Incorporating ETFs into you Investment Strategy
Adding ETFs to your existing investment strategy can help diversify your portfolio and give you access to markets you may not have considered before. Here’s a look at what ETFs are and how to use them.
Investing in ETFs
What are ETFs?
ETF is short for exchange traded funds. They combine the features of funds and equities into one instrument. Like other investment funds, they group together various different assets, such as stocks or commodities. This helps the ETF track the value of its underlying market as closely as possible.
For instance, there are ETFs that track the FTSE 100, containing constituents of that index proportional to the FTSE’s price. Other exchange traded funds may group together companies working in certain sectors, like lithium producers, or follow an asset like gold.
Trading ETFs works similarly to how commodities or shares are traded in that they are sold via exchanges. Each fund is split up into units which you can buy or sell. This way, you can get exposure to a whole sector by buying or trading a single unit of this instrument.
Why add ETFs to your investment strategy?
There are lots of reasons why institutional investors put their money into exchange traded funds.
- Diversity – Portfolio diversification is used by successful investors to protect against risk. ETF shares allow them to hedge against negative movements in single sectors or markets. This is because this type of instrument offers access to multiple markets in a single trade. They can also be used to trade multiple asset classes, such as equities, commodities, and bonds.
- Transparency – Inside ETFs, you can find all the assets it holds, giving you good visibility to your exposure. Additionally, because they are traded like shares on exchanges, they are more easily accessible and tradeable than other types of fund.
- Variety – As mentioned above, exchange traded funds offer just as much variety as stocks and other asset classes. They can also be used to employ any number of different investment strategies inline with individual investment goals, such as increasing capital, portfolio hedging, or looking for new investment opportunities.
Choosing the right ETF
Here are some considerations to take into account when adding ETFs to your portfolio or investment strategy.
- Benchmark index – With hundreds of thousands of options available, you should select a benchmark index that suits your trading style, interests and overall strategy. For instance, if you think renewable energy is worth investing, you may select a renewables ETF full of green energy stocks.
- Fund size – Some funds will naturally be larger than others. Larger funds tend to benefit from economies of scale, cutting fees and saving investors funds in the long run. They often have better liquidity too. Larger liquidity often means better spreads, lowering transaction costs.
- Fund structure – There are two main types of ETF available. Physically replicated ETFs use assets to track their index, while synthetically replicated ETFs use derivatives. Each of these types of ETF has different features and benefits that you should consider before buying. Physical replication offers greater transparency into the fund’s assets and is generally considered the less risky option. Conversely, some markets make physical replication either hugely inefficient or just impossible, so synthetic replication is used here.