Types of Exchange Traded Funds and differences between them

Have you ever thought about what an Exchange Traded Fund ETF is? Variety, versatility, and limited costs that are difficult to match with other investment products are Exchange Traded Funds’ hallmarks. But not all ETFs are the same: there are different types of them.

Typically, the types of ETFs are classified based on how it is built, how it replicates its reference market, and the type of asset it replicates. Using one or the other will depend on how complex your investment strategy is because just two of them or index funds are enough to invest around the world without spending a lot of time.

What is an ETF, and how it differs from an index fund

ETF is the acronym for Exchange Traded Fund. This implies that they are investment funds with a functioning more similar to that of a share than a fund. Exchange Traded Funds trade like stocks and can therefore be bought and sold in real-time at any time.

Besides, transfers between them are not exempt from paying income tax. ETFs and index funds are similar yet different. Exchange Traded Funds were also made to track stock indices, but today they can go much further during the trading day. 

They can imitate the stock market’s movement and a specific sector such as technology or commodities. A fund could do this too, but generally, this task falls on exchange-traded funds.

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Types of ETFs

There are two different formats: those that replicate a specific index and those that reference a sector, market, or country. However, they can also be grouped according to other variables.

Physical, Sampling, and Synthetic ETFs

A physical type tracks the target index by holding all or some of the index’s underlying assets. As its name suggests, a physical Exchange Traded Funds has the shares of its benchmark physically. It buys them to hold them in the portfolio while maintaining the weight of each one. The result is that its performance will always be very similar to that of the index, but subtracting the commissions that it can charge.

Another alternative is a sampling one. In this case, not all the titles of an index are bought, but the most representative ones. This reduces the number of share purchase and sale operations, although it may affect the tracking error. In other words, the ETF may deviate somewhat more concerning the evolution of the index.

In contrast, a synthetic ETF does not have physical stocks but instead often uses financial derivatives and other products to mimic the index’s movement. This means that its behavior may be slightly different from the stock indicator. However, since its mission is to go up or down with the index, there are usually no large deviations.

Short ETF or Inverse ETF

Exchange-Traded Funds may invest lower. Thus, there are short Exchange Traded Funds, the most common, which rise when their benchmark index does. On the other hand, there are inverse ETFs, which rise when the index falls. That is, they behave in the opposite way to how the stock index does.

Accumulation ETF or Distribution ETF

In this, a listed fund does not differ from an index fund or a common investment fund. They must also decide what to do with the dividends they receive and reinvest or distribute them.

A distribution ETF will enter the dividends that you collect in your account. It distributes the dividends it gets. Meanwhile, an accumulation one will reinvest those dividends, which will make it take better advantage of compound interest and sometimes grow above the index itself. This type of ETF is the most common.

Leveraged ETF or regular ETF

The financial leverage is to use debt to finance an investment. The ETFs that typically use leverage are synthetic ones. Thanks to this leverage, they can achieve additional profitability compared to a regular ETF, but also, the losses can be more significant.

The level of leverage of the exchange-traded fund will determine the additional intensity in gains and losses.

What is the main benefit of Exchange Traded Funds?

One of the main advantages of Exchange Traded Funds is that every trading is done via a mutual fund company that provides the shares. For such reasons, investors need to wait for the end of the day, once the fund net asset value is said prior to the price they’ve paid for additional shares once buying that day, and also prices they’ll get for shares they’ve sold that day.

Once in every 24 hours is eligible for the majority of long-term investors. However, some individuals search for additional flexibility. Exchange Traded Funds are both bought and sold via the opening days of the markets. The pricing of these funds shares is constant via normal exchange hours.

Prices differ from one day to the next

These prices differ from one day to the next, primarily because of the intraday value changes of underlying assets regarding the fund. Exchange Traded Funds investors understand in the matter of seconds the exact amount of funds they’ll get paid to purchase shares, and also how much they will receive once they decide to sell. 

The trading of ETF shares happens almost instantly, which makes managing a portfolio intraday a breeze. Moving money between particular asset types, such stocks, bonds, or commodities, is simple. In an hour, investors can efficiently allocate their funds to the investments they want, then change their allocation the following hour. That is not generally recommended, but it’s able to be done.

Risk management and portfolio diversification

Investors who lack expertise in certain fields may want to swiftly diversify their portfolio by adding exposure to certain sectors, styles, industries, or nations. ETF shares might be able to give a buyer simple access to a certain target market segment given the large range of sector, style, industry, and nation classifications that are available.

Nowadays, almost all of the world’s major asset classes, commodities, and currencies trade ETFs. Additionally, cutting-edge new ETF structures represent a specific trading or investment approach. For instance, an investor can purchase or sell stock market volatility through ETFs, or they can make ongoing investments in the currencies with the highest yields.

An investor may occasionally be exposed to high risk in a specific industry.

Tax advantages

ETFs have two significant tax advantages over mutual funds. Mutual funds often pay greater capital gains taxes than ETFs because of structural differences. Additionally, unlike mutual funds, which pass capital gains taxes to investors over the course of the investment, an ETF only incurs capital gains tax when the investor sells the ETF. ETFs, in brief, have reduced capital gains and are only subject to payment upon sale of the ETF.

For ETFs, the tax situation surrounding dividends is less favorable. ETFs can distribute either qualified or nonqualified dividends. If an investor holds an ETF for at least 60 days prior to the payout, it will be considered qualifying.

Lower prices

Regardless of the structure, all managed funds have operating costs. These expenses consist of distribution fees, administrative fees, marketing expenses, custody fees, and fees for portfolio management. Costs have historically played a significant role in predicting profits. Generally speaking, the projected return for a fund is higher the lower the cost of investment is.

Compared to open-end mutual funds, the costs associated with operating ETFs can be reduced. The brokerage companies that store the exchange-traded assets in customer accounts incur client service-related fees, which results in lower costs. When a company does not need to staff a call center to handle inquiries from thousands of individual investors, fund administrative costs for ETFs can decrease.

Diversification of holdings and risk control

Investors that lack the necessary expertise in certain sectors, styles, industries, or nations may seek to swiftly diversify their portfolio. ETF shares may be able to give an investor simple exposure to a certain chosen market segment given the broad number of sector, style, industry, and nation classifications accessible.

 

Nowadays, almost every significant asset class, commodity, and currency in the world trades ETFs. Innovative new ETF structures also represent a certain trading or investment approach. They, for instance, allow investors to buy or sell stock market volatility or make ongoing investments in the currencies with the highest yields. An investor may occasionally face high risk in a particular industry.

Bottom Line

Exchange Traded Fund is an investment fund that works as a share, rather than a fund. It is traded like stocks, so traders can buy and sell them whenever they want, in the real-time.