatives by investing directly in the asset class.
Can You Day Trade ETFs?
Just like listed shares, ETFs are traded on exchanges and have real-time prices that fluctuate during trading hours. This makes them suitable for day trading and other trading styles.
2020's Best ETFs to Invest in
Now that you know what ETFs are, along with their benefits and disadvantages, what are some of the best ETFs to start your investing journey?
While there is no clear answer as to what the best ETFs are, higher-risk investments may appeal to the risk profile of younger investors, as they have the time to benefit from long-term trends and to build wealth through ETF income stream, while retirees might prefer lower-risk investments. Here are some to think about, with your risk profile in mind.
Top Gold and Silver ETFs
Gold and Silver are both defensive, or safe haven, assets. This makes them a popular choice during times of economic uncertainty, as well as in high-inflation environments. Some ETFs are backed by physical gold holdings and many are listed globally.
One of the best choices for traders is the SPDR Gold Shares (GLD), due to its strong liquidity and lower transactions costs associated with bid/ask spreads. As for the long-term investors, the iShares Gold Trust (IAU) is a good match because its annual expense ratio is 15 basis points below GLD.
Best Real Estate ETFs
Real estate investors can get diversification benefits from real estate investment trusts (REITs) of various types. A REIT is an entity that develops or manages real estate properties to produce income. There are many types of REITs, including residential, commercial (e.g., factory outlets, health care facilities, hotels, office and shopping centres), industrial, and mortgage REITs.
As required by law, REITs must disburse at least 90% of their taxable income each year to shareholders by paying them dividends. REITs are regulated in the USA by the US Securities and Exchange Commission. Furthermore, investors can purchase shares in mutual funds or ETFs that hold one or many REITs in their portfolios.
Some portfolios in this category also invest in real estate operating companies. Here are some of the top-ranked real estate ETFs:
- Vanguard Large-Cap ETF CFD (VM)
- SPDR Dow Jones International Real Estate ETF CFD (RWX)
- iShares US Real Estate ETF CFD (IYR)
- Schwab US REIT ETF CFD (SCHH)
Best Vanguard ETF For 2020
Vanguard is a pioneer in the field of ETFs and is one of the world's largest and cheapest providers. It has about $6.2 trillion in global assets under management, as of January 31, 2020.
The Vanguard FTSE Developed Markets ETF (VEA) Fund is one to watch, as one of the 3 largest US listed ETFs. As developed market stocks are trading at large discounts relative to the S&P 500, investors could be looking to invest in the VEA again for 2020. According to Investopedia, VEA provides exposure to nearly 3,900 stocks from 24 countries.
Best Index ETFs
While many investors will be happy with the performance that the S&P 500 index over the last few years, some will seek to diversify their portfolio and find other markets that can increase their overall returns.
Some investors may also want to invest in something they know more about, such as technology stocks. The Nasdaq 100 index, which includes many of the world's top technology shares, gained more than 50% from January 2019 to January 2020.
So how can you invest in the Nasdaq 100 index?
There are many ETFs that track the performance of the Nasdaq 100. For example, there is the First Trust NASDAQ-100 Technology Index Fund (QTEC) ETF. This gives the investor an exposure to a wide range of technology shares such as Facebook, Apple, Amazon, Netflix and Google, in the form of ETF.
Best Growth ETFs
What are growth ETFs? Simply, these ETFs are considered to possess growth characteristics, rapidly growing sales, and relatively high price-to-earnings ratios. They include:
- Vanguard Growth ETF CFD (VUG)
- Technology Select Sector SPDR Fund ETF CFD (XLK)
- Consumer Discretionary Select Sector SPDR Fund ETF CFD (XLY)
- iShares Nasdaq Biotechnology ETF CFD (IBB)
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Best Dividend ETFs
Investors seeking dividend yields have plenty of ETFs to choose from. But bear in mind that while a company's dividend track record can be informative, it cannot be relied on as a forecast of future dividend yields. Neither the earnings nor the earnings/dividend payout ratio in the past can be relied on to occur in the future.
