What is ETF? How to trade and invest in ETFs?

Gianluca Lombardi, 10 min read
Last Updated: 6 June, 2023

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With the investment world buzzing with the surging popularity of ETFs (Exchange Traded Funds), many investors and traders are jumping on this bandwagon. The key attraction lies in their simplicity, transparency, and affordability. They are a superb gateway for investors to dip their toes in a wide array of asset classes like stocks, bonds, commodities, and real estate. To enlighten yourself more about ETFs, our ETF Guide is your go-to resource.

We’ll equip you with the essential know-how of ETFs, revealing how you can smartly invest in them.

Guide to ETFs

The growing preference for Exchange Traded Funds (ETFs) among retail investors is quite evident today. The distinct benefits that ETFs carry over mutual funds, like minimal transaction fees and lower expense ratios, make them a favourite among investors. Coupled with the flexibility of transacting multiple times a day, akin to trading stocks, they are indeed a compelling investment option. To help you navigate through the nitty-gritty of ETF investing.

Understanding ETFs

etf - exchange traded funds

An ETF, or exchange traded fund, is a unique investment vehicle designed to mimic the performance of a specific stock market index, industry sector, or asset. The ETF framework was conceived in 1990 by the US investment titan Leland, O’Brien and Rubinstein (LOR). The idea was to amalgamate various stocks into a unified cluster that could be listed and traded as a single unit on an exchange. This vision materialized with the inception of the modern ETF, launched on the Toronto Stock Exchange in Canada in the same year. By January 1993, the S&P 500 Trust ETF was born, which continues to be one of the most actively traded ETFs.

This particular ETF encapsulates the 500 most significant US companies, aligning as closely as possible with the S&P 500 index. Despite their resemblance to mutual funds in many ways, ETFs distinguish themselves by being exchange-traded, enabling them to be bought and sold just like traditional shares.

ETFs cover an extensive range of asset classes, from shares and bonds to real estate and commodities. To transact ETFs, you’ll need to have a trading account with a stockbroker or an investment platform.

The Genesis of ETFs

One crucial aspect of understanding ETF trading lies in knowing how they are brought to life. ETFs might resemble mutual funds, but their creation process significantly differs. Mutual fund investors directly send their funds to the mutual fund company, which in turn purchases securities and issues new fund shares to the investor. When investors wish to sell their mutual fund shares, they return them to the fund company in exchange for money – hopefully more than their initial investment.

On the other hand, ETF creation is a non-cash process. A potential ETF manager submits a proposal to the US Securities and Exchange Commission. If approved, the sponsor then collaborates with a market maker (often a big institutional investor) to create or redeem these new ETF units. The sponsor and market maker can sometimes be the same entity.

The market maker of the new ETF borrows the underlying shares, usually from a pension fund, placing them into a mutual fund to form the base of the ETF shares. Subsequently, the shares of the newly formed ETF are distributed by the trust, granting investors legal ownership over the shares held by the trust.

What are the advantages and disadvantages of ETFs?

etf bricks background

Exchange Traded Funds, or ETFs, are a popular investment tool in today’s financial landscape. The rise in their popularity is attributed to several benefits they offer, which makes them a valuable component in your investment portfolio. But like any other investment, ETFs come with their own set of pros and cons. Let’s delve into what these are, as well as how to leverage ETFs in your investment journey.

  • Cost-Efficiency: One of the major attractions of ETFs is their cost-efficiency. As passive investments that mimic the performance of a particular index, they generally come with lower expense ratios compared to actively managed mutual funds
  • Portfolio Diversification: ETFs allow investors to diversify their portfolio with ease. Purchasing a single ETF provides exposure to a wide array of stocks or bonds, thereby spreading the risk.
  • Flexibility: ETFs can be traded on the stock exchange just like individual stocks, providing flexibility and ease of trading. This means you can buy and sell them throughout the trading day at market prices.
  • Tax Efficiency: Unlike mutual funds, the unique structure of ETFs helps avoid some of the tax implications that can erode investment returns.
  • Transparency: ETFs provide high transparency as they disclose their holdings on a daily basis, which is a big plus for investors.

Downsides of ETF Investing

  • Trading Costs: Despite having lower expense ratios, ETFs can incur trading costs such as broker commissions, which might eat into your investment return, especially if you trade frequently.
  • Liquidity Issues: Some niche or sector-specific ETFs might have low trading volumes, leading to liquidity issues and larger bid-ask spreads.
  • Limited Yield: The diversified nature of ETFs can limit the potential yield. While they help spread risk, they also spread potential earnings among a broader pool of securities.
  • Risk of Closure: Less popular ETFs face the risk of closure, which can lead to unexpected costs for investors.

Lack of liquidity can make trading difficult: ETF asset classes such as bonds are less liquid than ETFs tracking popular indices such as the FTSE 100 or S&P 500. This can make it difficult to sell at the desired price.

