ETF trading AU

ETF – Exchange Traded Funds

Exchange Traded Funds (ETF) offer clients a high liquidity, low-cost option that is also transparent. AvaTrade is proud to bring you this fully comprehensive guide on trading ETF. We will bring you all the information related to ETF trading, from the technical and fundamental elements to the strategies required to successfully trade ETF.

This in-depth guide to ETF will answer all of your questions, including: what is an ETF? How are ETFs created? What is the market potential of ETF? Our discussion will go on to provide details of the different types of ETF that are currently available, as well as the pros and cons of trading ETF. We encourage you to read through this article at your leisure, taking in key tidbits of information to help you during your trading sessions.

Once you are done with this ETF guide, you will have a good idea about how ETF functions. The table of contents guide, along with each of the categories is designed to drill down deeper into each topic, with interesting content that you can benefit from.

ETF Table of Contents:

What is an ETF?

Exchange Traded Funds (ETFs) are investment options that you can trade on the stock market. They function in a similar way to shares. They are also similar in form to investment funds. The raison d’être for trading ETF is to combine your capital in a fund that will be used in a way similar to investing in shares, bonds, or other products. In return for your investment, you will receive interest payments.

The underlying financial instrument can be a share, a basket of shares, a group of commodities, a market index, or a bond. The portfolio manager is tasked with ensuring that the ETF maintains high performance levels, similar in style to the performance of the underlying financial instruments.

If you are the type of trader who enjoys passive investments, ETFs are passively managed funds. The performance of ETF mirrors that of the underlying financial instruments. This means that the ROI is generally in line with the returns generated by the component assets. There are exchange-traded funds available for a wide selection of underlying financial instruments, foremost among them indices. It just so happens that indices are also the most cost-effective ETFs to trade. A handful of ETFs are based on active funds, but these require entry/exit commissions, and careful management.

The cost of an ETF is known as TER. It is generally expressed as a percentage of the amount to be traded. Custodian bank fees determine the market cost of ETF. However, there are other factors to consider such as distribution costs, and provider rights. The cost of an ETF does not include transaction costs for adjustments, or swap fees.

How Are ETFs Created?

An ETF is a fund. This means that it is a combination of assets pooled together. This investment option was designed to meet the needs of traders and investors wanting a diversified portfolio, and not to concentrate capital in a small selection of financial instruments.

In 1993, the USA introduced the first ETF to duplicate the performance of the S&P 500 index. This was designed for retail investors, and to provide access to the financial markets. After the global financial crises, the popularity of ETFs has increased dramatically. Major investment juggernauts such as the Investment Company Institute believe that approximately 30% of all stock trading in the US involves ETFs, and the global trading volume of ETFs exceeded $6 trillion in 2020.

How does ETF Work?

ETF fund managers are tasked with creating ETFs. They will generate a list of stocks that will comprise the ETF basket of shares/units. This also determines the investment objectives of the fund. Next, this list of stocks will move down the chain of command to authorized participants known as APs. They then work to generate the list of assets in the ETF and return the basket of goods to the promoter a.k.a. the fund manager.

Next, the fund manager delivers the stocks that form part of the basket of goods to the APs, so that they can sell them on the stock exchange, or to brokers. Once the ETF is on the primary market, it can be traded (bought and sold), by final buyers a.k.a. traders. It is worth pointing out that whenever an ETF is bought or sold, you the trader are applying demand pressure, or supply pressure that affects the performance of the fund.

How do ETF fund managers ensure that the performance of the ETF replicates that of the underlying financial instrument, even in the face of independent trades?

When ETFs are traded, the underlying financial instruments are not being bought and sold. Therefore, with these markets tending to move in different directions, their prices must be continually monitored for close correlation. Authorized Participants (APs) make not-so-subtle changes to demand and supply by altering the availability thereof. They may create new ETFs, or redeem them from the sponsor, for securities.

Another notable form of investment options available to traders is that of clone indices or synthetic indices. The pricing mechanism of these clone indices is intentionally close to that of the underlying financial instrument, but it doesn’t happen through redemption mechanisms. Rather, pricing is closely controlled by using swaps a.k.a. derivative contracts. ETNs are a classic case which we will examine further in this Exchange Traded Funds Guide.

