What is an ETF?
An exchange traded fund (ETF) is a basket of securities that trades on an exchange similarly to stocks. An ETF is a fund that can hold multiple underlying assets, rather than only one like a stock does. This makes it a popular choice for diversification.
An ETF can include stocks, bonds, commodities and currencies, to name a few. ETFs will often track an index fund as a marker of performance.
How does investing an ETF work?
Like with stock investing, ETF investing involves taking a longer view toward income generation. Because there is a wide range of ETFs to invest in, you must do your due diligence and consider both your timeframe and favourite sectors.
For example, you might want to have an ETF with stocks in several regions to account for geographical volatility, or invest in both the dollar and tech stocks to try and balance out economic shocks.
You can invest in ETFs on most online investing platforms. You could then use dollar cost averaging to spread your investments out over a period of time, or lump-sum investing, depending on your long-term ETF strategy.
How does trading an ETF work?
Much like with trading and investing in stocks, an ETF strategy can have a short or long term focus. However, trading may be more suitable for some people in the short term.
Traders can buy and sell ETFs throughout the day, just like any stock. You can use technical analysis tools to track suitable entry and exit points for buying or selling an ETF.
People will open a trade on an ETF throughout the day based on news or wider market factors that push its resistance and support levels, which will affect supply and demand for that ETF. This price continually changes during trading hours, providing opportunities for profit but also for loss.
You can get price quotes at any time during market opening hours. With expertise, one could move on to sophisticated strategies like
swing trading and sector rotation.
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ETF investing strategies
Dollar cost averaging
Dollar cost averaging is the technique of buying a fixed-amount of an asset on a regular schedule, regardless of the changing cost of the asset.
Through dollar-cost averaging, an investor may compensate for the volatility inherent in ETFs and take advantage of short-term price movements that might prove more valuable than investing in one go.
Say you invest $2,400 in an ETF in a lump sum in January. At the end of the year, the ETF has grown 6%, so your investment is now worth $2,544. Or, imagine you invest $200 each month of the year. The ETF may see a sharp decline of 20% at the start of the year before gradually ascending through the rest of the year. Your investment could be worth more than it would have with the lump sum put in at the start of the year, were this scenario to occur. However losses could occur at another point or in a different way to make pound-cost averaging less profitable.
Such investors may take a few hundred dollars every month and, instead of placing them into a low-interest saving account, invest them in an ETF or a group of ETFs.
Asset allocation
Decades of research have shown that asset allocation – how you divide assets across broad asset classes – is the primary driver of a portfolio's risk and return.
The low investment threshold for most ETFs makes it easy for a beginner to implement a basic asset allocation strategy, depending on their investment time horizon and risk tolerance.
As an example, beginner investors might be 100% invested in equity ETFs, with goals of long investment time horizons and high-risk tolerance. As they become more experienced, they may shift to a less aggressive investment mix. This could look like 60% in equities ETFs and 40% in bond ETFs.
Buy and hold
For this strategy, you purchase an ETF that is diversified across multiple asset classes. Then, you use dollar-cost averaging or lump sum investing to continue topping it up on a regular basis.
This is one option for those who don't have time to learn about investing, or for those that would prefer not to pay further costs.
When buying and holding, a trader or investor might consider a fund that has a lower expense ratio. These have been shown to often outperform managed funds over the long run.
ETF trading strategies
Trend following
Trend following is one way to trade ETFs. It involves buying an ETF at the beginning of its upward trend or shorting it at the beginning of its downward trend. This can be done through classic technical analysis tools like moving averages to gauge the ETF's resistance and support lines.
Swing trading
You can use swing trading to take advantage of large swings in the market. Swing trading can take anywhere from a few days to a few weeks to work out.
Because ETFs are typically baskets of stocks or other assets, they may not exhibit the same degree of upward price movement as a single stock in a bull market.
By the same token, their diversification also makes them less susceptible than single stocks to a big downward move. This can offer less risk of capital erosion, which is an important consideration for beginner traders.
Day trading
Day trading is often viewed as one of the more accessible ETF trading strategies because it is characterised by high volatility. This means that you have the ability to buy and sell ETFs at any time throughout the trading day. Some of the most popular ETFs for day trading are:
- SPDR S&P 500 (SPY)
- Gold Miners ETF (GDX)
- ProShares VIX Short-Term Futures ETF
- ProShares Ultra VIX Short-Term Futures ETF (UVXY)
- iShares MSCI Emerging Markets ETF (EEM)
Day trading an ETF can provide you with short-term opportunities, but they can also be rather risky due to the use of leverage, making it important to manage your risk accordingly. Leveraged ETFs hold debt and shareholder equity, which can amplify losses when a trade loses money.
Betting on seasonal trends
Like most assets, ETFs can be subject to seasonal shocks, depending on the assets that make up the fund.
Some months – typically September and October – tend to perform well for commodities such as gold because of strong demand from India ahead of wedding season and the Diwali Festival of Lights – the celebration of which spans many major UK cities. Oil and natural gas, meanwhile, can experience a spike in the UK during the colder months when there is increased demand for energy to heat homes and buildings.