Types of ETFs

Inwestorzy mają obecnie do dyspozycji wiele rodzajów funduszy ETF. Do głównych rodzajów funduszy ETF należą:

  • Stock index ETFs: their purpose is to track a specific stock market index, such as the S&P 500, the FTSE 100 or the Nikkei 225. Examples of stock ETFs include the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 index, and the iShares FTSE 100 UCITS ETF (ISF.L), which tracks the FTSE 100 index. Investing in index ETFs can be a great way to gain broad exposure to the stock market at low cost.
  • Sector or industry ETFs: these aim to provide exposure to specific areas of the stock market, such as technology companies, healthcare companies or financial companies. An example of a sector ETF is the Healthcare Select Sector SPDR ETF (XLV), which provides exposure to healthcare-related stocks within the S&P 500 index.
  • Style ETFs: These are designed to track stock indices based on a particular investment style. An example of a style ETF is the iShares Edge MSCI USA Quality Factor ETF (QUAL), which invests in large- and mid-cap US stocks that have strong fundamentals.
  • Bond ETFs: These aim to provide exposure to fixed income securities. They can include all types of bonds, including US Treasuries, corporate bonds, high-yield bonds, etc. An example of a bond ETF is the iShares Barclays 1-3 Year Treasury Bond ETF (SHY), which provides exposure to US Treasury bonds.
  • Commodity ETFs: Their purpose is to track the price of commodities, such as gold or oil. An example of a commodity fund is the SPDR Gold ETF (GLD), which tracks the price of gold.
  • Real estate ETFs: These are used to track real estate indices. An example of a real estate ETF is the Vanguard Real Estate ETF (VNQ), which tracks the performance of the MSCI US Investable Market Real Estate 25/50 Index.
  • Leveraged ETFs: are designed to provide greater exposure (2x, 3x, etc.) to a stock or underlying market. An example of a leveraged ETF is Proshares Ultra S&P 500 (SSO), which provides twice the daily return of the S&P 500 Index. Leveraged ETFs can increase your potential investment returns, but they can also increase your losses.
  • Inverse ETFs: these funds are designed to help investors profit from a falling index or underlying market. If the underlying index is falling, an inverse stock index ETF will rise. An example of an inverse ETF is the ProShares UltraPro Short QQQ ETF (SQQQ). This ETF rises if the underlying index, the NASDAQ 100, falls. Note that this particular ETF is also leveraged and provides 3 times the risk exposure.

How investing in ETFs works

Trading and investing in ETFs is quite simple. Here’s an overview of the basics.

Profits from a growing market

If you believe that a stock market index or asset (e.g. gold) may rise in the future, you open a BUY position in an ETF that covers that index or asset. This is called a ‘long stop’. For example, if you believe that the S&P 500 Index will rise over the next year, you open a BUY position in an ETF such as the SPDR S&P 500 ETF (SPY) that tracks the performance of the S&P 500 Index. If the S&P 500 Index rises, your investment in the SPDR S&P 500 ETF (SPY) will increase in value and you can close the trade at a profit if you wish. However, if the S&P 500 Index falls, the value of your ETF will also fall, meaning you will incur a loss.

Profit from a falling market

If you believe that a stock index or asset may fall in the future, you can open a SELL position in an ETF that covers that index or asset. This is called a ‘short position’. You can open a SELL position in an ETF by trading contracts for difference (CFDs). Contracts for difference are financial instruments that give investors the opportunity to profit from the price movement of a security without owning the security.

For example, if you think the S&P 500 Index will fall over the next three months, you can open a SELL position on the SPDR S&P 500 ETF (SPY), which tracks the performance of the S&P 500 Index. If the S&P 500 Index falls, you will profit from your short position. However, if the S&P 500 Index rises, you will suffer a loss.

Dividends

The third way you can potentially profit from ETFs is through dividends. Dividends are cash distributions that some companies pay out to their investors from their profits. Not all companies pay dividends, but many established companies do. If you own an ETF that invests in dividend-paying companies, you will receive regular dividends. For example, if you hold the iShares FTSE 100 UCITS ETF (ISF.L), which targets a number of dividend-paying companies listed on the London Stock Exchange, you will receive regular dividends. Fees for ETFs There are two types of fees associated with ETFs:

  • Transaction commissions: these are the fees charged by brokers and investment platforms for making a transaction. There are no commissions on eToro for opening or closing positions in EU ETFs.
  • Ongoing fees: These fees, sometimes referred to as the ‘general factor’, are charged by the ETF company, such as iShares or ProShares. Ongoing fees are usually very low. For example, the ongoing fees of the SPDR S&P 500 ETF are approximately 0.095% per annum.

If you need more information about how eToro works and what other assets you can trade there, check out our full eToro review and feedback.

