ETFs (Exchange Traded Funds)

ETF stands for Exchange Traded Fund, and it is a basket of securities packed together in a single instrument that can be bought and sold on the traditional stock market.

An ETF is a financial instrument which combines some of the attributes of a stock and some attributes of a mutual fund. So buying an ETF gives the trader the advantages that can be obtained from both stock and mutual fund investing.

ETFs provide a lot of flexibility in terms of investing options. Picture a scenario where a trader wishes to invest his money in several markets, but is constrained by not having the financial requirements for each individual market investment or he/she simply does not want to have to endure the cumbersome processes such as paperwork and tracking each investment individually. Perhaps, a trader may even want to participate in possible bullish markets abroad and does not know how to go about investing money in another country. By purchasing an ETF that contains assets in several asset classes, or combines local and foreign investment vehicles, a trader can get all the exposure he wants in several potentially profitable opportunities.

Traders can trade ETFs on the stock markets just the way stocks are traded. For instance, the Nasdaq has a basket of ETFs that traders can buy and sell. Typically, the asset composition of each ETF is fixed in various proportions, and priced according to the demand and supply dynamics that operate in the financial markets. Traders can now look at the composition of each ETF to decide if they meet their investment needs, and then purchase the number of units that they want at the market price. The price of the ETF changes on a day to day basis as trading is performed on it, and traders can go long or short-sell the ETF as they wish.

Tips to Buying ETFs

Investing in ETFs introduces some complexities into the equation, since they basically contain a basket of assets each with its own peculiarities. The factors that influence the movement of a stock index are not the same that create volatility in an instrument like gold or silver. In some cases, an ETF may contain assets located in a different country which have a set of rules on how assets are traded. Some of these different nuances behove the trader to consider his ETF investment carefully.  Some of the tips that ETF investors should consider before buying that juicy-looking investment are as follows:

A bull market somewhere may translate into a bear market elsewhere. You may be faced with a choice of what ETF to buy based on the constituent assets. The unrest in the mines in South Africa owned by some of the world’s biggest producers of gold and platinum have seriously undermined the production levels of these assets, leading to a demand surge and an increase in the price of these commodities. As a result, the platinum-based ETF ETFS Physical Platinum Shares (NYSEArca: PPLT) soared by 10% in September while the UBS E-TRACS Long Platinum TR ETN (NYSEArca: PTM) gained 12.4% in the same time frame. When news filtered out that an agreement had been reached on ending the strike, these ETFs retreated in price.

The political crisis in Cote d’Ivoire in 2011 led to a sharp spike in cocoa prices, and cocoa ETFs and ETNs experienced price appreciations. These are situations that a trader should consider when choosing an ETF basket as ETFs vary with constituent assets, regions, sectors, etc.

From the examples we have shown here, sometimes the investor’s risk appetite and the political and economic situation in a country will play a huge role on the kind of ETF the trader decides to invest in. A systemic market event will lead money to exit the stock market and into fixed-income instruments with guaranteed returns such as bonds, so it may make sense to buy bond ETFs during such periods.

ETF Taxation

Earnings on ETF investments are taxed. If your ETF investment spans assets listed in several different countries, it makes sense to understand what the taxation policies of those countries are. There is no point investing money in an ETF containing assets from countries where profits are heavily taxed. In such instances, the trader may be better off investing such money in other assets or in other territories with more modest taxation policies. In the same vein, you also need to know what you are paying in fees and commissions for your ETF investments.

Investment Strategy

What is your ETF investment strategy? Are you buying ETFs for retirement? You may try leveraged ETFs as those are the ETFs with lower risk, suitable for those about to retire. How much risk can you take on? How long do you want to hold an ETF? What is the motivation for purchasing an ETF as opposed to other forms of investments? The answers to some of these questions will give you an idea as to the type of ETF to buy, how to buy, when to buy and how long to hold the investment before selling. Defining the investment strategy will help a trader buy the right type of ETF.

Research ETFs Before Buying

It always pays to carry out some due diligence on the ETF market, and try to know a little bit about ETFs before putting money in it. Do not take some of the sales pitches of some of the self-professed ETF investment gurus to heart. Some are compensated to shell out endorsements on some ETF products, so the obvious conflict of interest would not be in your favour.

These ETF buying tips do not constitute an exhaustive list of the considerations that an investor should make before buying an ETF, but they will serve as a guide on how to go about ETF investments.

How to Invest in an ETF

ETFs are traded on stock exchanges like NASDAQ. You cannot just walk into a shop to buy an ETF. You have to trade ETFs on stock exchanges, and the only access to stock exchanges is through licensed brokers. SO the starting point of an ETF investment for a beginner is to look for a brokerage where you can deposit money and trade exchange traded funds. There are several ETF brokers to choose from. The most important parameters are to find a broker that is licensed, regulated and has a wide range of ETFs to choose from.

Understanding ETF Investments

It would be foolhardy to simply find a broker, take money and start trading without having even the most basic knowledge of ETFs. It is good to understand what kind of ETFs are available for you, what ETFs you should be trading, the process of trading ETFs, fees applicable, and any other information that will affect the outcome of your trading. We will therefore touch on a few of these topics for your information.

Types of ETFs

There are several ways of classifying ETFs. The commonest method is by classifying ETFs according to the basket of securities that they carry. In this class, you can have commodity ETFs, stock ETFs, bond ETFs, currency ETFs, etc. These are ETFs that are made up of a basket of strictly commodities, stocks, bonds and currencies respectively. ETFs can also be classified according to the sectors that the assets are listed in, and such ETFs would include stock assets listed in a particular sector (e.g. pharmaceuticals or real estate). ETFs can also be classified as local ETFs and foreign ETFs (containing assets listed in foreign exchanges). ETFs may also track baskets of assets in a direct manner, or in an inverse manner (inverse ETFs, which move in an opposite direction to the asset(s) being tracked). So you must understand what type of ETFs that are available and which ones you should be trading.

As a beginner, you should trade just the simplest ETFs. These are ETFs that either track a single security, or track a basket of securities that are either listed in the same sector or are of the same asset type. You must keep it simple initially and avoid trading complicated setups until enough experience has been acquired.

Fees

ETF investing, though traditionally cheaper than mutual fund or hedge fund investing, also carries fees. The fee structure for ETF investments differs from broker to broker. It is left for you to find out what you will be paying to purchase or sell an ETF.

You will also pay the broker’s trading fees every time you buy or sell ETF shares.

Trading Process

This is quite simple. A trader is expected to simply buy or sell an ETF depending on the expectation of where the price of the ETF will go, and this is a function of the performance of the basket of securities being tracked.

A few brokers may provide a demo account for new traders to practice ETF trading. This will also afford the trader the opportunity to get used to the trading platforms used for ETF trading.

Further Reading