Everything You Need to Know About ETF Trading

An Exchange Traded Fund (ETF) is a basket of securities that trades on an exchange.

ETFs have become incredibly popular because they offer diversification similar to a mutual fund, and also the flexibility and liquidity to transact like a stock.  

Related article: Trading and Investing

There are many types of ETF such as equity indices, equity sectors, bonds, commodities and leveraged ETFs but by far the most popular is the SPY ETF which replicates the U.S. S&P 500 index.

Purchasing one asset is obviously much easier than purchasing all 500 assets in the index so it’s a simple way to diversify.

The SPY ETF has a market capitalisation of $ 421.4 billion and at a peak has been as much as 16% of all transactions on the NYSE.

The SPY average daily volume is double that of the second largest fund the Invesco Nasdaq (QQQ) ETF, and five times the volume of third largest fund, iShares Russell 2000 (IWM).

ETF fees are known as the expense ratio. It is the total percentage of the fund’s assets used for administrative, management and all other fees.

Expense ratios are important when choosing a fund as they can impact returns materially. The SPY expense ratio is currently 0.094%, incredibly low! 

A tracking error is when an ETF’s performance deviates from the performance of an index that it tracks.

This usually occurs during high levels of volatility where the ETF manager struggles to keep the basket of assets in-line with the index.

For instance, the manager may use futures to track the index, but futures can deviate from the index price though this is usually temporary as arbitrageurs’ profit from these discrepancies.

To limit the chances of tracking errors it is best to look for funds with high volume, and open-ended funds (where the ETF can be transferred for stock).

Again, these funds are more likely to be monitored by arbitrageurs who will profit from keeping tracking errors back into line.  

ETFs trade on exchanges and are incredibly easy for a retail investors to access.

All retail broking platforms provide ETF prices and most offer leverage to scale positions as well, but this increases risk significantly.

Hedge funds and institutional investors are also large investors and traders of ETFs and high frequency algorithms arbitraging prices keep tracking errors low.