Another way of betting on trends is through the 'sell in May and go away' phenomenon. This refers to US equities, which have historically tended to underperform over the six-month May–October period, compared with the November–April period.
Betting on seasonal trends is risky. This is why it would be best to have a stop-loss set up so that you can limit losses. However, even with a stop-loss, there is the chance of slippage risk which can amplify losses.
Hedging
ETFs offer beginners an efficient method of hedging that can protect against downside risk in a substantial portfolio.
Suppose you have inherited a sizeable portfolio of US blue chips and are concerned about the risk of a large decline in US equities. One potential approach is to short stocks using CFDs. Or, you can hedge your chosen stock with options and CFDs. Some traders initiate short positions in ETFs like the SPDR S&P 500 ETF or the SPDR Dow Jones Industrial Average ETF (DIA).
If the market declines as expected, your blue chip equity position will be hedged effectively. That's because the declines in your portfolio will be offset by gains in the short ETF position.
What to consider when trading or investing an ETF
Check the ETF's track record
Review an ETF’s past returns over different time periods to understand how it has performed in various market conditions.
Has an ETF succeeded in gathering assets?
The size of an ETF's asset base can provide insights into its popularity among investors. A larger asset base often indicates greater liquidity and stability, as well as the potential for lower expenses.
Is there reasonable trading volume?
Adequate trading volume ensures that you can easily buy or sell shares of the ETF without significantly impacting the market price. Low trading volume may result in wider bid-ask spreads and increased transaction costs.
Does the performance of an index ETF closely match the index it's aiming to track?
For index-based ETFs, it's important to evaluate how closely the ETF's performance aligns with the underlying index it seeks to replicate. Tracking error, or the deviation from the index's returns, should be minimal for an effective index ETF.
What are the tax implications of the ETF, including its turnover rate and potential capital gains distributions?
Consider factors such as the ETF's turnover rate, which indicates the frequency of buying and selling securities within the fund. Higher turnover rates can lead to increased capital gains distributions, potentially resulting in tax consequences for investors.
How well-diversified is the ETF?
Assess the holdings of the ETF to ensure it provides exposure to a broad range of assets or sectors, reducing the risk associated with individual stocks or industries.
Think about the companies behind the ETF and their record financially as well as with regulators
Research the companies managing the ETF, including their financial stability and track record on earnings and dividends. Additionally, consider their adherence to regulatory requirements, which ensures transparency and investor protection.
Consider costs like expense ratios
ETFs have expense ratios, which represent the annual fees charged by the fund for managing and operating the ETF. Lower expense ratios are generally preferable, as they can have a significant impact on long-term returns.
Trading risks
While traders and investors like ETFs for their diversification, there are still risks to consider when trading them. ETFs are prone to the same market and political risks as individual securities. It's important to consider these and regularly check in on the securities within your preferred ETF.
How to invest ETFs
- Create your live account with us in minutes
- Choose our Smart Portfolios, which are managed for you, or share dealing
- If you choose share dealing, you could do further research on how to diversify your portfolio and manage your risk
- If you choose our Smart Portfolios, we will ask you some questions about your risk tolerance
- Invest a lump sum or set up a regular instalment to fund your account
How to trade ETFs
- Research your preferred market
- Decide which ETF you want to trade
- Open a CFD trading account or practise on a free demo account
- Select the ETF which you want to trade using CFDs
- Set your position size, manage your risk and place your deal
- Monitor your trade
CFDs - short for 'contract for difference'- are leveraged derivatives. This means you don't own the underlying ETF, but you're betting on its price movement.
You can trade CFDs on the spot market, which is suitable for shorter term trading as the spot price is the immediate real-time price of the asset.
You can also trade CFD futures, which are best for medium to longer term trades as they allow you to speculate on the price that the underlying asset will be on a specific date. As there are no funding charges on CFD futures – they are a popular choice for those who plan to keep positions open longer than a day or two.
With CFDs, your currency exposure and initial margin will vary according to the contract of the ETF chosen. Your wins or losses will depend on the outcome of your prediction. To manage risk when trading CFDs, many traders set stop loss orders to prevent outsized losses.
Remember, trading with CFDs comes with added risk attached to leverage. Your position will be opened at a fraction of the value of the total position size – but you can gain or lose money much faster than you might expect. Your losses can exceed the initial margin that you paid because potential profits and possible losses are magnified to the full value of the trade. It's a good idea to keep in mind that when you're making your predictions, past performance isn't a guarantee of future patterns.
ETF strategies summed up
- An Exchange Traded Fund (ETF) is a basket of securities that can be traded on an exchange in the same way as stocks
- You can trade an ETF throughout the day or invest in one for a long-term strategy
- Trend following, swing trading, day trading and betting on seasonal trends are a few ways you can trade ETFs for a short-term strategy
- Dollar-cost averaging, asset allocation and buy and hold are a few strategies used by investors for a longer-term strategy from an ETF
- When trading or investing in ETFs, you should consider past performance, its volume, its performance against a tracked index and how well-diversified the ETF is, but remember past performance doesn't guarantee future returns
