A Beginner’s Guide to Understanding ETFs

Site Administrator | October 17, 2011

Responsive image

It is a strong belief of ours that it is extremely important to understand the overall trend of a market or sector before trading a specific stock.  A great way in getting an idea of how a particular sector is performing is to look at an ETF.  If you have been around the trading block, chances are you have heard the term "ETF" passed around a time or two.  ETF's can be a very helpful tool in gaining exposure to different sectors - whether it be an index, commodity or even a foreign currency.   If you have ever wondered what exactly an ETF is, how it is traded or are simply looking for highly liquid ETF's to trade, then look no further...

We would especially like to thank the great folks over at Benzinga for this special guest post by Jayson Derrick:

An ETF is an investment fund traded on a stock exchange. The fund can be invested in equities, currencies, bonds, commodities, derivatives, swaps, futures contracts, etc. Purchasing an ETF entitles you to participate in profits if the holdings increase in value, or to realize a loss if the holdings decrease in value. An ETF is open to any investor that has access to buy and sell stocks through any licensed brokerage account.

What determines the value of an ETF?

The value of every ETF will always correspond to the value of its holdings, which constantly fluctuate. For example, the SPDR Gold Trust ETF (NYSE: GLD) is an ETF that holds bricks of gold, which are stored in a secret warehouse somewhere in London. If the price of physical gold were to increase throughout the day, the bricks of gold held by the ETF managers are now more valuable, resulting in an increase in the ETF share price.

What is an “Index ETF”?

An Index ETF is a fund that attempts to duplicate performance of a particular index by investing in the exact holdings, in the exact same proportions, as the underlying entity (referred to as “replication”).

The most actively traded ETF is the SPDR S&P 500 (NYSE: SPY [FREE Stock Trend Analysis]). As outlined above, the fund holds all 500 securities in the exact same proportions as the underlying Standard and Poor's 500 Index. If the S&P 500 index falls by 1.25% in any given day, it is reasonable to assume that SPY will lose approximately the same value.

Most, if not all, indexes are investable through their corresponding ETF. For example, the Financial Select SPDR Fund (NYSE: XLF) is designed to seek investment objectives that correspond to the returns of the Financial Select Sector Index.

What is an inverse ETF?

An inverse ETF is designed to provide investors with the opposite return of an index or commodity. For example, the investment objective of the ProShares Short Dow 30 (NYSE: DOG) is to provide an return that is equal to the inverse of the performance of the Dow Jones Industrial Average. If the Dow were to drop 2.4%, it is very reasonable to assume that DOG would gain 2.4% in value. Likewise, if the Dow were to gain 2.4%, assume that DOG would lose 2.4% of its value.

What is a leveraged ETF?

A leveraged ETF is designed to magnify the performance of the underlying index through the use of complex swaps. A leveraged ETF can provide a return equal to two or three times the performance of the underlying index. For example, the ProShares UltraPro S&P 500 (NYSE: UPRO [FREE Stock Trend Analysis]) ETF is designed to achieve a return of approximately 300% of the S&P 500 index. If the index were to gain 1.5%, it is reasonable to expect UPRO to gain 4.5%.

There are also ETFs which provide a leveraged inverse. The ProShares UltraShort S&P 500 (NYSE: SPXU) ETF is designed to achieve a return of approximately 300% of the inverse of the S&P 500 index. If the index were to gain 1.5%, it is reasonable to expect the ETF to lose 4.5%.

What advantages do ETF's offer?

• ETFs can be easily bought and sold. ETFs offer investors the ability to buy or sell their holdings almost instantly, whereas mutual fund transactions take quite a bit of time to close (generally end of the day). That liquidity is a major benefit considering the extreme amount of volatility the market has experienced over the past few years.

• ETFs offer significant tax advantages over mutual funds. When an investor has a gain in an ETF, he/she is not taxed until the product is sold, allowing for the investor to hold onto that gain until the closing transaction. Mutual funds, on the other hand, impose a tax for every realized gain. For example, when a fund manager makes a profitable trade, the gains are passed on to the investor along with the tax.

• Modern ETFs offer exposure to products that traditionally have not been available to common investors (or too expensive), such as corn (Teucrium Corn Fund ETF: (NYSE: CORN))

• ETFs can be used to gain exposure to international markets. For example, one could invest in Brazil via the iShares MSCI Brazil ETF (NYSE: EWZ [FREE Stock Trend Analysis]).

Why is it widely discouraged to hold leveraged ETFs for more than one day?

Leveraged ETFs are re-balanced daily, meaning that the holdings can fluctuate greatly from one day to the next. Leveraged ETFs also continuously lose value due to compounding.

Let us take a look at the mathematics behind this using a made up ETF (XXX), which trades at $10.00. This ETF is designed to offer 3x leverage to its underlying index (XXXa), which is valued at 1,000. After one day of trading, the index gains 40 points (4%) and the ETF accordingly rises 12% to close at $11.20. The next day, the index loses the previous gain of 40 points and closes back at 1,000. This 40 point drop corresponds to 3.85%. As a result, the ETF loses 11.55% and will close at $9.91. As you can see, even though the index has retained the same value, the ETF has not.

Does an ETF stay close to its “true value”?

For the most part, yes it does. Keep in mind that the assets being held in the ETF have a value that can be determined. If an ETF is undervalued, sophisticated traders with advanced analytic equipment will buy the ETF at its discounted price, thus pushing the value closer to its “true range”. This type of trading is known as “ETF arbitrage.” Sophisticated trading machines are constantly scanning the market for such opportunities, making it rare for an ETF to deviate more than 0.5% away from its “true value” for a prolonged period of time.

How popular are ETFs?

Over the past few years, ETFs have exploded in both volume and popularity. The increase in investor interest has led to the creation of a seemingly endless number ETF funds.

The ten most popular ETFs in terms of trading volume in the market currently are:

1.) SPDR S&P 500 (NYSE: SPY)

2.) Financial Select SPDR (NYSE: XLF)

3.) PowerShares QQQ Trust (NASDAQ: QQQ [FREE Stock Trend Analysis])

4.) iShares Russell 2000 Index Fund (NYSE: IWM)

5.) iShares MSCI Emerging Index Fund (NYSE: EEM)

6.) Direxion Financial Bull 3x Shares (NYSE: FAS)

7.) ProShares UltraShort S&P 500 (NYSE: SDS)

8.) iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX)

9.) iShares Silver Trust (NYSE: SLV)

10.) Vanguard MSCI Emerging Markets (NYSE: VWO)

Is an ETF a suitable investment for everyone?

Yes and no. Many ETFs are simple to understand and provide great investment opportunities, however leveraged ETFs are designed specifically for investors with advanced knowledge since the funds hold complex derivatives and forward swaps.

There are countless ETFs in the market to choose from, ranging from very common to very strange. Before making any trade, it is prudent to know exactly what you are buying (or selling) – so do your research. As always, potential investors should exercise caution and consult with experts whenever necessary.

Sino Clean Energy moved 10.75% higher after Benzinga Pro reported the Chairman share purchase. Try Benzinga Pro for free now and don't miss out on opportunities like these!   

Be sure to join us for our next event and Register for: Options Education


The TradingPub
“Trade, Talk, Learn – Cheers to Success”
Follow us on twitter