At this point, you may be scratching your head and thinking: ‘Why are ETFs interesting financial instruments?’ For many reasons, notably the fact that ETFs are responsible for arbitrage.

Pros and Cons of Trading ETFs

There are many benefits of Exchange Traded Funds (ETFs), and they are posted below:

  • Pricing Transparency
    With an ETF, you can always stay up to date about the daily price changes, courtesy of the ticker symbols. You compare this to the underlying financial instruments themselves. The Net Asset Value (NAV) is updated daily for your convenience. This is a great way to keep a handle on the risk/reward ratio.
  • Affordability
    it’s a lot more expensive to compile a portfolio of individual securities than it is to invest in an ETF. For starters, individual stocks like Google, Amazon, Tesla, and others will cost a fortune compared to an ETF which is priced affordably and comprises a basket of financial instruments. With ETFs, you have an added advantage of cost-effectiveness over other alternatives such as mutual funds, and actively managed funds. Those types of financial investments are usually associated with high commissions and high costs.
  • Fully Diversified Investments
    ETFs are made up of scores of different stocks, across multiple market segments. This makes it much easier to diversify your asset holdings, and reduce your commissions.
  • Tax Benefits
    ETFs are passively managed investments. This qualifies you for tax advantages. It also means that there are lower charges than actively managed funds. The tax element is only applicable once the ETF has been sold.
  • Simplicity and Flexibility
    you can buy and sell ETFs as you wish. Since these financial instruments do not expire, you can trade them as single units, or in batches. Low capital requirements are necessary for ETFs.
  • ETFs Offer Issuer Risk Protection
    As with other types of funds, the individual components of an ETF – units or shares – belong exclusively to the owners. If there is a primary market default, or a fund manager default, there will be no effect on the ETF.

The advantages of ETFs are clear. However, the good has to be taken with the bad before a decision is made. One of the notable errors apparent with ETF trading is known as tracking errors. This represents the difference in price between the underlying financial instruments, and the price of the ETF itself. Recall that ETFs track the performance of the sum total of the assets that comprise the ETF. From time to time, differences between the bid/ask spread can occur. This generates arbitrage possibilities that can work for the trader, or against the trader. Of course, it depends what position you take in the financial markets.

One of the most important reasons why ETFs are selected is for portfolio diversification. By spreading your capital across multiple financial instruments, you are effectively hedging against market volatility. However, the caveat rests with careful selection of your financial instruments. The right assets must be chosen; i.e. those with growth potential.

AvaTrade is here to help you make these important decisions. We offer a wide range of exchange-traded funds (ETFs) for your express benefit. You can pick the ETFs that are best suited to your trading needs, your risk profile, and your goals.

Different Types of ETFs

ETFs are part of a diversified family of financial instruments known as exchange-traded products. These types of investment options include many different forms of ETFs. Their names are direct derivations of the underlying financial instruments, or of specific features which characterise them.

As a case in point, you might be trading exchange-traded notes, exchange traded commodities, or exchange traded currencies. With exchange traded commodities – ETCs – the financial instrument is predicated on the performance of the index. With exchange traded currencies, it’s the underlying currencies that give the ETC value. With ETNs, it’s a different ballgame. Exchange Traded Notes can include a variety of assets, and are typically issued by companies to replicate specific benchmarks, such as an index.

As you can imagine, the variety of ETFs is substantial, including commodities, bonds, equities, currencies, inverse relationships, and leveraged options too. They are further divided up according to sector, or according to the underlying identifying characteristics. By and large, the most commonly traded ETFs are those related to indices. These exchange traded funds mimic the performance of a ‘basket of goods’ such as the S&P 500, commonly called SPDR funds. Another popular SPDR option is GLD, an exchange traded fund for gold shares.

Popular ETFs provided by AvaTrade

Trading NameType of ETF
MSCI Brazil Index FundMimics the performance of the Brazilian index, with ticker MT4 #EWZ
MSCI Emerging Markets Index FundMimics the performance of emerging markets, with ticker MT4 #EEM
S&P 500 VIX short-term futures ETNMimics the performance of the VIX, the volatility index of the Standard & Poor 500, with ticker MT4 #VXB
Energy Select Sector SPDRMimics the performance of multiple companies in the energy sector, with ticker MT4 #XLE
Market Vectors TR GoldminersOffers traders exposure to companies operating in the global mining and quarrying sector, with ticker MT4 #GDX

Trading ETFs wth AvaTrade

Since ETFs cover a broad spectrum of the financial markets, your chosen broker must offer the diversity required to trade them. Fortunately, AvaTrade is one such broker which offers you competitive prices on your ETF trades.

