Imagine being able to trade any financial instrument on earth. Think how easily you could access strongly trending global markets… without… being limited to U.S. stocks and bonds.
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Many investors erroneously believe you need specialized futures trading accounts to trade anything but the stock market. This was accurate up until just a decade or two ago.
Today, things have changed radically. Now everyone with a stock investing account can take advantage of nearly every financial market. I am not talking about mutual funds or managed futures where someone else makes the decisions for you.
I am talking about a financial tool where you make every investing decision. Just like a stock, this financial tool is traded on the major stock exchanges. However, it’s designed to mirror the underlying commodity, sector, or index. If you haven’t already guessed it, I am talking about Exchange Traded Funds or ETF’s for short.
What Exactly Is An ETF?
An ETF is a pooled investment vehicle with shares that can be bought or sold throughout the day on a stock exchange at a market-determined price. Like a mutual fund, an ETF provides investors a proportionate share in a group of stocks, bonds, and/or commodities.
ETFs regulated by the SEC are subject to the same regulatory requirements as mutual funds and unit investment trusts. The difference between mutual funds and ETF’s is simple to understand. Mutual funds are bought and sold at a single price—NAV—computed at the end of the day. Mutual funds are also sold through a variety of channels. These channels include including financial advisers, broker-dealers, or directly from a fund company.
On the other hand, most investors buy and sell ETF shares via a broker-dealer at market-determined prices in the same way as stocks. Anyone trading for awhile has noticed the growth in exchange traded funds. These trading tools as popular as ever… and… have become a leading part of the entire stock trading industry. Over the past few years, the trading volume in ETF’s has boomed when compared to the rest of the marketplace.
At the start of 2014, ETF’s were 25% to 30% of the total traded volume in the U.S. During some months, this percentage leaped to 40% on several days. Wow, nearly 50% of all traded volume—talk about popular! 1,375 different ETF’s are available in the United States alone from 46 providers.
Around 39% of these ETF’s track domestic stocks. 26% are built on international stocks. 14% are commodity and futures. 11% are fixed income… and… the remaining 3% are built on currencies.
ETF’s are designed to trade like stocks. But traders must be aware of several key differences before taking the plunge into ETF trading. Unlike stocks, volume does not always equal liquidity. Because authorized participants can generate additional ETF shares out of a fund’s underlying assets.
The reverse also holds true. Authorized participants can redeem ETF shares by converting them back into the underlying asset. This fundability by authorized participants means ETF’s can have liquidity despite being lightly traded. These facts are critical to note when choosing what ETF to trade.
ETN’s v ETF’s: What’s The Difference and Why Should You Care?
Another crucial factor to note is the difference between Exchange Traded Notes ETN’s and ETF’s. The two products trade in a similar manner. However, ETN’s involve certain risks not associated with ETF’s. Therefore, knowing the difference between the two trading tools is a must for every investor.
ETN’s are a structured product created as a senior debt note by the issuing banks. This means the ETN is dependent on the credit of the underlying bank. Therein lies the first design difference.
ETF’s represent a stake in the actual underlying product and are not subject to the same credit risk. For the investor, there is more risk in ETN’s due to the above and actual market risk. ETF’s are subject only to market risk. ETN’s are issued by major, top rated banks. But, if a bank’s credit rating is cut, it will negatively affect the ETN regardless of the underlying market move.
On a positive note, ETN’s track the underlying product/indexes exactly, unlike ETF’s. The reasoning behind this is a bit odd, but makes sense if you think about it. ETN’s are guaranteed to track the underlying product tic for tic by the issuing bank. They replicate the performance exactly; wherein ETF’s often have limits imposed making an exact replica impossible.
It’s important to understand that the exact tracking is minus the management fee imposed by the ETN. The management fee is the only payment or distribution in the ETN… which… brings us to the next difference—Taxes.
ETF’s are subject to make yearly capital gain and income distributions. Both are taxable events for the holder. ETN’s do not make these distributions. So the investor can defer taxation until the ETN is sold or matures. In some senses, the ETN is more like a bond, and ETF’s are more like stocks. If you are confident in the long term viability of the issuing bank, ETN’s offer advantages not found in ETF’s.
The Key Takeaways:
ETF’s and ETN’s enable stock traders to trade nearly every global and domestic financial market. Often, when stocks are not in a defined trend, other global markets are trending. Savvy traders can use ETF’s and ETN’s to capture moves once reserved only for sophisticated investors with futures trading accounts.
ETN’s and ETF’s are similar. But ETN’s expose one to more risk since they are dependent on the credit of the issuer. ETN’s and ETF’s trade similar to stocks. However, it’s critical to keep in mind that volume does not always equal liquidity in the shares.
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