ETF trading is one of the best options for conservative trading. Their volatility is lower than that of stocks and options, but higher compared to bonds. Long term investing of exchange traded funds can be a viable way to generate stable income.
The risk associated with ETFs is based around the composition of an exchange traded fund. ETFs directed at high-volatility sectors such as biotech or medicine, pose higher risks. The same is true for ETFs based around developing regions, e.g. Latin America and South East Asia. ETFs that are directed to stable sectors, such as energy and food, and stable regions like USA and Europe, pose lower risks to the investors.
Choosing an ETF
Statista reports that in 2017,ETFs existed worldwide. In 2016, the number of ETFs in USA was . Although the numbers may seem large, they are rather small. This becomes clear when the numbers of markets and public companies are taken in.
The choice of the right ETF depends on the risk an investor is willing to take on. The first thing to be done when choosing an ETF: its composition. This means finding out what companies the ETF is composed of, and their shares in the total of the ETF.
Alternatively, for exchange traded funds based on different markets, it’s important to know the share of each market in the exchange traded fund.
The ETFs then can be sorted by their composition:
Large cap companies, established markets
Mid-cap companies and growth stocks
New companies, emerging markets
Although the phrase “too big to fail” was proven wrong during the 2008 crash, larger companies with more assets and bigger cash flows, are more stable investments than smaller companies. Hence, an ETF composed of larger companies could also be regarded as a safer investment.
A large market share is an important factor in the success of a company. A company which loses a portion of a large market share wouldn’t face a bankruptcy. The same isn’t true for new companies with small market shares. Thus, the newer the companies an ETF is composed of, the riskier it is.
Example of high risk going hand in hand with new companies: web company ETFs. Web-based companies are a fairly new investment type. Also, as an investment type, they already have had a crash (Dotcom Bubble).
The declining moving averages clearly signal that the ETF is in a downtrend, however there is some potential for price growth.
It’s not every day that investors lose more than 10% of their investment value in just over three weeks (KWEB). Moreover, after 2 months have passed, the price of the KWEB ETF still hasn’t regained even 15% of its peak.
An important lesson not necessarily related to exchange traded funds, can be learned from the crash of internet company ETFs. The media environment was celebratory, rather than sceptic during the fast ascent of the internet ETFs. Interesting observation: only 33% of top headlines about the KWEB ETF had negative words or phrases in their headlines:
Hence, all investors must remember that only they will feel the impact from their investments. An analyst may say that a certain investment is going to see unprecedented growth or decline. However, only the investor is going to be impacted by it.
Emerging markets and ETFs dedicated to them also come with high risks. The political environment in emerging markets is often unstable, which negatively affects the investments associated with those markets.
Emerging markets and their companies are also often deeply interconnected with their governments. This is a double edged sword: during times of economic growth, the companies benefit from government spending and tenders. Yet, during times of economic decline, the companies are hit even harder. All because of their deep ties with governments. This situation creates additional risk to the investors.
Exchange traded fund’s risk also depends on the industry it is focused on. ETFs focused on elastic goods and services, carry more inherent risk than ETFs focused on inelastic ones. Investing in a car maker ETF would bring more risk to the investor than investing in a grocery store ETF. The best long term ETF in this case would be one that is focused on an industry that produces completely inelastic goods.
As with any investment calculating returns is a priority. The choice of an exchange traded fund to invest in, also depends on the dividends the ETF pays out.
Calculating the dividends of an ETF is important for those looking for supplemental income. The investor value of an ETF, in this case, changes depending on the ratio of dividend:price of unit of ETF. The higher the ratio (yield) is, the more valuable the ETF becomes to the investor seeking dividends.
Out of top 50 dividend paying ETFs, the average dividend yield was 4.68%. The highest dividend yield belongs to DEM ETF (11.04%). The lowest yield of the top 50 dividend paying ETFs belongs to GRI ETF (2.02% yield).
ETFs vs mutual funds
Exchange traded funds and mutual funds are two very alike investment types. They both feature inherently diversified investments. ETFs and mutual funds are also managed by portfolio managers.
The technical side of ETF and mutual fund trading, however, is different. ETF entry price is essentially the current price of one ETF unit. A mutual fund entry price is not based on the current share price of the fund. It is based around an investment minimum, which is around a few thousand dollars or euros. Thus, mutual fund investing may not be accessible to investors without a few thousand dollars or euros in cash.
An exchange traded fund is a more direct investment. The price of an ETF fluctuates daily, and it is possible to get a better price depending on the time of the day. For mutual funds, the price does not change intraday, and every investor pays the same price (irrespective of the time of the day they buy).
Low risk ETFs
A low risk ETF is one that is not related to new industries or companies. However, there is an additional type of ETFs that carry a relatively low risk. They most likely are the bond ETFs.
Bonds are viewed as being one of the safest and most conservative investments. Their volatility is low, their risk is very low, and their returns are consistent and stable.
It would only be logical that bond ETFs would be the exchange traded funds with the lowest risk.
Risk of bond ETFs varies by the market the bond comes from. Generally, the more stable the market and its economic policy, the less risk the bond ETF will carry.
ETF trading: intraday and long term
Day trading ETFs is not as popular as intraday stock trading. Yet, it still has its benefits. It is not possible to intraday trade shares of a mutual or index fund. The opposite is true for ETF shares.
