Get to know the investment asset that has become popular among investors in recent years due to its diversification possibilities and relatively low maintenance costs.
An Exchange-Traded Fund (ETF) is a type of security that tracks a sector, index, commodity or other asset. ETFs can be bought or sold on an exchange in the same way as regular stocks. The design of an ETF remains arbitrary and depends on the strategy of its creators. And in this way, an ETF can track anything from the price of a single commodity or a few stocks to a large and diverse collection of securities. ETFs can also be structured to provide exposure to precious metals such as gold and the commodities sector. ETFs are called exchange-traded funds, because they are traded on stock exchanges just like corporate stocks.
Types of ETFs
- Index funds
Index funds are the most common type of ETF. They consist of stocks or other financial instruments that are part of a market index, such as the S&P 500 or FTSE 100. The purpose of index funds is to track the performance of the market and get results close to the index.
- Sector funds
Sector funds focus on a specific industry or sector of the market, such as the technology industry or the medical industry. They attract the attention of investors who want to focus on a specific industry or market sector, but do not want to buy individual stocks each time. However, sector funds can be riskier than index funds, as they are more exposed to changes in a particular sector. - Bond funds
Bond funds invest in bonds issued by governments, companies or financial institutions. They are attractive to investors who are looking for a relatively stable investment income. However, sometimes bond funds can be riskier than index funds, because bonds issued by companies are exposed, for example, to the risk of changes in credit ratings. - Commodity funds
Commodity funds are funds that invest in commodities such as precious metals, oil or grains. They can be an alternative for investors who want to take advantage of the potential increase in commodity prices, but do not want to invest in commodities physically. However, it should be remembered that commodity prices are characterized by relatively greater volatility.
Advantages and disadvantages of investing in ETFs
Advantages
- Ease of trading and low transaction costs: ETFs are very easy to buy and sell, as they are traded just like regular stocks. In addition, transaction costs are usually lower than traditional mutual funds, which means that investors can save on fees associated with the purchase and sale.
- Access to a variety of markets and industries: ETFs give investors easy access to a variety of markets and industries that would be difficult or expensive to reach otherwise. These can be, for example, foreign markets, technological industries or raw materials.
- Portfolio Diversification: ETFs are typically made up of many different stocks or bonds, meaning that investors can easily diversify their portfolios, thereby minimizing investment risk.
Disadvantages
- Unmanageable: Investors in ETFs typically have no control over which stocks or bonds the fund invests in. These decisions are made by the fund manager, who is tasked with aligning the composition of the portfolio with the fund’s objectives.
- Risk of targeting: ETFs that focus on only one market or industry are more likely to be affected by changes in that sector than diversified funds. This means that in the event of sudden turmoil in a particular market, investors in such funds may suffer greater losses.
Distributing and Accumulating models
Accumulating ETFs
Accumulating ETFs reinvest the dividends and income the fund generates instead of paying them out to investors as payouts. In this way, if applicable, the Net Asset Value (NAV) of the fund increases, giving their investors an increase in the value of their investments.
Advantages:
- Potential increase in the fund’s net asset value
- Longer investments can yield higher returns by reinvesting dividends
Disadvantages:
- They do not give direct access to dividend payments
- High NAV valuations can mean that accumulating ETFs are more expensive than distributing ETFs
Distributing ETFs
Distributing ETFs pay investors dividend payments and the income the fund generates. Investors can enjoy regular dividend payments from the fund.
Advantages:
- Direct access to dividend payments
- Providing a stable source of income for the investor
Disadvantages:
- They do not reinvest dividends, which may mean less potential growth in the fund’s net asset value
- Less flexible investment strategies: Distribution ETFs tend to have less flexible investment strategies than accumulation ones. They are required to pay dividends on a regular basis, which means they must invest in companies that pay dividends.
Physical and Synthetic ETFs
Physical ETFs
Physical ETFs are funds that invest in real assets such as company shares, bonds or commodities. In other words, with physical ETFs, the fund actually buys assets to reflect the composition of the index it is aiming to track. For example, if a physical ETF is designed to track the S&P 500 index, the fund actually buys stocks of companies on that index to reflect its composition.
The main benefit of physical ETFs is that investors are assured that their funds are directly backed by real assets, meaning their investments are not exposed to counterparty risk. In other words, investors’ investments are protected against the possible bankruptcy of a financial services provider.
However, it should be noted that physical ETFs are less flexible in structure than synthetic ones, which means they may be less adaptable to changing markets or investors’ investment goals.
Synthetic ETFs
Synthetic ETFs, on the other hand, do not invest directly in real assets, but enter into swap agreements with a counterparty that commits to pay an amount equivalent to the value of an index or other asset that the fund is designed to reflect. In other words, synthetic ETFs achieve their exposure to the markets by entering into swap agreements with a counterparty. These are agreements concluded between the fund and the counterparty, in which the counterparty undertakes to pay to the fund the profits or losses resulting from the investment, which the fund would be able to achieve by investing directly in the assets to which a given ETF relates.
The main advantage of synthetic ETFs is that they are more flexible than physical ETFs. They can use various strategies such as leverage or short selling to achieve higher returns.
However, it should be remembered that synthetic ETFs are also riskier than physical ETFs, as investors’ investments are only secured by the counterparty, which may not be able to meet its obligations to the fund. In this way, investors risk losing their investments in the event of a counterparty going bankrupt.
Physical and synthetic ETFs differ in many ways. Physical ETFs invest directly in real assets, giving investors greater investment security, but they are less flexible and costly to maintain. Synthetic ETFs, on the other hand, enter into swap agreements with a counterparty, giving them more flexibility and lower holding costs, but they are riskier and more complex in structure.
Thanks to the growing popularity of ETFs, investing in them has become easier and more accessible for the common investor, however, it is still important to understand exactly how these funds work and what are their potential benefits and risks. Investing in ETFs can be an effective way to diversify your investment portfolio and increase your chances of achieving desired returns. At the same time, it should be remembered that each ETF has its own specific features, such as structure, maintenance costs or investment area, which may affect the final investment results. Before making an investment decision, you should carefully research the structure of the ETF and understand the risks associated with investing in a given asset class.