What are ETFs and how can you trade and invest in them?
Exchanged-Traded Funds (ETFs) are one of the fastest growing areas of the financial markets. Investors like them because they are cheap and transparent, and offer easy access in terms of coverage. Even sophisticated hedge funds trade ETFs because of their deep liquidity.
According to some estimates, assets held by ETFs worldwide have doubled over 2013-2018 to more than US$5 trillion. In Europe, AUM of the entire ETF sector is estimated above $800 billion – a number that is expected to grow further in the coming years.
With ETFs now increasingly popular, investors need to learn how to take advantage of this burgeoning asset class. Broadly speaking, ETFs offer investors one of the following benefits:
Which are the best brokers for trading and investing in ETFs?
Here is a quick guide to some of the best UK brokers that offer access to ETFs for trading or investing:
- IG – ETF spread betting
- Saxo Capital Markets – DMA ETF CFDs
- Hargreaves Lansdown – ETF investing
- Nutmeg – Wealth management through ETFs
Diversify Your Portfolio With ETFs
One of the most important uses of ETFs is to diversify your portfolio across asset classes. In the past, you need to buy stocks and gilts separately, topped up with a vault full of physical gold coins. Now, you can easily diversify across different asset classes in a single stock account.
For example, with just five ETFs, you can have a balanced exposure of equity, bond, property, and gold.
- iShares FTSE 100 (ISF)
- Vanguard FTSE All World ETF (VWRL)
- SPDR Barclays 15+ Year Gilt (GLTL)
- iShares UK Property (IUKP – holding REITs)
- iShares Physical Gold (SGLN)
If you hold another five ETFs, you can gain exposure into mid-/small-cap, emerging market equity, corporate bond, dividend, or sector ETFs. Wonderful, isn’t it?
Of course, the trick now is to allocate capital efficiently across each asset class. This, however, is dependent on investor’s personal views and circumstances.
As a general rule of thumb, the younger the investor the more risk he/she should take. Younger investors should aim for long-term capital appreciation, which may carry somewhat higher risk, such as emerging markets ETFs like Vanguard FTSE Emerging Market (VFEM).
How to use ETFs for hedging
Earlier this year, I discussed hedging market volatility with ETFs (see here).
To recap, when you have a portfolio of shares but do not wish to sell any even though you think the market is toppy, you could buy volatility ETFs. These volatility ETFs go up in value when equity prices fall.
The second way to hedge with ETF is to buy short ETFs. A short ETF moves in the opposite direction to the index it tracks. For example, a 1% drop in the FTSE 100 Index will result in a 1% rise in the short ETF value. Most of these short ETFs are synthetic ETFs.
In the UK, the Xtrackers FTSE 100 Daily Short (XUKS) is one such ETF that offers an inverse performance to the FTSE 100 Index (see below). It rallied from 380 to 430 in the second half of 2018 as the FTSE 100 weakened from 7,700 to 6,700.
A word of caution: Like volatility ETFs, inverse ETFs are not meant for long-term hold – simply because of the way these ETF returns are calculated. They could lose value even when the underlying index is rangebound. Therefore, the holding period of these short ETFs must be short in duration.
Searching For Income Among ETFs
For older investors, the focus would be income. There are several ways to extract income from ETFs. Broad equity-focussed ETFs may not satisfy some investor’s requirement completely because the average yield could be too low. To focus on dividends would require a different composition.
To this end, iShares UK Dividend ETF (IUKD) selects FTSE 350 stocks based on their dividend yields. At the moment, it yields a chunky 6.5%. The only drawback is that high-yielding stocks may perform poorly – hence the high yield (see chart below). If you wish to buy high-dividend stocks from across the world, then Vanguard FTSE All-World High Dividend Yield (VHYL) may suit this purpose.
In the US, dividend aristocrats ETFs – ie, firms paying dividends for many decades – are popular. The SPDR S&P Dividend (SDY) has more than $17 billion AUM.
Apart from equity dividend, bond ETFs could be an area to earn income with relatively low price volatility. In the US, the short-dated bond fund – iShares 1-3 Year Treasury Bond ETF (SHY) – yields about 1.7%. Not too bad considering it holds US Treasuries only. In the UK, because the base rate is low, the payout is much lower. For example, the SPDR Barclays 1-5 Gilt ETF (GLTS) has a yield of less than 0.5%.
To chase yield, investors are more active into corporate bonds, such as the iShares Core £ Corporate Bond ETF (SLXX), which gives a comparatively better yield of around 2.7% (see below).
ETFs have benefitted hugely from the secular shift into passive investing because active funds, despite their high fees, have not really outperformed the general market. So, why pay?
ETFs’ increasing popularity sets in motion a virtuous cycle. More providers move into the market, drawing innovation and providing wider asset coverage – which, in turn, attracts more capital. ETFs are proven financial instruments that should have a place in every investor’s portfolio.
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Jackson has over 10 years experience as a financial analyst. Previously a director of Stockcube Research as head of Investors Intelligence providing market timing advice and research to some of the world largest institutions and hedge funds.
Expertise: Global macroeconomic investment strategy, statistical backtesting, asset allocation, and cross-asset research.
Jackson has a PhD in Finance from Durham University.