Investing and trading with so much rapid growth in the ETF industry can be disorienting. The number of ETFs has grown every year and it is important to us as traders to understand these products and how they relate to the primary markets that we trade every day.
What Is An ETF?
Exchange-traded funds (ETFs) are investment products that allow investors or traders to buy shares in a “basket” of assets with a similar theme, much like a traditional mutual fund. ETFs provide exposure to a large number of underlying products such as equities, commodities, currencies, fixed income or credit, or companies based on region. The goal of most ETFs is to bundle similar asset classes together creating a diversified pool of common assets which traders can then buy and sell just like common stock.
When we buy an ETF, we are purchasing shares of a portfolio which is designed to track the return of an index such as the S&P500, or a basket of assets such as commodities, currencies, or equities. ETFs are ideal for smaller investors who are looking to profit on a trade setup or trend without concentrating risk in a single company.
An example would be the XLE (Energy ETF) which pools together energy-based stocks such as Exxon (XOM), Chevron (CVX), Conoco (COP), and some of the oil services names such as Schlumberger (SLB) and Kinder Morgan (KMI).
In this case, the resulting product is an asset group of energy companies, typically weighted by market cap, which an investor or trader can purchase if they believe the energy sector will see price appreciation but don’t want to take the concentrated risk of betting on a single energy company. When buying a single company in a sector we implicitly concentrate our risk – earnings could miss, the CEO could be involved in a scandal, a pipeline across the world could burst – all of which would be unforeseeable and increases the risk to a portfolio.
Because of their structure, ETFs allow us to participate in trend moves in a specific sector without putting all our eggs in one risk basket.
Advantages of ETFs Versus Mutual Funds
ETFs are very similar to mutual funds. Both have the goal of providing investment exposure to various sectors or industries while maintaining diversification within the portfolio so that risk is spread across multiple assets instead of overly concentrated in a single company or asset.
ETFs are significantly better than mutual funds in a number of ways:
- The fees for ETFs compared to mutual funds tend to be lower. Over time these seemingly small percent changes in fees compound and can considerably reduce our long-term gains from mutual fund investments. ETF fees are generally more competitive than mutual fund fees so we often see a race to the bottom in terms of costs, which benefits us as traders and investors.
- Taxes on capital gains paid on ETF profits can be less than those paid on similar gains in a mutual fund. This is due to mutual funds returning capital to shareholders which is reported as capital gains. An ETF would typically not pay out cash but would increase in price and the capital gains would not be realized until the investor or trader sold the ETF at a profit. Given lower fees and beneficial tax structures we start to see the efficiency of ETFs over traditional managed mutual funds.
- ETFs offer traders and investors significantly better execution speed and investment versatility. With a typical mutual fund if we look to sell we can only do so at end of day at whatever the closing price is for that product.
Given lower fees and beneficial tax structures we start to see the efficiency of ETFs over traditional managed mutual funds.
The mutual fund will consist of a diversified basket of companies some of which we may wish to invest in and many more that are in sectors that are not trending or depreciating. This means that the typical mutual fund will be partially filled with assets we would never invest in ourselves and when we wish to sell we will receive the closing price at the end of day for our shares.
Conversely, ETFs work just like common stock. We are not bound by the same restrictions as a mutual fund. We can sell any time the market is open, we can place a limit order to buy or sell at a specific price, and we can hand-pick an ETF that is weighted in a way that matches with our investment outlook. For example, if there is a daily trend in the energy ETF we can buy it on a return to a support level and look to sell on a rally to previous resistance.
ETFs also play well with options strategies that we implement every day at Simpler Trading. A trader could sell covered calls on an ETF they already own to further increase their return. They can also use spreads, butterflies, or iron condors on an ETF to gain exposure to price movement through traditional option strategies.
ETFs give us back the power to buy and sell at price levels that match with our investment or trading styles and goals!
Trading Your Theme
One of the most compelling features of ETFs is the ability they provide us to trade a theme, a specific asset, or sector. There are ETFs for almost all sectors and assets.
- Do you like emerging markets and high growth potential? … Then EEM (emerging markets ETF) is for you.
- Do you believe that oil will rise in to end of year? … Then USO (oil commodity ETF) may be your way to thematically get exposure to this sector.
- Do you think solar will be the next high growth industry but not sure which companies will win or lose along the way? … There’s an ETF for that, namely TAN (solar ETF).
It can be intimidating for new traders to trade futures products, the high leverage and daily volatility can be dizzying. Commodity and forex ETFs allow us to participate in market price movement while maintaining the familiarity of trading a common stock.
Almost any theme can be invested in via ETFs and they maintain the diversification, speed of entry and exit, and versatility that are staples of ETF structure.
One of the newer developments to come from ETFs are what we have called “the exotics.” These ETFs are similar in structure to what we have discussed, but differ in that they either have leverage built in directly within the product, or they are an inverse to a typical ETF.
Leveraged ETFs are just that – ETFs that track a specific index or asset pool and have a built-in leverage. For example, the SPY is the ETF that tracks the S&P500 one-to-one. If the S&P is up 1% we would expect the SPY to also be up 1%. Leveraged ETFs take this concept and increase both the potential reward and the potential risk through leverage. The SSO ETF is 2x the S&P. Meaning, that if the S&P index is up the same 1% in a day, the SPY will rise 1% and the SSO will rise 2% since it represents a two-to-one leveraged bet on the S&P.
Every large index has leveraged ETFs that correspond with it. We see ETFs with leverage of 2x and 3x the underlying – which allows us to increase our returns but we must also understand that leverage increases risk. Knowledge and practice is key.
ETFs are also available as inverse products. There are ETFs which gain in price as the market or a specific sector falls in price. These ‘bear’ ETFs allow us to take the other side of the trade if we believe that a trend move is reversing or if by our criteria we have reached an overbought level in the market. In a post-QE world, understanding inverse/short ETFs and how to implement them in your trading is key.
A very important note on bear ETFs – these are typically meant only for daytrading or at most 2-3 days in the product. To get the inverse return on a sector or index these ETFs invest in derivatives that are subject to time decay. Simply put, these are excellent products to trade intraday, however, they should not be thought of as an investment vehicle for longer than 2-3 days.
The Tail Wags the Dog
The ETF market has grown tremendously over the past ten years. It is imperative that as a trader or investor you understand these products and how they work, how they can serve as a vehicle for an investment or trade idea, but also how the ETF market feeds back in to indexes, equities, or commodities.
The ETF market has grown so large that it can now effectively “wag the dog.” This means that enough money is pouring in to ETFs that it is causing the funds to buy their underlying assets. Where normally, demand for shares would increase demand for the ETF… given their size, ETFs can now feedback in to the market itself. This creates additional demand for those assets beyond the normal supply and demand they would have without ETFs.
Even if you never trade an ETF directly, it is important to know whether money is flowing in to or out of a sector. We can see this by pulling up a chart of the ETF and comparing that to whatever we are trading. We want to see the ETF “tide” rising as well as the underlying asset “boats.”
These are all trades we look at every day at Simpler Trading. The more information we have about our market, the better positioned we will be to profit.
As traders, it is our responsibility to understand as much about these products as possible and use the information they provide us to make better decisions.
This post will be the first in a series designed to provide education on the opportunities ETFs present to us as traders.