Traders, investors, asset managers, and hedge funds try continuously to beat the market. But only 26% can do it over one year. The percentage falls dramatically when the period is longer.
So why try to beat the market? When you can invest in it with lower fees and get the same returns. That's how an ETF or Exchange traded fund works. So what is an ETF?
This article will explain everything you need to know about an ETF, how to invest in it and which brokers are perfect for getting you started.
What is an ETF?
ETF (Exchange-traded Fund) is a fund that replicates the performance of a benchmark index in the same proportions.
They stand out from traditional index funds by offering considerable liquidity and continuous quotation.
To clarify, let's take the SPDR S&P 500 ETF Trust (SPY), which replicates the largest and most known Index in the US, the S&P 500.
So basically, the Fund buys all the stocks that compose the S&P 500 with the same proportion. In that way, it can replicate the same performance and movement of its underlying index, the S&P500.
If the S&P500 is up 2% on that day, the SPDR S&P 500 ETF Trust (SPY) will also be up 2% or less(taking fees and tracking error into consideration).
How do ETFs work?
Exchange-traded funds seek to follow the performance of a benchmark index closely. For this purpose, asset management companies rely on three structuring techniques:
- Physical (or direct) replication
- Partial replication,
- Synthetic replication.
Physical replication: Requires owning the assets that constitute the index in the same proportions. In reality, however, this procedure can be complicated to apply to indexes of many securities like the S&P500.
Partial replication: Consists of having a basket of representative stocks with a high correlation to the index's performance. For example, if an ETF is to replicate the performance of the MSCI World Index, which is a 1600 stock index, it can only hold 300 stocks that are highly correlated with the index.
Synthetic replication: Relies on derivatives, in particular swaps. The fund contracts a performance swap with its counterparty (generally a trading room) in this configuration. It acquires a basket of securities and replaces the performance of this basket with the performance of the index via the swap.
Types of ETFs
- Equity ETFs
- Commodity ETFs
- Bond ETFs
- Currency ETFs
- ESG ETFs
- Leveraged ETFs
- Inversed ETFs
Today, the types of ETFs are very diverse. Indeed, if three-quarters of ETFs aim at replicating equity indices, other categories have evolved, such as
ETFs replicating interest rate or commodity indices, leveraged ETFs, short ETFs, or active ETFs.
1 - Equity ETFs
Are the industry's most used and traded ETFs. Stock market indices have sparked considerable curiosity among analysts and investors because they provide a synthetic representation of the dynamics of a market or geographical area (S&P500: American market, Eutostoxx 50: European market, Footsie: London market, Nikkei: Tokyo market, Nasdaq: technological companies.)
2 - Commodity ETFs
These are exchange-traded funds that reproduce the performance of commodity markets such as energy (natural gas or oil), precious metals (gold, silver, or platinum), or agricultural products (grain, for example)
Example: SPDR Gold Shares and United States Oil Fund LP.
3 - Bonds ETFs
Bond ETFs deliver broad, diversified exposure through an extensive portfolio of bonds in a single transaction at a cost-effective price.
In contrast to individual bonds, which can be challenging to acquire and expensive to trade, bond ETFs can be bought and sold during market hours, just like a stock:
Bonds ETFs can cover many types: government bonds, investment grade, high yield credit, aggregates, emerging markets, and ESG.
4 - Currency ETFs
These funds provide investors with exposure to the performance of a foreign currency relative to the domestic currency or, more generally, a currency pair. Currency ETCs replicate currency movements in the foreign exchange market by holding currency cash deposits or using forward contracts.
A currency ETF tracks a specific currency or, in some cases, a basket of currencies, giving investors access to the movements of multiple foreign currencies simultaneously.
Example: Invesco DB US Dollar Index Bullish Fund
5 - ESG ETFs
Emerging along the new generation of investors, ESG ETFs are funds that invest mainly in companies with environmental, social, and governance exposure.
The prominent ones are the ETFs exposed to alternative and new energy.
Example: iShares ESG Aware MSCI USA ETF and iShares Global Clean Energy ETF
6 - Leveraged ETFs:
The first leveraged ETFs saw the light in 2006, and their use remains limited to qualified investors, Although more companies have recently offered those products to retail investors.
These ETFs enable investors to earn two to three times the performance of the ETF's benchmark index. For example, for an ETF that guarantees two times the performance of an index, if the index grows by +3%, then the ETF's return will be 6%. However, if the index's performance is -3%, then the return of the ETF will suffer a loss of 6%.
