What are ETFs? Your guide to exchange-traded funds

3D concept of ETFs as an array of financial instruments

The most common questions asked by novice traders are: What are ETFs? What do ETFs stand for? 

ETFs, or exchange-traded funds, are a type of investment fund and exchange-traded products traded on a stock exchange. These versatile financial instruments offer flexibility and diversification to any trading strategy, making them popular among traders. 

Here’s what we’ll cover in this blog post:

ETFs: What are they

Imagine a buffet where an array of dishes is available without you having to order each dish separately to try it. ETFs work similarly, offering a diverse spread of assets bundled into a single trading vehicle.

When you trade ETFs, you’re essentially choosing a mix of assets, such as stocks, bonds, or commodities, without the hassle of owning each individually. These instruments are traded on stock exchanges, ensuring you can buy and sell them during market hours. 

💡Pro tip:

What are ETFs, and how do they work?ETFs, or exchange-traded funds, are a type of investment fund and exchange-traded product traded on a stock exchange. They allow traders to gain exposure to a diversified portfolio of assets without owning each asset individually. 
How are ETFs different from mutual funds?ETFs are traded on stock exchanges like individual stocks, allowing traders to buy and sell them throughout the trading day at current market prices. Mutual funds, on the other hand, are priced at the end of each trading day. ETFs often have lower expense ratios than actively managed mutual funds, making them more cost-effective. ETFs provide transparency as they disclose their holdings regularly, and mutual funds generally have less frequent and less real-time transparency in disclosing their portfolio holdings to investors.

Types of ETFs

There are various types of ETFs, with each having different underlying assets. ETFs come in multiple forms to suit different trading strategies and risk appetites. They may contain stocks, bonds, commodities, and indices. Some of the most popular categories include: 

Stocks ETFs

Stock ETFs, also known as equity ETFs, invest in stocks, either tracking a specific set of stocks, a stock market index, or a particular sector within the stock market. ETFs can receive dividends from their underlying assets, such as stocks or bonds. When these assets pay dividends, the ETF typically collects and distributes them to its shareholders. When it has been a good period for the assets, the ETF market price tends to increase. 

For example, the ARK Innovation ETF provides exposure to domestic and foreign stocks of companies that depend on or benefit from developments in artificial intelligence, automation, DNA technologies, energy storage, fintech, and robotics.

💡Pro tip:

Can I receive dividends from trading ETFs?While traditional ETFs receive dividends, ETF CFDs do not. Deriv makes adjustments to account for dividends. These adjustments are made on the ex-dividend date for CFD accounts, ensuring that no profit or loss is made from these scheduled public events. When you trade in traditional dividend-paying ETFs, you may receive periodic dividend payments based on the income generated by the underlying assets, such as stocks or bonds, held by the ETF. The frequency and amount of dividends can vary depending on the ETF’s holdings and distribution policy.

Bond ETFs

When trading bond ETFs, traders are exposed to a portfolio of bonds that are segmented according to their type, issuer, and maturity, among other factors. For example, the iShares iBoxx$ High Yield Corporate Bond ETF tracks an index of high-yield bonds of US dollar-denominated companies.

Bond ETFs can vary in risk and return depending on the types of bonds they hold. Some other examples include government bonds, corporate bonds, municipal bonds, international ETF bonds, and other fixed-income securities.

Commodity ETFs

These ETFs track the prices of commodities like gold, oil, or agricultural products. Commodity ETFs allow traders to speculate on commodity price movements without physically owning or storing the commodities. They offer accessibility and cost-efficiency, while direct commodities trading provides ownership and precise exposure to your chosen asset.

For instance, the SPDR Gold Shares ETF tracks the price of gold bars in the over-the-counter (OTC) market.

💡Pro tip:

Are ETFs taxed?When you trade CFDs on ETFs on Deriv, you’re speculating on the market performance of the ETF as a whole. These ETF CFDs are not taxed. Traditional ETFs are taxed. The tax treatment of ETFs can vary depending on factors like the ETF’s structure and the investor’s country of residence. In some cases, ETFs may offer tax advantages, such as minimising capital gains distributions. You should consult with tax professionals or review any tax documentation the ETF issuer provides for specific tax information.

