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What Is an ETF? Learn How to Trade and Invest in ETFs

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Exchange-traded funds (ETFs) have become extremely popular with traders and investors in recent years for good reason. Simple, transparent, and cost-effective, they offer a straightforward way to gain exposure to a wide range of assets including stocks, bonds, commodities, and real estate.

Interested in learning more about ETFs? This guide to ETFs is a great place to start. In this guide, we’ll walk you through the basics of ETFs and explain how you can invest in them.

What is an ETF?

An ETF, or exchange-traded fund, is a type of investment fund that aims to track the performance of a specific stock market index, industry sector, or asset.

ETFs are in many ways similar to mutual funds. However, unlike mutual funds, they are traded on the stock market. This means that they can be purchased and sold just like regular stocks.

There are ETFs available for virtually every asset class, including stocks, bonds, real estate, and commodities.

Some examples of ETFs include:

  • The SPDR S&P 500 ETF (SPY), which tracks the performance of the S&P 500 index.
  • The Technology Select Sector SPDR ETF (XLK), which offers exposure to US technology companies.
  • The SPDR Gold ETF (GLD), which tracks the performance of gold.

To buy or sell an ETF, you need a trading account with a stock broker or investment platform.

What are the advantages of ETFs?

There are a number of advantages to investing in ETFs.

These include:

  • Low costs: ETFs tend to have extremely low ongoing charges meaning that they can be a great way to invest cost-effectively. They are generally much cheaper than actively-managed investment funds because they do not have investment managers actively making investment decisions.
  • Diversification benefits: investing via ETFs is an easy way to diversify your portfolio. Through one security, you can potentially gain exposure to hundreds of different individual stocks. For example, the SPDR S&P 500 ETF (SPY) offers exposure to 500 different US stocks.
  • Instant access to a wide range of markets: ETFs can be a very useful asset allocation tool as they can help you gain access to different areas of the financial markets including foreign markets, commodity markets, and real estate markets. For example, if you’re looking for portfolio exposure to Chinese stocks, you could invest in the iShares China Large-Cap ETF (FXI). Similarly, if you’re looking for portfolio exposure to silver, you could invest in the iShares Silver Trust (SLV).
  • Transparency: ETFs are very transparent. Unlike mutual funds, investors can see exactly what an ETF holds.
  • Easily traded: Because ETFs are traded on the stock market, it’s very easy to buy and sell them. You can trade ETFs at any time during market hours.

Types of ETFs

There are many types of ETFs available to investors today.

Some of the main types of ETFs include:

  • Stock index ETFs: these are designed to track a particular stock market index such as the S&P 500, the FTSE 100, or the Nikkei 225. Examples of stock index ETFs include the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 index, and the iShares FTSE 100 UCITS ETF (ISF.L), which tracks the FTSE 100 index. Investing in stock index ETFs can be a great way to gain broad exposure to the stock market at a low cost.
  • Sector or industry ETFs: these are designed to provide exposure to specific areas of the stock market such as technology companies, healthcare companies, or financial companies. An example of an industry ETF is the Healthcare Select Sector SPDR ETF (XLV), which provides exposure to healthcare stocks in the S&P 500 index.
  • Style ETFs: these are designed to track stock indexes that are based on a specific investment style. An example of a style ETF is the iShares Edge MSCI USA Quality Factor ETF (QUAL), which invests in large-and mid-cap US stocks that have strong fundamentals.
  • Bond ETFs: these are designed to provide exposure to fixed income securities. They can contain all kinds of bonds including US Treasury bonds, corporate bonds, high-yield bonds, and more. An example of a bond ETF is the iShares Barclays 1-3 Year Treasury Bond ETF (SHY), which provides exposure to US Treasury bonds.
  • Commodity ETFs: these are designed to track the price of a commodity such as gold or oil. An example of a commodity ETF is the SPDR Gold ETF (GLD), which tracks the performance of gold.
  • Real estate ETFs: these are designed to track real estate indexes. An example of a real estate ETF is the Vanguard Real Estate ETF (VNQ), which tracks the performance of the MSCI US Investable Market Real Estate 25/50 Index.
  • Leveraged ETFs: these are designed to provide amplified exposure (2x, 3x, etc.) to the underlying shares or market. An example of a leveraged ETF is the Proshares Ultra S&P 500 (SSO), which provides 2x the daily return of the S&P 500 index. Leveraged ETFs can magnify your potential investment gains, however, they can also magnify your losses.
  • Inverse ETFs: these are designed to help investors profit from a decline in the underlying index or market. If the underlying index falls, the inverse stock index ETF will rise. An example of an inverse ETF is the ProShares UltraPro Short QQQ ETF (SQQQ). This ETF rises if the underlying index, the NASDAQ 100, falls. Note that this particular ETF is also leveraged and provides 3x the regular exposure.

