What are ETFs?
ETFs (Exchange Traded Funds) can be either a passively or actively managed fund traded on an exchange like a stock tracking an index, sector, commodity, or other assets. ETFs are traded on exchanges, similar to individual stocks, when the relevant exchange is open.
There are a number of different types of ETFs, catering to various asset classes and investment strategies. A stock index ETF is an exchange traded security that tracks the price of a stock index such as the FTSE100, bond ETFs focus on fixed-income securities, commodity ETFs invest in commodities, sector ETFs target specific industry sectors, and inverse ETFs aim to provide the opposite return of a particular index or asset class (e.g., an inverse S&P 500 ETF will have a positive return on days when the S&P index falls).
There are two types of ETFs: distributing or accumulating. Distributing ETFs will pay dividends to the investors, while accumulating ETFs will simply accumulate and reinvest income over time and not distribute it to investors. You can find general information about an ETF’s objective, risks, returns and cost in its Key Information Document (KID).
Leveraged and Inverse ETFs
Leveraged ETFs allow investors to amplify their exposure (and increase their risk) to the underlying assets by using borrowed funds, meaning both profits and losses are magnified compared to the underlying. These ETFs seek to provide a multiple (e.g., 2x or 3x) of the daily return of the underlying index. For example, if you trade a 2x leveraged ETF that tracks the S&P 500 index and the S&P rises by 1% on a particular day, the leveraged ETF will ideally gain 2% that day. Conversely, if the index decreases by 1%, the leveraged ETF will likely lose 2%.
What affects ETF prices?
ETF prices can be influenced by several factors, including:
- Performance of the underlying securities: The prices of underlying assets held by an ETF, such as stocks or bonds, directly impact its value. Positive or negative performance in those assets generally leads to corresponding price movements in the ETF.
- Supply and demand: Like any trade[AR(1] able security, an ETF’s price is affected by supply and demand dynamics in the market. Increased demand leads to price appreciation, while higher supply can result in price depreciation.
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Market news and indicators: Economic indicators, company news, geopolitical events or changes in market sentiment can all affect the prices of an ETF’s underlying securities and, consequently, the price of the ETF that tracks them.
What are the risks when trading ETFs?
When trading ETFs, it’s important to be aware of the potential risks. These include:
- Market risk: ETFs are subject to market risk, which means that their values can fluctuate based on overall market conditions. Thus, economic downturns, geopolitical events or changes in investor sentiment can impact ETF prices.
- Liquidity risk: Some ETFs may have lower trading volumes, which can result in wider bid/ask spreads. If an ETF has low liquidity, it may be more difficult to buy or sell shares at favourable prices. In addition, ETFs that trade less liquid assets, such as small cap stocks for example, can also experience greater price fluctuations. If an ETF invests in an illiquid asset (a security traded less frequently) this could result in greater price fluctuation on the underlying security.
- Counterparty risk: Certain ETFs use derivatives as a substitute for a given security, e.g., a stock. This is usually referred to as synthetic replication, as opposed to physical replication (actual stocks and bonds). Also, ETFs that engage in securities lending can also be subject to counterparty risk, although typically securities lending is only done with collateral in return to mitigate risk. In general, counterparty risk arises when the counterparty involved in these transactions fails to fulfill its obligations, potentially affecting the value of the ETF.
- Tracking error risk: refers to the possibility that an ETF’s performance may deviate from its underlying index due to factors like fees, transaction costs or imperfect replication.
- Other risks: Leverage risk is associated with leveraged ETFs, as they aim to amplify returns but can also magnify losses. Concentration risk may occur if an ETF is heavily invested in one specific sector, country or asset class.
- Psychological risks: Emotional decision-making and lack of discipline can lead to poor trading outcomes.
How much can you lose in ETF trading?
The maximum loss you can face when trading ETFs depends on the amount invested and the performance of the ETF. If all underlying assets were to go to zero, you could lose all of your investment.
When trading leveraged ETFs, however, it’s essential to understand that this type of ETF magnify both gains and losses. While they aim to provide amplified returns, adverse market movements can result in significant losses. Due to the compounding effect of daily rebalancing, leveraged ETFs may deviate from the performance of the underlying index over longer periods. You should carefully assess the risks and closely monitor leveraged ETF positions to avoid potential losses.
Potential additional costs and charges with ETFs
While ETFs charge different costs, the main cost is the ongoing cost, which represents the annual fee for managing the fund. This covers operational costs, administrative expenses and management fees. The ongoing cost is deducted from the ETF’s assets and is reflected in its net asset value, which in turn is reflected in the market via the bid/ask price.
Investors may also incur brokerage commissions when buying or selling ETF shares. These are fees charged by brokers for executing trades.
The difference between the bid and ask prices of an ETF represents a transaction cost. A wider spread can result in higher costs when trading ETFs.