Exchange-traded funds, or ETFs as they are commonly known, have been around for several years now. However, it was only recently that these investment vehicles gained the popularity they enjoy today. ETFs have become so popular that a couple of years ago they not only became mainstream investments but overtook conventional mutual funds by a wide margin.
ETFs explained
An exchange-traded fund is a basket of securities, much like a mutual fund, except instead of buying the shares directly from the company issuing them, you buy them on your favoured stock market during trading hours. It makes investing in ETFs very flexible while also putting an investor potentially at risk (more on this later).
Exchange-traded funds are what the name suggests—funds that are issued by a company and can be bought or sold on the stock market. Unlike conventional mutual funds, though, shares in an ETF are available to purchase throughout the trading day just like any other security on the stock market, which makes them very flexible. However, this also means that you run the risk of potentially buying the fund for its incorrect price or selling it for even less (if you’re unlucky enough to).
This volatility is part of the reason why mutual funds were more popular than ETFs up until 2012, as they provided investors with less risk by purchasing their shares directly from those companies instead of via the stock market.
How to get started with ETFs?
Getting started with ETFs usually begins with understanding what they are. Simply put, an ETF is just like a unit trust or mutual fund which invests your money into different types of assets such as stocks, bonds and commodities. They come in two forms: physical shares or units and synthetic shares or units.
Physical shares play out similarly to how unlisted index funds work; upon purchasing these ETFs, you own actual physical shares which the issuer holds. On the other hand, synthetic shares are derivative instruments that track an index – collateral rather than physical assets backed by them.
As ETFs are essentially just like any other type of security, there is no reason why you cannot invest in them just like you would with your other types of investments! However, you will need to weigh up these considerations before making a decision:
You should determine whether ETFs suit your investment needs and risk appetite. As it is still possible for ETF prices to go down instead of up (even though this typically does not happen), you should accommodate this possibility in your portfolio.
When scaling into or out of positions, take care to focus on bid-ask spreads that can impact your returns. Keep in mind that you will be responsible for any trading fees the exchange charges when buying and selling ETFs.
Benefits of investing in ETFs
ETFs make interesting short term instruments for trading with if you can time the market correctly. There are typically no restrictions against buying or selling an ETF, so do not worry about needing a certain amount of money to start.
Importantly, know that professional traders can exploit capital gains from arbitrage opportunities when there are discrepancies between prices offered across two different exchanges. To avoid being one of their victims, consider using limit orders instead of market orders when making securities transactions with wider bid-ask spreads. Moreover, to reduce slippage, aim to transact when there are no major news announcements.
Summary
You might be wondering why you should bother learning about the stock market when ETFs can simply deliver results without you having to do much at all. You will need a more robust understanding of the economy, in general, to predict how it will affect different aspects of life. Suppose you are interested in investing in exchange-traded funds. In that case, we recommend that you contact a reputable online broker like Saxo Bank and try a demo account before committing your own money.
