An ETF is a pooled investment security that functions similarly to a mutual fund. ETFs usually follow an index, sector, commodity, or other assets. Unlike mutual funds, ETFs can be bought or sold on a stock exchange like regular stocks. They can track the price of a single commodity or a wide range of securities. ETFs can also be designed to follow specific investment strategies. You can know “What is exchange-traded funds?” now.
Types of Exchange-traded Funds
Different types of ETFs are accessible to investors for generating income, speculating, and benefiting from price increases. They can also be used to hedge or partially offset risk in an investor’s portfolio. Below is a concise overview of a few ETFs currently available in the market.
Passive and Active ETFs
Passive and actively managed exchange-traded funds are the two main types of ETFs. Passive ETFs aim to mirror the performance of a broader index, such as the S&P 500 or a specific sector. For example, there are around nine ETFs focused on gold mining stocks as of December 2023. These ETFs exclude inverse, leveraged, and low AUM funds.
On the other hand, actively managed ETFs do not follow an index. Instead, portfolio managers make decisions on which securities to include in the portfolio. While these funds offer advantages over passive ETFs, they are generally more expensive for investors. Let’s delve into actively managed ETFs further.
Bond ETFs
Bond ETFs are utilized to offer consistent income to investors. The income they provide is determined by the performance of the bonds they are based on. These bonds can consist of government bonds, corporate bonds, and municipal bonds issued by state and local governments. Unlike the bonds themselves, bond ETFs do not have a specific maturity date. Typically, they are traded at a price that is either higher or lower than the actual bond price.
Stock ETFs
Stock exchange-traded funds are a collection of stocks that follow a specific industry or sector. For instance, an ETF might focus on automotive or foreign stocks. The goal is to offer a diversified investment in a particular industry, including both established companies and promising newcomers. Unlike mutual funds, ETFs have lower fees and do not require actual ownership of securities.
Industry/Sector ETFs
Industry or sector ETFs are investment funds that specifically target a particular sector or industry. For instance, an energy sector ETF will consist of companies that operate within the energy sector. The purpose of industry ETFs is to capture the potential growth of that industry by closely tracking the performance of the companies operating within it.
A notable example is the technology sector, which has experienced a significant increase in funds being invested in it in recent years. Additionally, ETFs mitigate the risk of volatile stock performance since they do not involve direct ownership of individual securities. Moreover, industry ETFs are also utilized to strategically shift investments between different sectors based on economic cycles.
Commodity ETFs
Commodity ETFs invest in commodities like crude oil or gold. They offer various advantages. Firstly, they help diversify a portfolio, which makes it easier to protect against market downturns.
For instance, during a stock market slump, commodity ETFs can act as a buffer. Secondly, owning shares in a commodity ETF is more cost-effective than physically possessing the commodity. This is because it eliminates the need for insurance and storage expenses.
Currency ETFs
Currency ETFs are investment funds that follow the performance of currency pairs, including both domestic and foreign currencies. These ETFs have various uses. They can be utilized to speculate on currency prices based on political and economic changes in a country. Additionally, they serve as a means to diversify a portfolio or protect against volatility in forex markets for importers and exporters. Some currency ETFs are even employed as a safeguard against inflation. Interestingly, there is even an ETF option available for bitcoin.
Inverse ETFs
Inverse ETFs aim to make profits when stocks decrease in value by selling stocks and buying them back at a lower price. They use derivatives to sell stocks short. In essence, they are wagers on the market’s decline.
When the market goes down, an inverse ETF increases proportionally. It’s important for investors to know that many inverse ETFs are actually exchange-traded notes (ETNs) and not true ETFs. ETNs are like bonds that trade like stocks and are supported by an issuer, such as a bank. Make sure to consult your broker to determine if an ETN is suitable for your investment portfolio.
Leveraged ETFs
A leveraged ETF aims to generate returns that are multiples of the returns of the underlying investments. For example, if the S&P 500 increases by 1%, a 2× leveraged S&P 500 ETF will generate a return of 2% (and if the index decreases by 1%, the ETF would lose 2%). These ETFs utilize derivatives like options or futures contracts to amplify their returns. Additionally, there are leveraged inverse ETFs that aim to achieve an inverse multiplied return.
Conclusion
ETFs are a low-cost option for investing in a diverse range of securities, even with a limited budget. Instead of purchasing individual stocks, investors can buy shares of an ETF that tracks the overall market. However, it’s important to consider additional expenses associated with investing in ETFs.
