What are ETFs (exchange-traded funds)?

As you have seen, investment training articles mostly talk about curious topics such as currency nicknames, the origin of the indices o catalytic events to take advantage of the volatility of financial markets. Along with these lessons, we have been putting the current situation of the investable asset markets in context. So in today's investment training we are going to talk about a type of investment that we have recommended in most articles: ETFs.

What are ETFs?

An Exchange Traded Fund (ETF) is a type of investment fund that operates like a mutual fund. ETFs usually follow indices, sectors such as commodities or stocks or other types of securities. Unlike mutual funds, we can buy and sell ETFs on a stock exchange, in the same way we can purchase stocks or other assets. Purely, ETFs follow the movements of a basket of assets, and can be diversified or focused on a single sector or asset class. The first ETF was SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index, and is actively traded today.

What are ETFs used for?

As we explained in previous articles, being able to have a diversified portfolio of assets can end up being more expensive due to commissions. At the same time, being able to correctly track a long list of assets of different classes can end up being a big headache. That is why indices were devised, to allow investors to invest in a diversified basket of assets of the same class, such as stock, commodity or currency indices. With ETFs we follow the same dynamic, but with a characteristic that defines it; the possibility of investing in different assets of different classes. For example, we can invest in the Ark Investments ETF to gain exposure to the portfolio of assets managed by Cathie Wood's fund.

What types of ETFs are there?

In order to distinguish the different types of ETFs that are available on the market, we are going to continue the investment training on ETFs by explaining what types we can find. 

Stock ETFs

Stock ETFs are made up of a basket of stocks to follow a single industry or sector. For example, a stock ETF may track stocks of automobile companies. The goal of these ETFs is to offer diversified exposure to a single industry that includes stocks with good returns and new entrants with growth potential. Unlike mutual funds, stock ETFs charge lower fees and do not require holding stock titles. The SPDR S&P 500 ETF Trust tracks the movements of the S&P 500 index. 

Industry/Sector ETFs

Industry or sector ETFs are funds focused on a specific sector or industry. For example, an energy sector ETF will include companies that are part of that sector. The idea behind industry ETFs is to gain exposure to the rises of that industry by following the movements of companies in that sector. An example is the technology sector, which has generated good returns during the last decade. At the same time, the disadvantage of stock volatility is also mitigated with an ETF because it is not made up of securities directly. Industry ETFs are also used to rotate in and out of sectors during economic cycles. The SPDR Select Sector Fund- Industrials follows the development of a basket of industrial sector assets. 

Bond ETFs

Bond ETFs allow us to invest in bonds, which will distribute the income from it depending on the bond they are tracking. Government, corporate, and municipal (state and local) bonds may follow. Unlike bonds, bond ETFs have no expiration date. They are generally traded at a premium or discount compared to the current price of the bond. The Vanguard Total Bond Market ETF tracks the development of the global bond market. 

Currency ETFs

Currency ETFs are investment vehicles that track the movements of currency pairs, local and foreign currencies. Currency ETFs have different purposes. They can be used to speculate on currency prices based on the political and economic conditions of a country. They are also used to diversify a portfolio or as a hedge against volatility in currency markets. Some of these are also used to protect us against inflation. The Invesco DB USD Index Bullish Fund follows the development of the dollar index. 

Commodity ETFs

Commodity ETFs invest in commodities such as oil or gold. Commodity ETFs offer us different advantages. We can diversify our portfolio, thus facilitating coverage against market declines. For example, commodity ETFs can offer protection during a stock market crash. Additionally, holding shares of a commodity ETF is cheaper than owning the commodity. This is because in commodity ETFs we do not pay for insurance or storage of the commodity itself. The SPDR Gold Trust ETF follows the development of gold market prices.

inverse ETFs

Inverse ETFs try to generate profits from declines in the assets they follow. When the market goes down, an inverse ETF grows proportionately. Many of these ETFs are exchange-traded notes (ETNs), not true ETFs. An ETN is a bond, but it trades like a stock and is backed by an issuer, such as a bank. The ProShares Short QQQ allows you to generate profits based on the falls of the Nasdaq-100 technology index.  

Leveraged ETFs

A leveraged ETF seeks to offer the investor exposure to a leveraged asset. For example, if the S&P 500 index rises by 1%, a 500x leveraged S&P 2 ETF will return 2%, but if the index falls by 1%, the ETF will lose 2%. These products use derivatives such as options or futures contracts to leverage their income. There are also inverse leveraged ETFs, which seek a multiplied inverse gain. The ProShares UltraPro Short QQQ allows you to generate profits with 3x leverage from the declines of the Nasdaq-100 technology index. 

Pros and cons of exchange-traded funds (ETFs)

ETFs both have their advantages and disadvantages, we are going to review the pros and cons of this investment training on ETFs. We can highlight that ETFs have lower maintenance costs than traditional funds, ranging from 0,05% and generally not exceeding 0,40%. This is because ETFs are passively managed, which is why they have such a low fee unlike actively managed funds. It is also worth highlighting the facilities it offers investors to operate in different asset classes in a diversified manner. Finally, they also have greater liquidity than traditional funds, since it is possible to invest and divest an ETF at any time.

Pros	Cons
Access to many assets from different industries/sectors.	Those with active management have higher costs.
Low fees compared to traditional funds.	A lack of liquidity can negatively affect operations.
Risk management thanks to diversification.	ETFs that focus on a single industry are limited in terms of diversification.
ETFs focused on specific industries.

Pros and cons of investing in ETFs. The main disadvantage to highlight is that ETF managers have to replicate the behavior of the market. Therefore, we could be at a disadvantage if a liquidity crisis occurs, as investors will sell their ETF holdings en masse and, consequently, forcing managers to sell their positions in times of decline. This can also cause the manager to have to assume a very high price differential (spread). 

Conclusions from this investment training on ETFs

As we have seen throughout this ETF investment training, this investment vehicle has both its advantages and disadvantages. But clearly the facts in favor outweigh those that go against, given that offering the investor the possibility of being able to diversify their capital in different asset classes or sectors is a great point in favor. This fact allows us to reduce commission payments for different assets and at the same time simplify investment monitoring. As a final recommendation to put an end to this article, we recommend the page etfdb.com/etfs, a page where you will be able to search for ETFs of different types, sectors and much more. 

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