What Are ETFs and How Do You Trade Them? - The Coventry Observer

11th Aug, 2022

What Are ETFs and How Do You Trade Them?

Correspondent 5th Aug, 2022

The global value of ETF Assets Under Management (AUM) went above $10 trillion in 2021, rising over 50 times in value within the previous 19 years. This indicates growth, showing that the market holds some quality that attracts more investors yearly.

You are one of those investors now.  However, like other new investors, you are faced with the problem of not knowing how to trade ETFs.

Thankfully, you are at the right place, as this article presents you with all you need to know about ETFs, including

  • The definition of ETFs,
  • The different types of ETFs you may invest in,
  • The benefits and drawbacks of ETFs, and
  • How to start trading ETFs. Let’s get right in.

What Are ETFs?

Exchange-Traded Funds (ETFs) are pools of securities that you may buy and sell on trading platforms. An ETF is tied to or “tracks” the price of a group of securities, ranging from indexes to commodities, sectors, or even investment strategies.

To explain further, we relate ETFs to how they are similar to/differ from mutual funds and stocks. One ETF is a combination of different investment assets. These investment assets may be of the same type (like multiple stocks) or different types (like stocks, commodities, and bonds). This is how they differ from regularly traded stocks, which are individual.

ETFs are similar to mutual funds, where you have a bundle of securities in one portfolio but differ on the ground that you may trade them at any time of the day. This is where they share similarities with regular stocks.

Overall, ETFs are just packages of securities you trade on stock exchanges. Now, there are different varieties of ETFs you come across.

Categories Of ETFs

There are four categories of ETFs generally. These are Diversified passive ETFs, Niche passive ETFs, Active ETFs, and Fixed-income ETFs.

Diversified passive ETFs are the primary forms of ETFs we have explained, which are bundles of assets that cut across different varieties of investment assets. Here, the assets are preselected from popular and broader indexes or asset classes, like the S&P 500 index (comprising diversified stocks of companies in multiple industries).

Niche Passive ETFs encompass bundles of assets preselected from a specific industry or asset class. An example of this is ETFs containing only stocks of silver mining companies.

Now, unlike these preselected bundles, Active ETFs are pooled with assets that your portfolio manager specifically selects. These assets may not be from the same broader or specific asset class and give you the possibility of more significant gains and greater losses.

Fixed-income ETFs are simply pools of bonds traded just like stocks. These are called “Bond ETFs”, and offer a little discount on the regular price of each bond. We then pick out the benefits and drawbacks of trading ETFs.

Benefits Of ETFs

The most apparent advantage an investor gains from trading ETFs is the innate diversification of the portfolio associated with buying a bundle of securities. Other advantages include the possibility to buy and sell at any time of the day effortlessly, and the absence of a minimum investment limit, giving it an edge over mutual funds.

ETFs may also be traded on leverage or shorted (like regular stocks), enabling investors to make money from a fall in value. Passive ETFs attract low costs, and index-based ETFs offer you greater tax efficiency when managed well.

Nonetheless, just like every other subject in the world of finance, ETFs also have disadvantages of their own.

Drawbacks Of ETFs

The first downside of trading ETFs is related to the cost of Active ETFs. You incur a lot of brokerage commission fees when you have your portfolio manager deal with active ETFs. This is because more actions are required to set up a portfolio, unlike passive ETFs already preselected.

Capital gains are distributed sometimes, and these distributions attract capital gain taxes. With how frequently investors are allowed to trade, ETFs’ characteristic “tax efficiency” may be done away with.

Thankfully, the advantages of ETFs outnumber the disadvantages, so you should feel comfortable if you plan to deal with them. Now, where do you start your ETF journey?

How To Trade ETFs?

An “authorized participant creates ETFs, ” usually a large financial institution that buys multiple shares and places them in a trust. Creation units (bundles of 10,000 to 60,000 shares) are formed from this and made available to the general public through agreements with brokers (sponsors).

Now, if you want to deal in ETFs, you deal with these brokers or sponsors. You make your research on the best trading platforms available to you and create a brokerage account with a trading platform that allows you to deal with ETFs.

You then research the exact variety of ETFs you want to trade. Remember that ETFs are not like regular individual stocks but consist of a pool of stocks or/and other investment assets. This means you need to do more research that thoroughly covers the diversity of assets in your ETF portfolio.

Once all this is done, you select a trading strategy that fits your personality and the ETF you are trading.

As a beginner, a good strategy is spreading investment costs over long periods. This helps you manage risks more safely and also progressively learn more about trading ETFs without risking a high-valued portfolio. You then proceed to more advanced procedures and techniques like swing trading.

Buying and Trading ETFs

When generating a brokerage account, you either go for a manual account that you manage entirely on your own or an account with an AI advisor that helps pick and invest in ETFs and other assets.

Whether you pick ETFs manually or through robo-advisors, certain factors are considered. These are

  • Trading volume
  • Expenses
  • History
  • Holdings, and Commissions.

Trading volume indicates how popular the ETF is, with ETFs with higher trading volumes serving as more accessible investment choices for traders. Expenses include the administrative costs (expense ratio) charged by your broker; history indicates the past performance of that particular ETF, while holdings are simply the types of assets contained in the ETF bundle.

Most ETFs are commission-free, so investors check to see whether an ETF has associated commissions. Avoiding these helps to reduce your expenses.

Conclusion

ETFs are one of the most popular trading options amongst investors, given the number of advantages and opportunities inherent in them. Nonetheless, success with them requires choosing the right ETF to invest in and employing the best trading style that suits you.

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