What is ETF Trading? - A Beginners Guide

What is an ETF?

The abbreviation ETF stands for exchange traded fund, a type of security that trades on exchanges, similar to the trading of stocks. ETFs were introduced in 1993. The website of the Johannesburg Stock Exchange defines ETFs as: ‘Exchange Traded Funds or ETFs are listed investment products that track the performance of a group or “basket” of Shares, Bonds, or Commodities. These “baskets” are known as indices.’ Put differently, an ETF tracks the performance of its underlying basket of assets, such as shares (stocks), commodities, bonds, or a particular market index. An ETF is one of various exchange traded products (ETPs), the other being, inter alia, exchange traded commodities (ETCs) and exchange traded notes (ETNs).  

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Types of ETFs

There is a wide variety of ETFs available to professional and novice investors. Some of the most common types of ETFs are:  

1. Foreign currency ETFs

This is a type of ETF that follows a basket of currencies, allowing investors access to several foreign currencies.  

2. Commodity ETFs

When investors buy commodity ETFs, such as oil or gold, they do not actually acquire the physical commodity. More precisely, these ETFs comprise derivative contracts like options, futures, and forwards, following the price changes of the underlying commodity. Alternatively, investors can buy a commodity stock ETF that invests in the ordinary shares of commodity producers, such as gold mines.  

3. Bond ETFs

Bond ETFs, also referred to as fixed-income ETFs, are useful to reduce a portfolio’s volatility and to provide a fixed stream of income. However, Bond ETFs track low-liquidity investment securities like government and corporate bonds. Bond ETFs are actively traded instruments, contrarily to bonds that are not actively traded in secondary markets.  

4. Equity ETFs

Equity ETFs, also known as market ETFs, are some of the most traded ETFs on exchanges. Typically, equity ETFs follow stock market indices or sectors. They can track an index in its totality or an index that represents a specific industry like the energy or agricultural industry. Some market ETFs enable investors to invest in companies with different market capitalisations, from small cap to large cap.  

Some features of ETFs

• Divide ownership of their underlying assets into shares.
• Trade on exchanges similar to the trading of shares (stocks), implying that ETFs trade during the course of a trading day.
• Prices fluctuate during the trading day, due to purchasing and selling by investors. The fluctuation of prices pertain to ETFs, as well as to the underlying assets of the ETFs.
• Do not possess their own net asset value (NAV).
• Values calculated at the end of every trading day.
• Can be liquidated to cash quickly, implying that they have prices that enable investors to easily purchase and sell them.
• Well regulated by a country’s financial regulatory authorities. In South Africa, regulated by the Johannesburg Stock Exchange (JSE) and the Financial Sector Conduct Authority (FSCA).

 

Advantages of ETFs

Exchange traded funds (ETFs) have become popular among investors (professional, private, or novice) for various reasons, being extremely popular investments for active as well as passive investors. Here are some of the advantages of ETFs.

• Diversification. ETFs grant exposure to a variety of underlying instruments, such as asset classes, commodities, stocks, and bonds. Also enabling investors to trade in various markets at the same time.
• Enable risk management through diversification. For example, if the price of one underlying asset falls, another underlying instrument’s price can increase, balancing the two prices out. Diversification also reduces the risk of suffering losses.
• Can be purchased and sold easily and thus extremely liquid.
• In South Africa, exempted from securities transfer tax (STT).
• More cost-effective compared to their equivalent mutual funds. They also provide low expense ratios and smaller amounts of broker commissions, compared to buying stocks individually.
• Convenient way to trade. ETFs allow investors exposure to a wide variety of investment securities without the effort to extensively research, analyse, and allocate their investments.
• Ideal for new investors, utilizing various trading and investment strategies.

 

Disadvantages of ETFs

Although extremely popular with numerous investors and providing a variety of advantages, ETFs still encompass some disadvantages, exposing investors to some risks. Disadvantages pertaining to ETFs an investor should take note of are:

• Low trading volumes (Lack of liquidity)

The advantage of buying an ETF over a specific equity, such as shares form a particular company, declines when the particular ETF experiences low trading volumes. Express differently, an ETF that lacks liquidity implies that you will not be able to sell it reasonably quickly without changing its price. A too wide bid-ask spread may be inordinately costly. Before deciding to invest in a particular ETF, consider its average trading volume and make sure it is liquid. A trusted way to execute this is to examine the bid-ask spreads and the price movements of the specific ETF over a certain time frame, such as a week or month.

• Fluctuations of underlying instruments

One of the key advantages of ETFs is their diversification. However, the fact that an ETF holds more than one underlying asset does not safeguard it against volatility. The vulnerability of an ETF to volatility depends on a variety of factors. Such as, among others:

• The scope of the fund - an ETF that follows a broad market index such as the JSE ALSI will probably be less volatile than an ETF that tracks a particular sector such as financials.
• Types of investments it includes.
• With regard to international ETFs that invest in a specific country, the fundamental economic issues of a country, such as economic health, currency strength, and political stability, are of crucial importance.

A useful rule of thumb in this regard is to be aware of what the particular ETF is tracking and to comprehend the underlying risks pertaining to it.

• Costs

Even though their cost effectiveness is listed as one of their advantages, you have to consider that every time you buy or sell an ETF, you still pay commission - although smaller amounts. When actively trading ETFs, you can considerably reduce your investment earnings with commissions quickly accumulating. Therefore, if possible, try to follow a lump sum approach instead of regular smaller investments when buying an ETF.  

How to trade ETFs

• Be careful when you trade leveraged ETFs, considered the risk involved in leverage trading.
• Open a brokerage account with a trusted and qualified broker. Ascertain that the broker provides efficient training to trade in the different markets in which ETFs are traded.

In South Africa, an ETF broker must be an authorised Johannesburg Stock Exchange (JSE) equity member.

• Utilize a trading platform that enables investors to buy ETFs from different providers.

Some platforms are designed for manual trading, whilst others are for traders who prefer automatic trading.   Note: This article does not intend to provide investment advice. Its aim is solely informative.  

Frequently Asked Questions

  Is Forex an ETF? Currency ETFs are financial products with the goal of providing investment exposure to forex currencies. Is ETF a good investment? ETFs are currently hugely popular mainly because it allows investors to own a diversified set of securities quickly. How do you trade in ETF? Read our beginners guide on ETF Can you lose money with ETF ? Synthetic ETFs are riskier. Also as with any other investment there is the risk that value can fall leaving you to lose money. What are the biggest risks of ETF? Trading risks, tax risks, the bottom line, tracking error, portfolio risks, lack of price discovery.    

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