What are ETFs? Your guide to exchange-traded funds

October 17, 2023

ETF

What are ETFs? Your guide to exchange-traded funds

The most common questions asked by novice traders are: What are ETFs? What do ETFs stand for?

ETFs, or exchange-traded funds, are a type of investment fund and exchange-traded products traded on a stock exchange. These versatile financial instruments offer flexibility and diversification to any trading strategy, making them popular among traders.

Here's what we'll cover in this blog post:

ETFs: What are they

Imagine a buffet where an array of dishes is available without you having to order each dish separately to try it. ETFs work similarly, offering a diverse spread of assets bundled into a single trading vehicle.

When you trade ETFs, you're essentially choosing a mix of assets, such as stocks, bonds, or commodities, without the hassle of owning each individually. These instruments are traded on stock exchanges, ensuring you can buy and sell them during market hours.

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Types of ETFs

There are various types of ETFs, with each having different underlying assets. ETFs come in multiple forms to suit different trading strategies and risk appetites. They may contain stocks, bonds, commodities, and indices. Some of the most popular categories include:

Stocks ETFs

Stock ETFs, also known as equity ETFs, invest in stocks, either tracking a specific set of stocks, a stock market index, or a particular sector within the stock market. ETFs can receive dividends from their underlying assets, such as stocks or bonds. When these assets pay dividends, the ETF typically collects and distributes them to its shareholders. When it has been a good period for the assets, the ETF market price tends to increase.

For example, the ARK Innovation ETF provides exposure to domestic and foreign stocks of companies that depend on or benefit from developments in artificial intelligence, automation, DNA technologies, energy storage, fintech, and robotics.

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Bond ETFs

When trading bond ETFs, traders are exposed to a portfolio of bonds that are segmented according to their type, issuer, and maturity, among other factors. For example, the iShares iBoxx$ High Yield Corporate Bond ETF tracks an index of high-yield bonds of US dollar-denominated companies.

Bond ETFs can vary in risk and return depending on the types of bonds they hold. Some other examples include government bonds, corporate bonds, municipal bonds, international ETF bonds, and other fixed-income securities.

Commodity ETFs

These ETFs track the prices of commodities like gold, oil, or agricultural products. Commodity ETFs allow traders to speculate on commodity price movements without physically owning or storing the commodities. They offer accessibility and cost-efficiency, while direct commodities trading provides ownership and precise exposure to your chosen asset.

For instance, the SPDR Gold Shares ETF tracks the price of gold bars in the over-the-counter (OTC) market.

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Index ETFs

These are the most prevalent types of ETFs and are engineered to mirror the performance of a particular stock market index. For example, the SPDR Dow Jones Industrial Average ETF Trust tracks the Dow Jones Industrial Average index. Traders can gain exposure to specific sectors or to the entire market with index ETFs. Index ETFs are known for their cost-effectiveness, which makes them an attractive option for traders.

What sets index ETFs apart from stocks ETFs is that the latter primarily invest in individual company stocks, while index ETFs track the performance of various indices, including but not limited to stocks.

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Pros and cons of trading ETFs

Selecting the optimal asset to trade is like choosing a new car. You want an option that has good value, is reliable, and suits your needs.

Let's take a closer look at some of the advantages of ETFs and why you should trade them.

Diversification
ETFs offer a simple way to diversify across a wide range of assets rather than just a single asset. This can reduce the overall risk of your trading portfolio.

Liquidity
Liquidity refers to how easily an asset can be bought or sold without affecting its price significantly. ETFs can be bought or sold throughout the trading day, providing flexibility to you.

Transparency
You can easily see what assets ETFs hold, helping you make informed trading decisions. ETFs are required to disclose their holdings regularly. This means traders can easily see which stocks or bonds are in the fund's portfolio and track their individual performances and the performance of the ETFs.

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While ETFs offer many benefits, there are a few things to keep in mind:

Risk management
Even though ETFs provide diversification, they are not immune to market volatility and risk. Make sure to evaluate the risk associated with the underlying assets. Stay informed about current market conditions and news related to the sectors or asset classes covered by the ETF.

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Price discrepancies
The current market value of an ETF may not consistently mirror the precise value of its underlying assets. As ETFs are traded on an exchange, traders are subject to market dynamics during trading. This means that prices may potentially deviate from the net asset value (NAV), which is usually the basis for an ETF’s trading price.

Commissions and fees
While many online brokerages offer commission-free ETF trading, there may still be other fees, such as expense ratios, bid-ask spreads, and account maintenance fees. Understanding the fee structure of your chosen ETFs and the brokerage platform is essential before you start trading.

ETFs offer diversification, transparency, and liquidity, making them a valuable tool for traders to get on trading. Whether you're a beginner or an experienced trader, ETFs can play a significant role in your trading strategy, helping you build a well-balanced and diversified portfolio. However, like any other market, it's essential to do your research and consider your trading goals and risk tolerance before trading ETFs.

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It is always a good idea to create a demo account to start practising. Take the opportunity to explore the ETFs on Deriv MT5 or Deriv X, where you can gain experience and insights into how ETFs work.