Exchange Traded Funds - Types, Advantages and Disadvantages
Commodities investing can be a daunting task if your business is not related to them. Consider an accountant who wants to invest in corn. It would be a pity, if the only way to do so was to take physical delivery of the corn and then physically sell it later. Not only would it make the process more tedious, it would also make it much more expensive.
To circumvent these issues paper investment options were created. Investors did not have to directly buy the commodity that they wanted to stay invested in. Rather, they could buy into a fund that would invest on their behalf. One such form of this passive investing is called the Exchange Traded Fund of the ETF. In this article, we will look at the concept of ETF in more detail.
What is an ETF ?
An Exchange Traded Fund (ETF) is a fund that closely tracks the returns from an underlying commodity. For instance, a gold Exchange Traded Fund (ETF) would closely track the return on gold. This means that if the price of gold was to go up by 10%, the price of the ETF too would rise by 10%. Also, these funds are listed on and traded on the stock exchange, thereby giving investors unprecedented amounts of liquidity.
Types of Exchange Traded Funds (ETFs)
- Physical: The most obvious types of Exchange Traded Funds (ETF) are physical ETFs. These funds take possession of the underlying commodity and hold them. They are therefore able to mimic the returns provided by the underlying most closely. This is because only transaction and management costs are incurred in such a fund. Apart from that, holding this Exchange Traded Fund (ETF) is akin to holding the underlying commodity itself.
- Synthetic: Synthetic Exchange Traded Fund (ETF) is the opposite of physical Exchange Traded Fund (ETF). This is because synthetic ETFs do not hold the underlying commodity. They mimic the returns provided by the underlying. However, they do not have possession or even ownership of the base asset. Synthetic Exchange Traded Funds (ETFs) use derivatives like options and futures to track the changes in the underlying asset. These funds are able to mimic the returns provided by the markets most of the times. However, in some cases, their plans might fail and they may not be able to do so. Since there is no investment in the underlying, the quantum of risk is much larger and people who are not comfortable with derivative instruments must actually stay away from these Exchange Traded Funds (ETFs)
- Short: A short ETF mimics the movements in the underlying. However, the direction of the movement is opposite. For instance, if the price of gold were to rise 10%, the value of the short ETF is expected to depreciate by 10%. The management of the Exchange Traded Fund (ETF) accomplishes this by investing in assets which move opposite to the underlying asset. This opposite movement is established by calculating correlation from the past data. Correlation does not provide 100% accurate data. Therefore, many times a 10% rise in the price of gold may only cause a 5% decrease in the value of the Exchange Traded Fund (ETF).
- Leveraged: Leveraged Exchange Traded Funds (ETFs) are the riskiest of the lot. Such a fund provides a higher return but also faces a higher risk. For instance, a 10% increase in the price of gold could lead to a 20% increase in the value of the fund. At the same time, a 10% decrease will also cause a 20% downfall! These funds achieve this by using borrowed money along with investor money. This significantly increases the risk profile of such funds.
Exchange Traded Funds (ETFs) are cheap. This means that they provide the investors with opportunities to make investments with very little transaction costs. Also, these funds are listed on the stock exchange and are therefore very liquid! Investors can buy or sell their positions at a minutes notice and there wont be a major change in value.
Exchange Traded Funds (ETFs) also provide investors an opportunity to diversify their investments. By purchasing as little as one unit, an investor is able to get invested in several underlying assets. The return received is the hybrid of risk and return provided by multiple assets. Since traditional finance describes diversification as the antidote to risk, Exchange Traded Funds (ETFs) are claimed to have the ability to reduce risk.
Exchange Traded Funds (ETFs) do not exactly mimic the return on assets if they are synthetic. Also, they expose the investors to a wide variety of risks that are associated with passive investments. Some of these Exchange Traded Funds (ETFs) are only available in synthetic formats. For instance, coal based ETFs do not buy and store coal for obvious reasons! Instead, they create a portfolio that mimics the performance of coal. This may create additional risks and may not be a viable option for many investors.
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