What are ETFs

Before explaining what ETFs are, it is worth knowing what they stand for. ETF stands for Exchange-Traded Funds.

The big difference between an investment fund and an ETF is that an ETF is mandatorily listed on a stock exchange. An ETF is similar to an investment fund in the sense that it is composed of a set of assets where in this set you can have only one type of asset, such as bonds, stocks or commodities, or a combination of several. In the ETF we aggregate the various types of assets as one, where you can buy individual shares of the ETF and have the behavior of a “company” rise or fall in the stock market.  It is traded on the exchange on an ongoing basis. It ends up being the combination of a mutual fund and a stock.

Types of ETFs

This financial vehicle can be divided into:

  • Index ETFs – The most common and most sought after. It tries to replicate and follow world indices, one of the most followed being the S&P500;
  • Bond ETFs – Composed of bonds of various types. It is usually used to complement index/stock ETFs, in order to lower the risk of a portfolio composed only of slightly riskier ETFs.
  • Sector/industry ETFs – An investor can choose to invest in a specific market sector, such as technology, healthcare, or financials through this type of ETF. Especially useful for investors looking to take advantage of boom or bust cycles.
  • Commodity ETFs – Aims to track the price of a commodity or a group of commodities, such as gold or oil.
  • Inverse ETFs – These are ETFs that aim to profit from the decline in value of certain assets, markets, or indices.

Advantages

  • Diversification – When you buy an ETF of an index, you buy all the stocks that belong to that index. By doing so you diversify your portfolio with dozens or even hundreds of different stocks in one.
  • Low costs – As already mentioned, when you buy an ETF you are technically buying stocks from several companies, so you execute only one order. To replicate the ETF portfolio, when buying individually we would have costs for each one of those purchases, that is, we would execute several orders, each one with its own costs.
  • Easy to buy/sell – In a similar way to stocks, if the ETFs are traded on the stock exchange, they allow us, in a very quick and simple way, to be sold or bought according to our needs.

Disadvantages

  • Risk of bankruptcy – A remote possibility, but that must be considered. When ETFs are managed by a fund that does not attract enough clients to sustain the administrative costs, it can lead to a bankruptcy situation. This leads to the need to sell the assets sooner than intended and possibly even at a loss.
  • Lack of liquidity – ETFs that are thinly traded can lead to higher spread costs due to low demand. Likewise, there is the possibility that it may be more difficult to sell your ETF.
  • Excessive focus – Just as ETFs follow certain sectors or indices, they can leave out certain growth opportunities for smaller companies. The opposite can also happen, an ETF owning companies that show less growth, which brings down the overall yield of the ETF.

For whom?

This type of product is ideal for a large portion of investors. It has the great advantage of being relatively easy to invest in, it doesn’t require as much research work compared to buying each asset belonging to an ETF individually. It is therefore perfect for beginner investors, but at the same time for larger investors who want to diversify their portfolio in a particular sector, geographic area, or industry.

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