Leveraged ETFs generally use derivatives to guarantee this performance by using swaps, futures contracts, or calls. They can also use cash borrowing.
7 - Inverse ETF (Short)
An inverse ETF guarantees the investor the inverse of the benchmark's performance. These ETFs allow investors to profit from the decline of an index. For example, if the benchmark index falls by 2%, the ETF's performance will be +2%. However, if the index gains +2%, the ETF loses 2%.
A leveraged inverse ETF delivers a performance double or triple the inverse of the benchmark. These ETFs are structured using swaps, puts, or via the sale of futures. For example, for an ETF guaranteeing the triple inverse of the performance of an index, if the index has a return of -2%, then the ETF will have +6%. However, if the index grows by 2%, the ETF will have a return of -6%.
ETF vs Mutual Fund
In the United States, the world's largest ETF market, assets under management in exchange-traded funds are growing at the expense of traditional mutual funds.
Because of their simplicity and transparency, more investors and asset managers switched from conventional mutual funds to buy ETFs.
ETFs can be traded on an exchange where you can instantly see their price, their holdings, and all the information in just one click.
Mutual funds are less transparent and only present their prices after the market closes.
| Characteristics | ETF | Mutual Fund |
|---|---|---|
| Management style | Passive | Active |
| Expense ratio | Very low | Considerably high |
| Minimum investment | Low | High |
| Transparency | ✅ | ❌ |
| Exchange trading | ✅ | ❌ |
| Short selling | ✅ | ❌ |
How to invest in an ETF
- Find an ETF Broker here
- Open an account with this broker
- Compare the ETFs available
- Choose the one that meets your need
- Invest in the ETF and sit back!
How to Buy an ETF
Follow these four easy steps to buy your first ETF:
Step 1 - Pick the Best Broker for You.
Before you buy the ETF, you need to find a trading app or platform tailored for your need to start buying ETFs.
If you don't have a broker account and wondering which platform to use, our comparison page will help you get the best trading platforms depending on your financial goals.
Step 2 - Open an Account
Once you have the best platforms or broker in mind, you need to apply for an account to get started.
You just need to click on the button on our comparison page, and you will be directly on the sign-up page to get started.
Step 3 - Deposit Fund
Now that you have an account, you must make your first deposit.
Since that ETFs don't require a lot of capital to get started, you can make an initial deposit easily using:
- Credit/debit cards
- Bank transfer
- Mobile wallets (Paypal, etc.)
Step 4 - Buy the ETF.
To do so, search for the ETF name or ticker in the search buy, then click on the buy button.
Depending on the ETF you want, the minimum investment may vary.
Advantages and Disadvantages of ETFs
Low fees: Most ETFs have an expense ratio way lower than other assets.
Highly transparent: ETFs are like stocks, so they must disclose all their financial information.
Lower risk via diversification: ETFs are naturally diversified, which means fewer risks.
High flexibility and liquidity: Since they are traded on an exchange, you can buy and sell them anytime you want.
Tracking errors
Invisible risks
Can't beat the market
Conclusion
ETFs are a great way to make money for all investors. They will make your investment simple and passive.
Even if you are a beginner, ETFs are suited for you. You only need to pick the best broker to access the top ETFs available on the market.
Fortunately, our website comparison tool will help you get the best ETF broker, no matter where you live or how much you know about trading.
FAQ
It depends on your financial goals and time horizon, but investing in ETF is generally better than investing in one asset because of its natural diversification.
If you pick the wrong one, your money is at risk, but on the other hand, ETF invests in numerous companies, so the probability of losing your money is less.
In the long run, we all know that the stock market always goes up with some period of correction, so investing in ETFs is very lucrative if you pick the right one with the best broker.
If you start investing 5000$ in your 20s and put, let's say 200$ each month into an ETF that replicates the S&P500 and get an average return of 10%, after 25 years, your portfolio will be at 325 000$!
Of course, they are easy to use and transparent. You will only need to pick the right broker to meet your needs and start investing immediately.
The natural diversification of ETFs are the right asset investing beginners needs to achive their financial goals.
For a long time, Warren Buffet has been praising the benefit of investing in ETFs, he know that most traders and investors wont beat the market.
Their only chance is to be with the market, and if they are smart enough they can beat it with a combination of ETFs.