How investing in ETFs works

ETF trading and investing is quite simple. Here’s a look at the basics.

Profiting from a rising market

If you believe that a stock market index or asset (such as gold) is likely to rise in the future, you would open a BUY position on an ETF that covers that index or asset. This is called ‘going long.’

For example, if you believe that the S&P 500 index is going to rise over the next year, you would open a BUY position on an ETF such as the SPDR S&P 500 ETF (SPY), which tracks the performance of the S&P 500 index.

If the S&P 500 index does rise, your investment in the SPDR S&P 500 ETF (SPY) will increase in value, and you can close the trade for a profit if you wish. However, if the S&P 500 index falls, the value of your ETF will fall as well, meaning you will generate a loss.

Profiting from a falling market

If you believe that a stock market index or asset is likely to fall in the future, you could open a SELL position on an ETF that covers that index or asset. This is called ‘going short.’

You can open a SELL position on an ETF by trading Contracts For Difference (CFDs). CFDs are financial instruments that offer traders and investors the opportunity to profit from the price movements of a security without actually owning the underlying security.

For example, if you believe that the S&P 500 index is going to fall over the next three months, you could open a SELL position on the SPDR S&P 500 ETF (SPY), which tracks the performance of the S&P 500 index.

If the S&P 500 index does fall, you will profit from your short position. If the S&P 500 index rises, however, you will generate a loss.

Dividends

A third way you can potentially profit from ETFs is through dividends.

Dividends are cash payments that some companies pay to their investors out of their profits. Not all companies pay dividends but many well-established companies do. If you hold an ETF that invests in dividend-paying companies, you will receive dividends on a regular basis.

For example, if you hold the iShares FTSE 100 UCITS ETF (ISF.L) – which has exposure to a number of dividend-paying companies listed on the London Stock Exchange – you will receive regular dividends.

ETF fees

There are two types of fees associated with ETFs.

These are:

  • Trading commissions: these are the fees that brokers and investment platforms charge to place a trade. On eToro, there are zero commissions* to open and close ETF positions.
  • Ongoing charges: these fees, which are sometimes referred to as the ‘total expense ratio’, are charged by the fund company / ETF provider, i.e. iShares or ProShares. Ongoing charges are generally very low. For example, ongoing charges on the SPDR S&P 500 ETF (SPY) are around 0.095% per year.

*Zero commission on ETFs is only available to UK and European clients of eToro UK Ltd. and eToro Europe Ltd. and does not apply to short or leveraged trades.

Risks of investing in ETFs

All forms of trading and investing involve some degree of risk and ETF trading and investing is no different. The main risk that ETF traders and investors face is market risk or investment risk. This is the risk that the underlying index or asset falls in value. If you own an ETF and the underlying index or asset falls, the value of your ETF will also fall.

For example, if you buy a S&P 500 index ETF such as the SPDR S&P 500 ETF (SPY), and the S&P 500 index falls 20%, the value of your investment is also likely to fall by around 20%. Similarly, if you buy a gold ETF such as the SPDR Gold ETF (GLD) and the price of gold falls 20%, the value of your investment will also fall by about 20%. It’s important to note that leveraged ETFs carry additional investment risk.

For example, if you buy a leveraged ETF that offers 2x the exposure to the S&P 500 index and the S&P 500 falls 10%, you are looking at a loss of 20% instead of 10%.

Risk management strategies

You can never eliminate risk completely when investing in ETFs, however, there are ways to reduce risk.

One of the most effective ways to reduce risk is to diversify your portfolio. This means spreading your money out over many different investment assets so that you’re not over-exposed to any single asset. A diversified portfolio might have exposure to equity ETFs, bond ETFs, and commodity ETFs.

For stock index ETFs, adopting a long-term investment horizon is another strategy that can help reduce the risk of losing money. In the short term, stocks can be highly volatile. However, in the long run, the stock market tends to rise. So, generally speaking, the longer you invest for, the less chance you have of losing money.

For short ETF trades, stop losses can also be an effective risk-management tool. Stop losses help minimise investing losses by closing out losing positions before large losses build up.

How to choose an ETF

There are hundreds of ETFs available to investors today.

When it comes to choosing an ETF, the first thing to do is to define your goals and objectives, and your risk tolerance.

Common goals and objectives include:

  • Investing in the stock market, or a particular sector, to generate capital growth
  • Generating passive income from dividend-paying companies
  • Diversifying your investment portfolio across multiple asset classes such as equities, bonds, and commodities
  • Hedging your portfolio against risks such as falling share prices or currency movements

Once you have determined your goals and objectives, you can identify an ETF that can help you achieve them and is suited to your risk tolerance.

Origin: www.etoro.com

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