GET Financial Education Series - Stocks and CFDs
Exchange Traded Funds – Lesson 13
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Exchange-traded funds (ETFs) are investment funds that are traded on stock exchanges. Whilst they are not mutual funds, they do offer all of the benefits of diversification that you would enjoy when trading a mutual fund. ETFs also enjoy all of the benefits of liquidity that you have from trading individual shares.
ETFs offer instant diversification because, when you buy an ETF, you buy a piece of a fund that incorporates multiple assets. ETFs are like a large basket into which fund managers place various assets such as shares, bonds and commodities. When you buy an ETF you buy wholesale ownership of the basket and its contents as a whole, not piecemeal ownership of the individual contents.
You can make money with an ETF. As the value of the assets within the basket increases so does the overall value of the basket. Conversely, as the value of the assets within the basket decreases so does the overall value of the basket.. In other words as the assets within an ETF increase in value the value of the ETF increases, and as the assets within an ETF decrease in value the value of the ETF decreases.
Trading ETFs offers many benefits to you as an individual trader. We will cover the following in this section:
- Instant diversification
- Free trading
- Stop-loss orders
- Lower fees
Instant Diversification
ETFs give you the ability to simultaneously own multiple assets without having to buy each asset individually. Imagine, for instance, the trading costs that would accrue and the capital you would need to have in your account if you had to buy every share within the S&P 500 individually.
Diversification can also help protect you from unsystematic risk. For instance if you own only one of the shares in the Nikkei 225 Index, and that share loses value, you will lose money on your investment. However if you own the entire Nikkei 225 Index via an ETF, and that same share goes down, you have 224 other shares around it that are likely to ensure the value of the entire index either remains stable or climbs higher.
Many of the most popular ETFs track broad market indices. The following are just a few examples:
| S&P 500 |
| Dow Jones Industrial Average |
| FTSE 100 |
| DAX Index |
| Nikkei 225 |
| FTSE/Xinhua China 25 Index |
| NASDAQ 100 |
| CAC 40 Index |
Many ETFs also track various market sectors such as the following:
| Information technology |
| Energy |
| Materials |
| Industrials |
| Telecommunication |
| Utilities |
| Health care |
| Financials |
Free Trading
ETFs are freely traded on stock exchanges just like regular shares. As long as the stock exchanges on which the ETFs trade are open you can buy or sell any ETF. This is an advantage over mutual funds.
Mutual funds are only traded at the end of the market day once all of the assets within the funds can be valued. At that point the funds are assigned a closing value for the day, and you can buy or sell the funds at the closing value. Unfortunately during trading days when the assets within the funds are losing value you must hold onto the funds until the end of the day regardless of how much value the funds are losing.
In conclusion, whether you see the value of an ETF increasing or decreasing during the trading day you can buy or sell the ETF to take advantage of the price movement.
Stop-Loss Orders
You can protect your ETF trades by setting stop-loss orders. Because ETFs are freely traded you can set stop-loss orders that may take you out of your trades during the market day when your pre-determined price is hit. If you were trading mutual funds to obtain diversification, you would not have this ability because you can only buy or sell mutual funds at the end of the trading day after the markets have closed. So it wouldn't matter if your trigger price was hit during the market day because you would not be able to exit your trade.
Stop-loss orders allow you to implement appropriate risk management measures in your account. Consequently you can simultaneously protect your investment capital by both diversification and stop-loss orders.
Lower Fees
When you give your money to a manager to invest you usually have to pay that manager a fee. Typically the more active a role the manager plays in the investment decisions the larger the fee you will have to pay. ETFs typically have lower fees because they are passively managed, unlike many funds, including mutual funds that are actively managed.
Most ETFs track a specific index, market sector and so on. Since the composition of most stock indexes and share sectors barely changes, the managers of most ETFs do not often need to change the holdings within the fund. Consequently, because these managers do not play as active a role they charge a lower fee.
Most mutual fund managers, on the other hand, make daily decisions regarding what assets they are going to add to their portfolios, what assets they are going to keep in their portfolios and what assets they are going to remove from their portfolios. This active management and the trading fees it produces boost the fees that mutual fund managers charge their clients.
Instant Diversification