The pattern day trader rule, however, still applies to ETF trading. It means that a trader must have an amount equal or larger than $25,000 (in their trading account), in order to intraday trade. If the trading account dips below $25,000, the trader must immediately transfer money, so that the account will be worth at least $25,000. Otherwise, the trader will face the 90 lock down from trading.
Exchange traded funds, because of their lower volatility due to their inherent diversification of investments, are probably not the first choice for intraday trading.
Exchange traded funds, however, have a similar liquidity to stocks, and a better liquidity than mutual funds. In order to sell 1,000 shares of a lesser known company, an investor may have to wait up to a week. However, exchange traded funds with a lower profile still attract thousands of buyers every day.
By analysing Google Trends, it becomes clear that the interest in day-to-day trading ETFs, peaked during a period of economic uncertainty (October 2018).
Because ETFs are often seen in the same category as bonds and index funds (relatively low risk investments), the interest of trading them intraday peaks during market downturns.
The best choice for intraday trading of exchange traded funds would probably be ETFs related to consumer goods. ETFs related to technology (e.g. FAANGs) could also be a good choice. These industries and companies are the ones most affected by the news.
Long term ETF trading is the time horizon that most exchange traded fund investors choose. Two fifths of investors think that ETFs are a trading tool for the long term. Buying an ETF unit is cheaper than starting to invest in a mutual fund, and there is a higher degree of choice. ETFs are also inherently diversified investing instruments.
Their diversification depends on the type of ETF (country or region focused ETFs often have higher diversification than sector focused ETFs). Having a portfolio of a diversified exchange traded funds would essentially double the diversification (diversified investments + investment diversification).
As ETFs have lower management fees than mutual, index and hedge funds, investing in ETFs is a economically-sound strategy. More so, when the exchange traded funds are used for long term investing.
The best long term ETF in this case is dependent on the size of its fees and the diversification it brings to the whole portfolio. A fund with low fees and a high degree of diversification would be the best long term ETF for long term ETF investing and trading.
The future of ETFs
Bollinger bands® are a perfect fit for the analysis of the future trends of ETFs. By taking 5 ETFs with the largest trading volume, it will be possible to see the future of the ETFs that have the largest impact on the market.
The EEM ETF saw a very clear tightening of the price channels during the start of December. This is a sign of lower volatility in the future. Yet, the EEM exchange traded fund price has been touching the upper band since the first week of December. Theoretically, this could mean a bad buying opportunity.
QQQ ETF, before October 2018, had a very tight difference between the price channels. The channels now are even more far apart than in the start of October. This could mean that more volatility is in sight for the QQQ ETF.
The price of the SPY ETF has been moving above the centre line and is very close to the upper price band. This could mean that the SPY ETF is overbought.
VXX, the quintessential volatility ETF, had a great run from October to the start of December. The price has been travelling closer to the lower band – theoretically, it could mean a good investment opportunity.
It’s interesting to note that the XLF ETF has experienced a tightening of its price channels during the beginning of December. This theoretically means that the volatility of the XLF exchange traded fund will begin to lower.
ETF investing tips
Investing tips often focus around deriving the largest possible gains. This type of advice is often focused on timing the market (which almost never works). It also often teaches to focus solely on the technicals of trading.
ETF investing tips are different from that. Intelligent investment in exchange traded funds should be focused on the long term outlook. Moreover, the analysis should be mix of the technical and the fundamental.
ETFs can take up the majority of a portfolio of those searching for a stable income. Most ETFs pay out solid dividends to the holders of ETF shares. This income does not require an active investment strategy. Thus, this type of income fits retirees. It also could guarantee stable gains in the form of dividends, instead of growth in value.
An ETF can also be used as a hedge against recessions, economic downturns, market crashes, economic crises, and a plethora of other names of bad times for investors. A bear (inverse) ETF is used for that.
While options trading may not be for everyone, trading inverse ETFs is a popular way of protecting portfolios during market downturns. Inverse ETFs are different from traditional exchange traded funds in one significant way. The value of inverse ETFs increases when the value of their benchmark index decreases. Hence, a bear ETF could be a good investment choice during times of economic uncertainty.
Investing in bond ETFs is a way to diversify the conservative and low-risk component of any financial portfolio. Bond ETFs open up the possibility of diversifying low risk investments. Bond ETFs are also a good choice for locking in gains from decreasing interest rates.
Even the best ETF trading strategy won’t help to create wealth if the investor is irresponsible with their spending. Cutting back on expenses and using referrals, when buying, are great methods to maximise wealth building.
Risk and reward
Above everything, an exchange traded fund is an investing instrument. Any investment comes with significant risk and a potential for reward. An ETF is often viewed as a conservative and a low risk investment. Yet, there is so much variety between ETFs, that putting the label of “low risk” would simply be misleading.
Although the fear of missing out on investment gains often motivates investors, it isn’t the best investing strategy. Investing for stable returns and beating inflation is a far better strategy. Isn’t an investment, which constantly delivers stable gains, the best choice among others? An investment with high peaks and low dips, after all, has the potential to make some investors lose their minds.
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Disclaimer: this article should not be taken as financial advice. The article is solely a subjective opinion. The author does not own, and does not plan to own any of the investments discussed in the article.
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