Index ETFs

These are the most prevalent types of ETFs and are engineered to mirror the performance of a particular stock market index. For example, the SPDR Dow Jones Industrial Average ETF Trust tracks the Dow Jones Industrial Average index. Traders can gain exposure to specific sectors or to the entire market with index ETFs. Index ETFs are known for their cost-effectiveness, which makes them an attractive option for traders.

What sets index ETFs apart from stocks ETFs is that the latter primarily invest in individual company stocks, while index ETFs track the performance of various indices, including but not limited to stocks.

💡Pro tip:

Are ETFs cost-effective compared to direct index trading?Your cost of trading ETFs on Deriv is limited to the price of the asset at the time. Traditional ETFs are often cost-effective options for gaining exposure to an index. When trading a Dow ETF, for example, traders can benefit from lower trading costs and reduced transaction fees compared to directly trading the Dow Jones Industrial Average components. This cost-effectiveness can enhance overall returns for ETF traders.

Pros and cons of trading ETFs

Selecting the optimal asset to trade is like choosing a new car. You want an option that has good value, is reliable, and suits your needs.

Let’s take a closer look at some of the advantages of ETFs and why you should trade them.

  • Diversification
    ETFs offer a simple way to diversify across a wide range of assets rather than just a single asset. This can reduce the overall risk of your trading portfolio.
  • Liquidity
    Liquidity refers to how easily an asset can be bought or sold without affecting its price significantly. ETFs can be bought or sold throughout the trading day, providing flexibility to you.
  • Transparency 
    You can easily see what assets ETFs hold, helping you make informed trading decisions. ETFs are required to disclose their holdings regularly. This means traders can easily see which stocks or bonds are in the fund’s portfolio and track their individual performances and the performance of the ETFs.

💡 Pro tip:

Are ETFs suitable for long-term trading?ETFs can be suitable for both long-term and short-term trading. They offer flexibility, diversification, and low costs, making them a viable option for long-term traders seeking to build a diversified portfolio. However, some traders use ETFs for tactical trading and short-term strategies due to their intraday trading capabilities.

While ETFs offer many benefits, there are a few things to keep in mind:

  • Risk management
    Even though ETFs provide diversification, they are not immune to market volatility and risk. Make sure to evaluate the risk associated with the underlying assets. Stay informed about current market conditions and news related to the sectors or asset classes covered by the ETF. 

💡Pro tip:

What risks should I be aware of when trading ETFs?Be aware of market risk, which can lead to fluctuations in the ETF’s value.ETFs may have tracking errors, where their performance differs from the underlying index. Liquidity risk can impact the ease of buying and selling shares, especially in less-traded ETFs. It’s important to understand these risks before investing.
  • Price discrepancies 
    The current market value of an ETF may not consistently mirror the precise value of its underlying assets. As ETFs are traded on an exchange, traders are subject to market dynamics during trading. This means that prices may potentially deviate from the net asset value (NAV), which is usually the basis for an ETF’s trading price. 
  • Commissions and fees
    While many online brokerages offer commission-free ETF trading, there may still be other fees, such as expense ratios, bid-ask spreads, and account maintenance fees. Understanding the fee structure of your chosen ETFs and the brokerage platform is essential before you start trading.

ETFs offer diversification, transparency, and liquidity, making them a valuable tool for traders to get on trading. Whether you’re a beginner or an experienced trader, ETFs can play a significant role in your trading strategy, helping you build a well-balanced and diversified portfolio. However, like any other market, it’s essential to do your research and consider your trading goals and risk tolerance before trading ETFs.

💡Pro tip:

How do I choose the suitable ETFs for my trading goals?Selecting suitable ETFs involves considering your goals, risk tolerance, and preferences. Evaluate the ETF’s trading strategy, holdings, expense ratio, trading volume, and performance history. Align your choice with your specific objectives: growth, income, sector exposure, or other criteria.

It is always a good idea to create a demo account to start practising. Take the opportunity to explore the ETFs on Deriv MT5 or Deriv X, where you can gain experience and insights into how ETFs work.

The information contained in this blog article is for educational purposes only and is not intended as financial or investment advice.

Deriv MT5’s availability may depend on your country of residence.

Deriv X is unavailable to clients residing within the European Union.

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