What does ETFs stand for and how do they work? Your essential ETF overview

What are ETFs?

Exchange-Traded Funds, also known as ETFs, are investment funds that trade on stock exchanges, much like individual stocks. They are designed to track the performance of a wide array of assets, including stocks, bonds, commodities, or even indices. Think of an ETF as a basket of assets bundled into a single package, allowing you to gain exposure to a diversified portfolio without needing to own each asset individually.

Key Features of ETFs:

  • Diversification: Gain access to a broad range of assets, such as stocks, bonds, or commodities, in a single trade.
  • Flexibility: Traded on stock exchanges, you can buy or sell ETFs at any time during market hours, unlike mutual funds, which only trade at the end of the day.
  • Accessibility: ETFs offer exposure to markets or sectors that might otherwise be difficult or expensive for individual investors to access, such as international markets, niche industries, specific asset classes like commodities or emerging markets making them a versatile tool for expanding portfolio diversification.

Types of ETFs

ETFs come in various forms to suit different trading strategies and risk appetites. Some of the most common types include:

1. Stock (Equity) ETFs:

These ETFs hold baskets of stocks, tracking a specific market index or sector. For example, the ARK Innovation ETF provides exposure to stocks related to cutting-edge technologies like AI and robotics. Stock ETFs may pay dividends, which are collected from the underlying assets and distributed to ETF shareholders.

2. Bond ETFs:

These track a portfolio of bonds, segmented by type, issuer, or maturity. For example, the iShares iBoxx High Yield Corporate Bond ETF tracks high-yield corporate bonds. Bond ETFs can provide fixed income while varying in risk and return depending on their holdings.

3. Commodity ETFs:

These track the prices of commodities like gold, oil, or agricultural products. Commodity ETFs allow traders to speculate on commodity prices without needing to own the physical assets. A popular example is the SPDR Gold Shares ETF, which tracks the price of gold.

4. Index ETFs:

These ETFs aim to replicate the performance of a particular stock market index, such as the SPDR Dow Jones Industrial Average ETF, which tracks the Dow Jones index. Index ETFs are known for their cost-efficiency and are popular among long-term investors.

5. Sector & Industry ETFs:

These target specific market segments, such as technology or healthcare. For instance, the ARK Innovation ETF focuses on sectors like AI, automation, and fintech.

6. Style ETFs:

Style ETFs track stocks based on specific characteristics such as market capitalization, value, or growth. Value ETFs, for example, focus on stocks that appear underpriced based on fundamental metrics.

7. Volatility ETFs:

These ETFs allow traders to speculate on or hedge against market volatility. Unlike traditional ETFs, volatility ETFs track the performance of derivative contracts related to market volatility.

These ETFs allow traders to speculate on or hedge against market volatility. Unlike traditional ETFs, volatility ETFs track the performance of derivative contracts related to market volatility.

A table displaying the types of ETFs, their holdings, features and role

Pros and Cons of ETFs trading

Pros:

  • Diversification: ETFs provide instant diversification by bundling multiple assets into one, reducing overall portfolio risk.
  • Liquidity: ETFs can be traded throughout the day at market prices, offering traders more flexibility than mutual funds.
  • Transparency: ETFs disclose their holdings regularly, allowing you to easily track their assets and performance.
  • Cost-effectiveness: ETFs generally have lower fees compared to mutual funds, with lower expense ratios and transaction costs.

Cons:

  • Market risk: Like any investment, ETFs are subject to market risk, and their value can fluctuate based on the performance of the underlying assets.
  • Price discrepancies: Due to market dynamics, an ETF's trading price may differ slightly from its net asset value (NAV), potentially impacting returns.
  • Fees and commissions: While many brokers offer commission-free trading, ETFs still incur fees, such as bid-ask spreads and management fees, which can add up over time.

How to choose the right ETFs

Selecting the right ETF depends on your financial goals, risk tolerance, and market preferences. So what makes a good ETF to trade? Here are a few factors to consider:

  • Risk Exposure: Evaluate the ETF's risk profile, including sector, geographic, or asset-class exposure. This can help ensure it aligns with your risk tolerance and diversification needs.
  • Trading Volume: ETFs with higher trading volumes generally have better liquidity, making them easier to buy and sell.

Performance History: Review the historical performance of the ETF relative to its benchmark index or sector.

Getting Started with ETF Trading

To begin your ETF trading journey, open a demo account on Deriv MT5 or Deriv X and explore various ETF offerings. With a demo account, you can practice with virtual funds and familiarize yourself with how ETFs work before diving into live trading.

Whether you're looking to diversify your portfolio, gain exposure to specific markets, or hedge against volatility, ETFs can be a valuable tool in your trading strategy. Always do your research, stay informed, and consider your financial goals before investing in ETFs.

Disclaimer:

Trading is risky. Past performance is not indicative of future results. It is recommended to do your own research prior to making any trading decisions.

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