As with any investment, trading in ETFs involves risks, primarily market risk. This means that if the index or asset class your ETF is tracking decreases in value, the value of your ETF will also decrease. To mitigate this risk, diversification and adopting a long-term investment horizon can be useful.

When you’re ready to invest, platforms like eToro make the process simple. After setting up an account, you can explore various ETFs, choose the ones that align with your investment strategy, and start trading.

In conclusion, ETFs can be a smart addition to your investment portfolio. Their low cost, diversification benefits, and ease of trading make them an attractive option for both novice and seasoned investors. However, it’s essential to stay informed about potential risks and make well-reasoned investment decisions.

Remember, as Neil Patel often emphasizes, data is king. Staying informed and leveraging the power of data can go a long way in successful ETF investing.

Risk management strategies

Investing in ETFs can never completely eliminate risk, but there are ways to reduce it. One of the most effective ways to reduce risk is to diversify your portfolio. This means spreading your money across a number of different investment assets so that you are not overexposed to a single asset. A diversified portfolio can have exposure to equity ETFs, bond ETFs and commodity ETFs. For equity ETFs, adopting a long-term investment horizon is another strategy that can help reduce the risk of losing money.

In the short term, equities can be very volatile. In the long term, the stock market tends to be up. In general, the longer you invest, the less chance you have of losing money. For short-term trading in ETFs, stop-loss can also be an effective risk management tool. Stop-losses help minimise investment losses by closing losing positions before large losses accumulate.

ETF trading strategies for beginners

When it comes to investing in ETFs, understanding the different types of ETFs available is crucial. These range from index ETFs and sector ETFs to bond and commodity ETFs, and each serves a different purpose. For example, index ETFs like SPDR S&P 500 ETF allow you to gain exposure to the entire S&P 500 index with a single investment.

  • Growth schemes: they aim to provide consistent returns and these funds include shares of underlying companies with high growth potential.
  • Value investing: this type of investment can facilitate returns from companies that experience cyclical periods of growth.
  • Momentum ETFs are funds that invest in companies showing positive moments in the markets or in their industries. These funds can also short stocks of companies with negative momentum.
  • Social trading: you can also get started with ETFs by using the social trading option. At eToro, the copy trading feature allows you to follow users’ investments with long-term returns.

This basic option will help you understand how to invest in ETFs and what thought processes the most profitable eToro users use. Each user has a score that shows how much risk that user is taking on a scale of 1 to 10 – 1 being the lowest risk and 10 being the highest.

How to trade ETFs on eToro

Trading and investing in ETFs is easy on eToro. Here’s how to make a trade:

{etoroCFDrisk}% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work, and whether you can afford to take the high risk of losing your money. Don’t invest unless you’re prepared to lose all the money you invest.

  1. Create an online trading account by going to www.etoro.com
  2. Go to the ‘Markets’ page and then select ETFs
  3. Select the ETF you wish to trade, then select Trade
  4. Select either BUY or SELL depending on the direction you wish to trade
  5. Enter the amount you wish to trade or invest
  6. Select Open Trade

Summary

An ETF (exchange traded fund) is a type of investment fund that aims to track the performance of a specific stock market index or asset. ETFs are traded on stock exchanges. This means that they can be bought and sold in the same way as individual shares.

To invest in ETFs, you must have a brokerage account with an exchange broker or investment platform. ETFs are available for almost all asset classes, including equities, bonds, property and commodities. ETFs have many advantages, such as low transaction costs, diversification benefits, instant access to a wide range of markets, transparency and ease of trading.

There are many types of ETFs, including index funds, sector ETFs, style ETFs, bond ETFs, real estate ETFs, commodity ETFs, inverse ETFs and leveraged ETFs.

The main type of risk associated with ETFs is market risk. This is the risk that the value of the underlying asset or index will fall. The risk associated with investing in ETFs can be reduced by diversifying the portfolio. Trading ETFs on eToro is easy.

The eToro platform is easy to use and offers zero commissions on ETFs and low minimum investments.

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This information is for educational purposes only and should not be considered as investment advice, personal recommendation, suggestion or invitation to buy or sell financial instruments. This material has been prepared without regard to a specific investment objective or financial situation and has not been prepared in accordance with legal or regulatory requirements to promote independent research. Any reference to the past performance of a financial instrument, index or investment product in the package is not and should not be taken as a reliable indicator of future performance. eToro makes no representations and accepts no responsibility for the accuracy or completeness of the contents of this guide. Make sure you understand the risks involved in investing before committing capital. Never risk more than you are prepared to lose.

Gianluca Lombardi

Gianluca is the editor-in-chief of this site. A finance graduate, he is an active trader who has tested all trading platforms and knows all their secrets. Technology is his passion; he spends much of his free time in the metaverse. Gianluca loves learning new things, researching, discussing and writing about technology, especially when it comes to cryptocurrency and blockchain technology.