Whatever your investment interests, you will likely find ETF types to match them. ETF sponsors have expanded the universe of funds to include almost all asset classes and a number of index categories to satisfy investor demand for new ways to diversify their portfolios with passively managed products.

The roster includes ETFs linked to:

  • Broad-based traditional indexes that track hundreds or even thousands of securities.
  • Narrowly focused indexes, such as those that track fewer securities or those in a particular sector.
  • Nontraditional indexes, sometimes described as smart beta, strategy, or alternatively weighted indexes.

What are the types of ETFs?

Investors have access to various ETFs that can be used to manage risk in their portfolios, generate income, engage in speculation and price inflation, and make profits. Whatever your investment interests, you will likely find ETF types to match them.

ETFs can be classified as passively managed or actively managed. Most ETFs are passively managed, meaning a portfolio manager uses a published index to decide which assets to hold and how to weigh those shares in their portfolios. Actively managed ETFs do not aim to track an index of assets but rather have portfolio managers choose which securities to hold.

ETFs linked to commodity indexes offer access to the markets where physical and financial commodities are traded. Currency ETFs may track a single currency or a basket of currencies. They can be used to make currency price predictions based on a nation’s political and economic trends.

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Inverse ETFs

The inverse ETFs use stock shorting to try to profit from stock declines. Shorting is selling stock in anticipation of a decrease in value and buying it back at a loss. ESG exchange-traded funds provide a way for investors to participate in issues that are significant to them. These ETFs’ investment strategy considers the environment, corporate governance, and social responsibility.

Shares of a bond ETF represent a portion of a bond portfolio you can purchase. But unlike individual bonds, the majority of bond ETFs lack a maturity date.

The equity standard

Stock (equity) ETFs are made up of a group of equities that track a particular sector or industry. Today most ETFs are still equity funds. Their popularity may also result from stocks’ being a well-understood asset class with a long-term track record of providing solid returns despite the risks they pose.

Fixed-income ETFs

The fixed-income ETFs are linked to indexes that track various bonds, different issuers, and with different terms: and risk profiles. Mortgage- and asset-backed products, leveraged loans, preferred stock, and credit default swaps, among others, are included in this category. Unlike individual bonds, however, ETFs don’t promise a fixed rate of return or return of principal – two of the primary reasons appeal to buy-and-hold investors.


Commodity ETFs

ETFs linked to commodity indexes offer access to the markets where physical and financial commodities are traded. Most of these funds — except for those backed by gold bullion or other precious metals – buy futures contracts on the index they track. This means that the ETF’s market value reflects the underlying contracts’ changing value, not simply the market prices of the commodities.

Investors are attracted to these ETFs, whose returns are not correlated to the return on stocks and bonds, for the risk protection they can provide. However, since the underlying futures contracts expire regularly, the recurring cost of replacing them can threaten investment principal over time.

Index ETFs

Most indexes underlying ETFs continue to be market-capitalization-weighted. In these indexes, the companies with the largest market values — calculated by multiplying the market price of the security by the number of outstanding shares — exert a greater weight on the changing value of the index than companies with lower market values.

The assumption is that market-cap weighting provides the most accurate reflection of the market the index tracks as well as of the overall economy. However, one limitation of this approach is that, in some market environments, a few big companies can be doing very well while the rest need to catch up. A market-cap index would miss that indicator and might provide a misleading view of the state of the economy. In contrast, if the same components had been weighted equally, the index value provided might be more reflective of market reality.

What are strategy indexes?

Some ETFs are structured not simply to achieve a market return, sometimes called the market beta, but a return that’s different from beta in some particular way that could strengthen the overall performance of your portfolio. This objective is often described as smart beta. So, for example, if an ETF sponsor aims to provide a return that features increased dividend income, less volatility, or greater risk control than the market offers, it needs an underlying index that’s been designed specifically to meet that objective. Like traditional indexes, these alternatively weighted indexes follow a set of rules, known as the index methodology, that determines which components to include, how to choose them, and how to calculate the index value.

For example, if the objective is increased dividend income, the ETF would license an index composed of the highest dividend-paying stocks in a particular market index. When the stock market is strong, companies that pay dividends tend to increase them. And even if the market is flagging, many companies try to maintain dividend levels, at least partly to demonstrate their financial health. As a result, an index tracking these companies, if well designed, can meet its objective.

In contrast, an alternatively weighted index that tracks low-volatility stocks will typically provide a return that reflects how those stocks behave in different market conditions. For example, the index will rise during an upturn but not as much as a market-cap index. But in a downturn, the low-volatility index will lose less value, providing protection. Of course, an ETF that tracks an alternatively weighted index — and there are many varieties in addition to those described here — may pose greater risks and higher costs than a plain vanilla index. But you may decide that the added diversification more than compensates for the risk and expense.

Exotic ETFs

There are a number of highly specialized ETFs. An inverse ETF, for example, moves in the opposite direction from the index it tracks. That means the ETF goes up when the index goes down and down when the index goes up. A leveraged ETF aims to provide a return that’s twice (2x) or three times (3x) the return of its index. Both use derivative products, have higher than average expense ratios, and reset their returns on a day-by-day basis. Holding shares in either of these ETFs for more than a day or maybe two is almost certain to result in a loss.

How to choose the best ETF?

Investors today face a wide variety of ETF options, so it’s crucial to take the following things into account:

  • What’s the ETF’s underlying index? The index is the dominant influence on an ETF’s performance. You need to understand the index’s objective, how it’s weighted, and the securities it includes.
  • What does it offer? You’ll want to be clear about What the ETF has the potential to contribute to your portfolio and whether it suits your investment strategy.
  • What’s the cost? Price isn’t the only factor but is relevant in choosing among ETFs. Look at the costs and fees. You can estimate the expense ratio and transaction costs using the turnover rate.
  • What are the risks? In addition to market risk, which applies to all ETFs, you should understand the types of risks each ETF you’re considering poses. The more complex the strategy, the greater the potential risk.
  • What’s the market position? The first ETF member in a specific sector will likely capture the majority of assets before others join in. Therefore, it is wise to refrain from ETFs that are merely knockoffs of original concepts since they can fail to establish themselves apart from the market and draw in investor capital.
  • What’s the tracking error? Although most ETFs closely follow the underlying indexes, others do not. In all other respects, an ETF with fewer tracking errors is preferred to one with more inaccuracy.

Why should you invest in an ETF?

ETFs are an excellent place to start because they provide built-in diversity and only need a little capital to invest in various stocks. In addition, they can be traded similarly to stocks, and you can benefit from a diversified portfolio.

The reason why ETFs are a better investment option:
• You can quickly and conveniently buy one ETF that includes a variety of stocks rather than buying a ton of securities separately (which would take a lot of time).
• They are inexpensive and generally more affordable than mutual funds.
• The underlying investments are visible, and they are transparent.
• Offering the finest of both worlds – managed fund’s diversity and a stock’s tradeability.
• An effective ETF will strive to closely mirror the performance of the underlying index it invests in, as you know.
• They make it simple to reach markets. You can gain exposure to a wide range of assets with just one trade.
• Taxes are not due until you sell your ETFs for a profit. Therefore, you are in charge of deciding when to sell and pay capital gains tax.

What ETF Types Should You Buy and Why? Inna Rosputnia

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