Dividend-driven investors should look at:
- iShares US Real Estate ETF CFD (IYR)
- PowerShares Preferred Portfolio ETF CFD (PGX)
- Schwab US Dividend Equity ETF CFD (SCHD)
- SPDR S&P Dividend ETF CFD (SDYUS)
Top Artificial Intelligence ETFs
Artificial intelligence (AI) is a field of computer science that focuses on creating intelligent machines that can work and make decisions like humans. Some ETFs focus on this area and these are likely to benefit from the increased use of AI in various aspects of industrial or non-industrial robotics, automation, social media, autonomous vehicles, and natural language processing.
Some funds specifically invest in companies that develop AI, technological improvement, as well as development of new services and products. Some examples include:
- PowerShares QQQ ETF CFD (QQQ)
- Technology Select Sector SPDR Fund ETF CFD (XLK)
Other ETFs with Growth Potential in 2020
This is the a of ETFs focusing on specific sectors that could do well in a strong recovery:
- iShares US Aerospace & Defense ETF CFD (ITA)
- iShares US Home Construction ETF CFD (ITB)
- iShares Global Energy ETF CFD (IXC)
- SPDR S&P Bank ETF CFD (KBE)
- VanEck Vectors Oil Services ETF CFD (OIH)
- SPDR S&P Biotech ETF CFD (XBI)
- Vanguard FTSE Emerging Markets ETF CFD (VWO)
- Financial Select Sector SPDR Fund ETF CFD (XLF)
- Schwab US Large-Cap Value ETF CFD (SCHV)
Should You Invest in ETFs, or Trade ETF CFDs?
Contracts for Difference (CFD) and Exchange Traded Funds (ETF) are two of the preferred trading options for those who invest in the markets.
A CFD is a high-risk leveraged product, while an Exchange Traded Fund generally replicates an underlying index, as discussed earlier. For this reason, it is considered to be lower risk.
Depending on your risk-appetite, you can invest in ETFs directly, or you can trade CFDs based on ETFs.
The difference is that investing in an ETF directly is like investing in a share - you purchase a share of the ETF outright and hope to sell it at a higher price for a profit.
The CFD, on the other hand, is a derivative instrument, meaning it's a tool traders can use to trade underlying assets, without owning the assets themselves. It is a contract between a trader and a broker that can be bought or sold at an initial price based on the underlying asset (in this case, an ETF). Basically, you can speculate on whether you think the price of an ETF will go up or down, but you don't need to purchase a share of the ETF outright.
If the market moves in your favour, you close the trade (you close the contract), and collect the difference between the opening price and the closing price of the trade as a profit. If the market moves against you, the difference between the opening and closing price of the trade will be a loss.
When someone invests in an ETF, it is typically seen as a long-term investment - something you buy and hold for several years, with the intention of selling it for a profit in future.
CFDs, on the other hand, are used for active trading - some traders make trades in mere minutes, while others might keep trades open for a few days, weeks or months.
One of the reasons why CFD trades tend to be shorter is due to leverage. As discussed earlier, leverage allows you to access a large position for a small deposit, and it amplifies both your profits and losses. Because of this amplification, these trades either hit their profit targets or the maximum loss a trader is willing to accept, which means trades tend to be closed more quickly than traditional investments.
CFDs can be traded long (meaning you open a 'buy' trade in the hope that the underlying asset will increase in price, and you can sell it at a profit) or short (meaning you open a 'sell' trade in the hope that the asset will decrease in price, then you close the trade at a lower price, with the price difference being your profit).
Both of these factors make them a useful tool for active, short-term trading.
By contrast, ETFs are a better match for those seeking a passive investment, with a buy-and-hold strategy.
Invest in ETFs with Admiral Markets
In this article we've answered the question 'what are ETFs?', and outlined the benefits and disadvantages of investing in them, and shared our opinion about some top ETFs for 2020.
If you are ready to start investing in ETFs, it's essential that you choose a reliable ETF broker.
Admiral Markets is an award-winning, regulated broker that offers ETFs via our Invest.MT5 account. If you want to trade on 15 of the world's largest stock exchanges, with access to FREE real-time market data, advanced chart and technical analysis, a state-of-the-art trading platform and more, click on the banner below to open your account today!
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.