Types of Exchange Traded Funds and differences between them
Variety, versatility, and limited costs that are difficult to match with other investment products are Exchange Traded Funds’ (ETFs) hallmarks. But not all ETFs are the same: there are different types of ETFs.
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 ETFs 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. ETFs trade like stocks and can therefore be bought and sold in real-time at any time.
Besides, transfers between ETFs are not exempt from paying income tax.
ETFs and index funds are similar yet different. ETFs were also made to track stock indices, but today they can go much further. 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.
Types of ETFs
There are two different ETF 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 ETF tracks the target index by holding all or some of the index’s underlying assets. As its name suggests, a physical ETF 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 ETF. 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 ETFs, 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 ETF 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.