Be advised that AvaTrade generates revenues from the spread between the Bid price and the Ask price. There are no commissions charged for trading activity, unless specified by us.

AvaTrade also offers ETF trading via online CFD contracts. These are derivatives instruments which make it easy for you to leverage ETF trades at your leisure. By using contracts for difference, traders and investors can manage all aspects of ETF trading directly from the trading platform online. This low-cost option for trading ETFs provides access to cost-effective bid and ask prices, with low overnight interest rates.

Benefits of trading ETFs at AvaTrade:

  • Credible Brokerage
    AvaTrade is operational all over the world, and is regulated across multiple authorities. It is fully compliant with Australian ASIC regulations, the Central Bank of Ireland, B.V.I. Financial Services Commission, the Financial Sector Conduct Authority, ADGM, and MIFID 2 in Italiy, among others.
  • Competitive Spreads
    AvaTrade offers competitive spreads as low as 0.13%, and transparency of costs.
  • Customised Trading
    select your choice of Exchange Traded Funds (ETFs) and trade with confidence on our dynamic trading platforms.
  • Leveraged ETFs
    retail clients can enjoy leverage of 1:5, and professional clients can enjoy leverage of 1:20, as determined by ASIC regulations for investor protections.

Important Points to Note about ETF Trading

Now that you have been introduced to ETFs, and the different markets associated with them, here are the next steps:

  • Based on your trading budget, you will want to know what type of investments you’re interested in, and how much you wish to allocate towards each ETF.
  • Pick the ETF you want to trade, and settle on a trading budget for your investments. Be advised that ETFs are passively managed investments, particularly indices. They are easily accessible to traders. Include ETFs in your portfolio as part of a broader holding of assets. Diversified assets holdings are effective for risk mitigation purposes.
  • Register a trading account with a reputable brokerage, decide whether you will be using expert advice, or if you want to rely on the wisdom of the crowds with social trading via AvaSocial at AvaTrade.
  • Establish a trading plan and contemplate the returns you can generate on each Exchange Traded Fund and/or security. What is your risk profile? What is the expected return on investment? You can always protect your trades with stop loss and limit orders. AvaTrade features a powerful protection mechanism known as AvaProtect. Always stay abreast of the latest economic activity related to your ETF, such as pricing, performance, and dividends.
  • AvaTrade is a big proponent of ongoing learning when it comes to trading and investing in the financial markets. You can never know enough – so never stop learning.

FAQs about Exchange Traded Funds

  • What is ETF trading all about?

    ETFs are Exchange Traded Funds. Think of them as a basket of assets (indices, bonds, commodities, stocks, currencies) that allows an investor/trader to diversify into many different financial instruments at low cost. It is similar to a mutual fund, with the overarching purpose of mimicking the performance of the individual components that comprise the basket of securities. These are the underlying financial instruments. There are scores of ETFs available to traders, but you must first open a trading account with a reputable brokerage to get started. AvaTrade is a top-tier broker that you can trust with your ETF trades.

  • Can you generate a healthy ROI with ETFs?

    Absolutely! The ETF market has grown substantially in recent years, and it continues to attract investors and traders at a rate of knots. ETFs, like other financial instruments, are designed for growth. In this vein, a return on investment is the overarching objective of traders and investors. Like any investment opportunity, there are pros and cons. Careful and methodical research is needed to ensure that your investing in the right ETFs given your risk appetite, budget, and objectives. The more you know about the markets and the financial instruments, the better. Remember to trade responsibly at all times.

  • Can novices trade ETFs?

    Exchange Traded Funds (ETFs) are ideal in many ways for novice traders. For starters, these are transparent options, and they are cost-effective. ETFs are also highly liquid financial instruments. In terms of risk, an ETF parallels the price performance of the underlying financial assets. The tax burden associated with ETFs is also lower, since they are passively managed funds. Of course, any trade or investment is inherently risky, and ETFs are no different. It is important to do the requisite research into your chosen ETFs before investing real money in them. This is particularly true when leverage is involved.