What Is an Exchange Traded Fund: Leverage, Liquidity, Fee, & Tax


An exchange traded fund – or ETF is a fund that is traded in real time directly over the exchange – just like shares.

This article explains what an ETF is, the pros and cons of the product, and how to invest in exchange traded funds yourself.

So, what is an exchange traded fund – ETF?

An exchange traded fund, or ETF as it is also called is a fund that is traded directly on the stock exchange just like ordinary shares. An ETF tracks the development of an underlying asset, such as an index, a commodity or a currency. ETFs are part of the group of exchange traded products.

In a regular fund, you trade fund units directly against the fund company, which means that a fund transaction can take up to a few days to complete. ETFs are traded in real time on the stock exchange like shares, which means that you can very quickly both buy and sell your ETF shares.

How do ETFs work?

Because ETFs are listed on the stock exchange, you can trade with them several times a day, unlike regular funds that are traded at most once a day, sometimes less often than that.

An advantage of ETFs is that they are cheaper than, for example, actively managed funds or equity funds.

Another is that with exchange traded funds you do not take any credit risk against the issuer, unlike bull & bear certificates, warrants and mini futures.

Bull and bear

If you believe that the underlying asset will increase in value, invest in ETFs that are referred to as “long”, or “bull”.

However, if you believe that the underlying asset will decline in value, invest in ETFs referred to as “short”, or “bear”.

Leverage

ETFs can be with or without leverage, just like bull & bear certificates. The leverage means that you get an enhanced development on the underlying asset, for example 2 or 3 times as much.

In this way, you get a chance for a higher return but also take a greater risk because the lever goes in both directions.

Example

Anna has invested in an ETF with direction direction bull, leverage 2 and OMXS30 as underlying. If the Stockholm Stock Exchange rises 1%, Anna’s ETF will rise twice as much, ie 2%. But if it instead drops 1% in value, Anna’s ETF will fall 2%.

What is needed to be able to trade ETFs?

1. As easy as trading stocks

Trading ETFs is easy. The fund units are bought and sold individually over the stock exchange, just like shares.

Trading in ETFs also takes place with the same liquidation schedule as for shares (trading date plus 2 banking days), which means that ETFs also fit well in a portfolio of individual shares.

An order is placed on the number of ETF units to be bought or sold, the only thing needed is a depository or Investment Savings Account (Roth IRA).

The fund units can also be registered at an IPS or insurance depot. When buying and selling ETFs, you pay a commission according to the current price list.

2. Liquidity and spread

An ETF reflects the development of a specific market index or strategy. Based on the price change in the underlying assets, the market makers set a price in the ETF.

Both liquidity and the difference between the bid and ask price (“spread”) are linked to the underlying assets in the ETF.

For example, the spread is normally higher in a small company ETF compared to an ETF that follows an index with only large companies.

The liquidity and spread of the ETFs will vary continuously over a trading day.

However, the presence of market guarantees means that there is liquidity and trading opportunities in the ETFs, even if the number of trades in the ETF itself is few.

3. Currency exposure

ETFs are not currency hedged. This means that you as an investor have a currency exposure in the funds that have holdings listed in currencies that are not the same as the ETF’s trading currency.

What are the risks of trading ETFs?

As with trading in other exchange-traded products, the possibilities are many, but the risks can be great. Worth knowing are the currency risk, liquidity risk and market risk.

However, you do not take any credit risk against the issuer of the product.

If the fund company goes bankrupt, your money is safe, but if the issuer of, for example, a certificate should do so, you can lose all or part of your capital.

The difference between an ETF and a regular traditional fund

ETFs are traded and priced in real time on the stock exchange

The main difference between an ETF and a regular traditional fund is that the ETF is traded on the stock exchange. This means that it is priced and can be bought and sold in real time, just like a share.

As the price of the underlying assets in the ETF moves during the day, the price of the ETF will also change. Depending on when during the day you place your order, closing will take place at the price that applies at the very moment when the order is executed.

This gives you as an investor the opportunity to, for example, sell directly during large market movements or to both buy and sell during the same day.

Traditional funds, on the other hand, are priced only once a day.

In that case, it does not matter when an order is placed, everyone receives the price that is set at the fund’s time for valuation.

ETFs have low fees

Most ETFs are also characterized by low management fees. One of the explanations for this is that they are usually index funds.

In such a case, the manager does not have to make any active investment decisions but invests in the assets, and with the share, specified by the index that the fund follows.

This means that ETFs can be managed at a lower cost than a traditional actively managed fund.

ETFs are clear and predictable

ETFs are characterized by clarity and transparency. The fact that ETFs are in most cases index funds means that they do not offer any surprises.

The ETF moves just like the market it follows.

This means that you can advantageously use ETFs as cheap and simple building blocks when composing your investment portfolio.

Brokerage and fees for an ETF

A major strength of ETFs compared to ordinary funds is the very low management fees. There are ETFs that cost as little as 0.01 percent per year in management fees.

A large number of exchange-traded funds cost no more than 0.1 percent per year. Half of all ETFs cost no more than 0.3 percent.

The most expensive ETFs have a management fee of less than 1 percent per year. The contrast is great to the actively managed funds, which often cost more than 1 percent and sometimes charge several percent each year in management costs.

However, you must keep in mind that you have to pay a commission every time you buy or sell an exchange-traded fund, just like when you buy securities.

Thanks to online brokers, it is cheap.

FAQ – Frequently asked questions about exchange traded funds and ETFs

1. How big an ETF leverage can I get?

The largest leverage for European ETFs is 2x. Some US ETFs have 3x leverage.

2. Should I choose exchange traded funds or regular funds?

ETFs are better than mutual funds in several ways: they are usually cheaper securities, they are traded on the stock exchange and the deal goes through at once.

However, there is often much more information available to online brokers about regular funds. For an ETF (exchange traded fund), you sometimes have to look a little more for information about the fund.

For some specializations, it can also be difficult to find a suitable exchange-traded product.

3. Are ETF’s better than stocks?

ETFs often contain equities. It is like a kind of fund that can invest in several different assets. Therefore, it is not possible to say that ETFs (exchange traded funds) are better than equities.

Buying an ETF is a good alternative to buying pure stocks to get a better risk spread on your investments.

4. What are KID documents?

KID stands for Key Information Document. It is a fact sheet for packaged and insurance-based investment products.

The purpose of the KID document is for you as a buyer and investor to be able to compare different ETFs.

5. What are the disadvantages of ETFs?

There are few disadvantages to exchange traded funds. An exchange-traded fund that has leverage has the disadvantage that the value is eroded if the market moves sideways or if it is volatile.

Another disadvantage of certain exchange-traded products is that they do not own real shares but only various forms of financial products, e.g. terms. However, this is far from the case for all ETFs.

6. ETFs with reinvested dividends or payments?

Some exchange traded products distribute the dividends to your account while others reinvest them in the fund. If you need the cash flow for something else, for example if you live on your dividends, it is good to have dividend funds.

If you believe in the ETF, it is good that the dividends are reinvested, because then you will have a more interest-on-interest effect on your investment.

Conclusion

How are exchange traded funds taxed?

Depending on the type of depository your funds are in, you either pay a current tax on your holdings, or you tax when you sell your units at a profit.

If your exchange-traded funds are in a Roth IRA or in endowment insurance, you pay a standard tax as calculated on how large your holding is.

If you instead have the funds in a fund depository, you only pay tax when you sell your fund units at a profit. Then the tax is 30%.

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Kevin

This article has been reviewed by our editorial board and has been approved for publication in accordance with our editorial policies.

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