EVT #4: An exciting way to get exposure to almost any market

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Welcome back. After three tips in a row, this week I want to take a step back for a moment and introduce you to a very useful and versatile tool for traders that we will probably be using quite a lot in the future.

This tool allows you to get exposure easily to specific markets or market sectors or even short entire markets all without the hassle of complex procedures or the need to open a specialized broker account.

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For example, if you think that the Brazilian stock market is going to surge because the rebound in commodities will be good for commodity-dependent economies like Brazil, then you can do one of two things:

1. You could find a local Brazilian broker and buy a basket of major stocks listed on the Sao Paulo index (the Bovespa). This will involve lengthy procedures such as registration as a qualified investor, and the costs will be high.

2. Or you could log in to your normal online broker account and buy an exchange traded fund (ETF) which replicates the movement of the Bovespa index.

I think you can guess which option I'd recommend.

So what are ETFs?

ETFs are investment vehicles whose main goal is to replicate the price of an underlying security (this can be anything from an index, to a sector index, to a commodity, to interest rates - the list goes on).They do this by holding assets that track the movement in the value of the things that they want to replicate.

ETFs trade on stock exchanges like a normal share and can be bought or sold throughout the day. You can also hold them for as long as you like, just like a fund. However, they are much cheaper to buy and to administer than your average actively managed fund.

A standard fund will charge you between 3 and 5% up front in commission fees (paid to the person who sold you the fund). On top of that, the typical annual administration fee can range from 1 to 2%; ETF costs are much lower you suffer only the spread between the bid and offer prices while the administration fee is kept as low as possible, generally below 1% a year. Because they can be replicated and therefore arbitraged (I'll explain this below in a moment), ETFs also trade very close to the fair value.

To explain how an ETF works, let me use as an example an ETF that tracks the FTSE 100. All the issuer needs to do to replicate the FTSE 100 is to buy the 100 shares in the index in quantities that reflect their relative weight in the index (this would be costly and time consuming for the average investor). This means that the ETF and the FTSE 100 index will move in tandem, as they are composed of the same shares. If the price of the ETF on the stock market deviates from the value of the FTSE 100, you then have an arbitrage opportunity, whereby you would buy the ETF and sell futures or vice versa. The existence of this mechanism assures you that when you buy or sell an ETF, its value will be very close to the price of the underlying securities.

Examples

The range of ETFs available is incredibly diverse you can trade almost anything, anywhere.

Here is a simple description of the things you can do with them. For a start ETFs are available in both long and short varieties (ie the ETF rises when the underlying securities falls), allowing you to profit whatever the market does.

The main type is the index ETF, which replicates an equity index. These are available on nearly all major stock markets both in developed and emerging economies.

The second type, which is closely related to the index fund, is the sector ETF. These replicate the movements of single sector indices, allowing you to profit from a move in the financial or mining sector, for example. You can get exposure to almost any sector you can think of from technology, to healthcare, to utilities and even real estate.

The third type of ETF is the commodity ETF (sometimes known as an ETC, or exchange-traded commodity).These replicate (long or short) the prices of precious (gold, silver) or industrial (copper, nickel) metals, and other commodities (oil, natural gas, corn, wheat). The main value of these ETFs is that you can gain exposure to the underlying commodities without needing to use futures, thus saving you the hassle of opening a margin account and the possibility of having to take physical delivery.

The last type of ETF is the interest rate and bond ETF, which allows you easy exposure to the complex world of bonds.

The links below will provide you with a nearly complete list of all the ETFs traded. The first link links to the London Stock Exchange and lists all the ETFs traded there. You should be able to buy these for the standard commission that your broker charges. (in my case, £10) . Most of these ETF are also denominated in pounds so you won't have currency risk (although bear in mind that you do still have currency risk if the underlying asset is priced in a foreign currency such as the gold ETFs for example, where gold is priced in dollars).

https://www.londonstockexchange.com/en-gb/pricesnews/prices/ETFs/etfs.htm

The second link is to a website which provides a very good list of a lot of different ETFs. Do take time to browse through it so that you get to know all the markets that you can potentially look at profiting from.

https://etf.stock-encyclopedia.com/

Risks

The main risk with ETFs is that the market goes against you, as simple as that. However, if you buy an index ETF, your risk will be lower than if you buy a single share or a small portfolio of shares. This might sound strange, but it is due to the correlation between stock components in an index. Because correlation between stocks can be positive or negative your overall level of risk (defined as the volatility) will decrease. In other words, as one stock goes down, another goes up, so it means you have more protection you don't have all of your eggs in one basket.

Another risk is that the index does not correctly track the underlying security. This is called correlation risk. It is managed by the issuer and there is nothing you can do to protect yourself against such events. However do compare the graph for the ETF and the underlying securities and see if they match each other. Also, if you investigate the ETF in question and read the prospectus or the website of the issuer you should come across a measure of such correlation. For index ETFs this risk should be 0, but for some more exotic propositions it can be higher. In some cases it can reach as much as 5% (in other words, the performance of the ETF and that of its underlying security could differ by as much as 5%)

The third important risk is the liquidity risk, or the difference between bid and ask spread when you buy and sell. This is generally quite small. For example, for XESX LN (an ETF tracking the Dow Jones Euro 50 index) is around 50 basis points. It is also certainly smaller than if you subscribe to a normal fund. However do check the spread for the ETF before you consider buying. One way to evaluate the liquidity is to check the market cap of the fund (which in this case is the same as the assets under management). The larger it is, the less liquidity risk you carry.

Another issue with some types of ETF is counterparty risk. Some ETFs are fully-backed by physical assets in which case there should be no problems if the issuer goes bust as the assets are ring-fenced. However, others are based on derivatives, and there is the danger which has become more apparent in the past year or so that if the counterparty to the derivative contract goes bust then an investors' money will be lost.

Finally, as I mentioned above, if the ETF is not denominated in sterling (assuming you are a British-based investor), then you are going to have currency risk, and even if the ETF itself is denominated in sterling, you will still have currency risk if the underlying asset is in a foreign currency. .

One last thing to remember is that ETFs can be included in your Individual Savings Account (Isa) or SIPP. So depending on your circumstances this can be a tax-efficient way to save.

I'll be looking at some exciting ways to profit using ETFs in future issues, so if you have any questions on them in the meantime, do let me know. You can email me at eventstrader@f-s-p.co.uk.

Your capital is at risk when you invest in shares, never risk more than you can afford to lose. The share recommended is denominated in a currency other than sterling. The return from such shares may increase or decrease as a result of currency fluctuations. Spread betting is not suitable for everyone - ensure you fully understand the risks involved and never risk more than you can afford to lose. Prices can move rapidly against you and resulting losses may be more than your original stake or deposit. Please seek independent personal advice if necessary.

Figures are calculated using the closing mid-prices on the date on which shares are first recommended. All gains are gross, and returns will be affected by dividend payments, dealing costs and taxes. Past performance and forecasts are not reliable indicators of future results.

Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Editors or contributors may have an interest in shares recommended.

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