In previous articles, we have covered the general description of ETF’s and why they so great. Now it is time to discuss the types of Exchange traded funds (ETFs) which are based on differing holdings and behave as dictated by their base holdings, and ETF risk related to each of the ETF types.
7 common types of Exchange traded funds
- Index Exchange traded fund type: These are the most common type of exchange traded fund. They copy the entire portfolio, part or make a similar portfolio to another index e.g. stock index, bond index. They usually hold in their portfolios the exact content of the index or a representative sample and can deviate slightly, usually by a 5% – 20%, using futures, options, and swap contracts and the presence of stock not found in the index.
- Stock Exchange traded funds: These funds track stocks or indices that have stocks in their portfolios e.g. S&P 500 ETF. Many stock indices are niche while some contain stocks from a wide range of sectors. It is important to understudy these stocks or indices before choosing an exchange traded fund based on them.
- Fixed-Income ETF type: Fixed-income securities such as bonds and fixed income exchange traded funds do not respond easily to the market’s swing and are therefore less volatile and low risk ETF investment while still providing a stream of income. It is therefore recommended that a part of the portfolio be invested in fixed income securities.
- Inverse ETF type: These are specifically constructed to profit from a decline in the value of the underlying benchmark. It is similar to a type of investment involving holding short positions or using a complex arrangement of advanced investment strategies to make gain from declining prices.
- Leveraged Exchange traded funds: These are a type of exchange traded fund that is more sensitive and therefore yield greater response to market movements. Leveraged exchange traded funds tend to double or triple daily gains made in the market. Leveraged Inverse exchange traded funds will make double or triple gain of the loss made by falling prices of the benchmark on which it is based.
- Commodity exchange traded funds: Commodities e.g. gold, silver, and oil, behave differently to equities. It is, therefore, necessary to understand why one wants to invest in commodity exchange traded funds. There are exchange traded funds that invest in the common shares of commodity producers and these are very different from exchange traded funds that track price changes in commodities. The former has the high correlation with the stocks while the latter has little correlation.
- Currency exchange traded funds: In a bid to isolate or support one’s investment from the fall of the American dollar, a currency ETF type is prescribed. They are funds based on the price of a foreign currency. They were developed due to the strengthening of other currencies with respect to the dollar. It is counterintuitive to buy holdings of foreign companies because most of them trade shares based on dollar prices so currency exchange traded funds can be used.
There are other types of exchange traded funds, each having its own pros and cons. What is important is that one verifies all the characteristics of a particular exchange-trust fund and how fitting it is before investing in it. To find out more about the types and details investment strategies use ETFdb.com.
What is the risk associated with investing in ETF?
Every business has risk inherent. And exchange traded funds like every fund has a few but these risks can be avoided or properly managed if you DO YOUR HOMEWORK. Some of these risks occur arise even in mutual funds and other common securities.
- Market Risk: This is the single biggest risk. Exchange traded funds only serve as a package for investments so if a commodity or holding e.g. Proshares Ultra QQQ ETF (QLD) goes down badly e.g. 50%, there is nothing the exchange traded funds can do to change that.
- Commodity Tax: If an exchange traded fund is based on the shares of a corporation trading in a particular commodity e.g. gold, currencies, it might be unable to shield that commodity from being taxed even though the exchange traded fund behaves like a stock. This means for gold, you would still pay 28% tax no matter how long you had them because Internal Revenue Service sees them as ‘collectibles’.
- Uneven/High spread costs: As a direct result of the higher rate of exchange traded funds traded, more fees as the spread is incurred. The greater problem arises when spread cost changes after a particular amount of stocks are sold e.g. the first 100 holdings might have a spread of 0.002% while the next 1000 holdings having a spread of 0.2%. This can lead to the major reduction in profit.
Other risks include shutting down of an exchange traded fund, broken exchange traded funds risk, and brand-new-thing risk. These can easily be avoided by researching the market enough before investing. Trends tend to continue so except under good professional advice, a holding that makes up the periphery of your portfolio should be kept there.
Shall I invest In ETF's?
Various Exchange traded fund types offer the flexibility of stocks with the financial safety of a fund. Exchange traded funds have higher daily liquidity and typically cost lower than mutual funds. In most cases, ETF risk is much lower than investing in regular stocks due to diversification. And best of all, exchange traded funds are an efficient way of reducing tax deductions and maximizing profit without having the Internal Revenue Service after you. Why wouldn’t you invest in exchange traded funds?