Exchange Traded Fund (ETF): Meaning and Types
Exchange Traded Fund (ETF): Meaning and Types
What is an Exchange Traded Fund used for in the trading of securities?
The most successful financial innovation since the invention of financial futures can be considered the creation of Exchange Traded Funds, or ETFs. The main purpose of an ETF is to reflect the dynamics of the underlying financial instruments that are taken into account when forming each particular ETF. At the same time, an ETF is listed on an exchange and can be traded alongside ordinary stocks. ETFs were introduced on the stock exchanges of America and Canada in the 1990s. An ETF is a fund that owns certain assets. These can be stocks, bonds, oil futures, assets in the form of gold, foreign currency, and so forth.
Therefore, one of the advantages of trading ETFs is the ability to trade different types of stock exchange assets, even if these assets are not themselves available for trading on that exchange. Or it can be an excellent opportunity to trade a certain set of assets using a single financial instrument.
More than one and a half thousand ETFs are available for trading on the U.S. stock market. Over two hundred of them are actively traded financial instruments.
Types of ETFs
In order for a beginner investor or speculator to effectively choose one or another ETF for trading, it is necessary to clearly structure the array of ETFs presented on the stock market.
The following types of ETFs are represented on the stock market: Equity ETFs, Commodity ETFs, Bond ETFs, Currency ETFs, Index ETFs, Inverse ETFs, and Leveraged ETFs.
Equity ETF – a security that reflects the dynamics of a certain set of stocks. Mostly, these ETFs represent a set of stocks according to a particular industry or country. For example, it could be the energy sector or the industrial sector. Or the ETF may include stocks of issuers located in China.
Commodity ETF – an ETF that reflects the price of physical commodities. Such commodities can be agricultural products, natural resources, as well as precious metals. A Commodity ETF is mainly focused on a particular commodity. At the core of such an ETF may be a physical commodity stored in a certain location. A futures contract for the corresponding commodity may also underlie a commodity ETF. Less common are ETFs that reflect commodity indices in their value, which in turn can be calculated based on multiple commodities in the form of a combination of physical goods and various derivatives.
Bond ETFs. The underlying asset for ETFs of this type is bonds. This, in turn, makes it possible to trade debt financial instruments through the stock market.
Currency ETF – an ETF that reflects the value of a corresponding currency. This type of trading fund provides an opportunity to trade currency pairs without entering the Forex market.
Index ETF – an ETF that reflects the dynamics of a certain index as closely as possible. Of course, an index ETF may trade at a discount or premium relative to the index. But these periods are very short because any difference is very quickly offset by arbitrage from institutional investors.
Inverse ETF – an ETF constructed using various derivatives. The goal of this construction is to form an inverse relationship between the ETF price and its corresponding index or set of stocks. This means that if a certain index declines, the inverse ETF will rise. Conversely, if a certain index rises, the inverse ETF will fall. This type of ETF is very often used by institutional investors who have restrictions on short selling. Thus, to hedge their risks during market or sector downturns, institutional investors can buy this type of ETF.
Leveraged ETF. These ETFs are based on various assets, but their main feature is the presence of a certain leverage ratio for the ETF relative to its underlying asset. This ratio is usually 2 or 3. Therefore, this type of ETF can be called double or triple. For instance, if we consider a double ETF, it grows twice as much as its underlying asset grows. Accordingly, the decline of such an ETF will be twice the decline of its underlying asset. These ETFs allow for more aggressive speculation, and consequently, the risks of trading these instruments are also higher.
At the same time, an individual ETF may combine the characteristics of several of the types listed above. For example, it could be an index inverse ETF with a 3x leverage. These characteristics apply to the Direxion Daily S&P 500 Bear 3X ETF (SPXS).
Below is a table with examples of the described types of ETFs.