To understand what this article is about, we first need to be look at the definition of ETFs in general:
Exchange-Traded Funds, or ETFs, are investment instruments that combine the characteristics of mutual funds and shares. These instruments offer investors the possibility to diversify their portfolios efficiently by replicating an index. An example is the S&P 500 index, containing the 500 largest capitalisation companies in the US stock market.
In this article, we will not focus on all strengths of ETFs. Still, we want to emphasize two significant benefits of ETFs:
Costs: ETFs have much lower management costs than the usual investment funds.
Diversification:An ETF is nothing more than a basket of securities you can diversify however you like. If for some reason one security performs poorly, you have others that can offset their negative performance.
After gaining a general understanding of the topic, we will have a closer look at the three different types of ETFs.
What are equity ETFs?
Probably the most famous and widely used type of ETFs are equity ETFs. These ETFs aim to replicate a benchmark index, such as the S&P 500.
This ETF type can be divided into four additional types:
Geographical ETFs: These cover specific countries, like for example the Chinese or the American market. Some of these ETFs are also spread across geographical regions, such as emerging markets.
Sector ETFs: This type of ETF aims to follow a specific sector (technology sector or energy sector, etc.). Using ETFs of this type, rather than buying individual company shares, allows a broad diversification.
Smart Beta ETFs: This is an interesting type of ETF that follows certain investment ‘styles’. There are funds that invest in value stocks or that follow a market momentum.
Thematic ETFs: Very similar to sector ETFs, but in this case the ETF will contain stocks related to a single theme, e.g. electric cars or ESG themes.
In any case diversification is important to factor in when deciding which ETF you want to invest in. This example explains why:
Let's take an ETF that includes companies that are involved in space travel. This could be a fast-growing trend in the future, and that is why you maybe want to invest in it. However, you don't know which company will lead this market in 10 years. What do you do?
The solution could be to buy an ETF that replicates the whole market. That way, if the market grows in the future, as we assume in this example, all companies related to space travel are considered. It wouldn’t matter which company became the market leader: You would profit either way. In conclusion, diversification is an important factor to minimize your investment risk.
For whom are equity ETFs suitable?
Certainly anyone with a very broad time horizon. Investing in possible future megatrends requires time and patience. It takes time for the respective sector to evolve. You take the chance of getting high returns but also have to accept higher risks. If you are not convinced by this type of ETF, have a look at your other options in the next chapters.
What are bond ETFs?
Until now, we have talked about stocks. Let us now dive deeper into the topic of bonds.
For those who are not familiar with bonds: When we buy a bond, all we do is lend money to the entity that issued it, e.g. the state or a company.
What do we get in return? Usually you get a constant coupon, i.e. interest rate, plus the return of the invested capital at maturity.
If, for example, you invest €10,000 at an annual interest rate of 2 % for 10 years, you will receive €200 each year in return. At the end of 10 years, you will get the €10,000 that you lent back.
Most types of bonds work this way, but mentioning all of them would be out of the scope of this article. Let us return to bond ETFs instead.
By investing in this type of ETF, we are buying baskets of bonds that can be differentiated into two different types:
Country: Again, we may choose e.g. only Japanese or only American bonds.
Degree of risk: Bonds issued by Germany will be safer than those issued by Turkey. Consequently, we want to receive higher returns when investing Turkey, since we are taking a greater risk. The same applies to companies: Apple is one thing, a debt-ridden company close to bankruptcy is another story altogether.
We should therefore choose our bond ETF according to the risk of the bonds it contains.
Who determines the risk of a bond?
Luckily, there is someone who does the work for us. In fact, the risk of a bond is determined according to the rating given to individual bonds and is generally divided into investment grade or high yield.
High yield bonds are also called ‘junk bonds’. You might have heard of them in the 2008 financial crisis. Yes, you can also invest in this type of ETF, which only contains junk bonds. Of course, the risk is higher, but the return will also be higher.
We can also find ETFs consisting of only certain types of bonds (zero-coupon, convertible and inflation-linked). These are bond-specific technicalities that, if you are interested, we invite you to look into.
Finally, another assessment element is maturity. There are bonds and therefore ETFs with different maturities, from a few months to over 30 years.
Who should bet on this type of ETF?
Bond ETFs are generally suitable for those who want to invest medium- or long-term. They are often used to balance an equity portfolio by making it more conservative. In fact, many of the most popular portfolios are built with a percentage of bonds ranging from 40 % up to 60 % or 80 %.
This ‘trick’ is often used to work out how much of a bond portfolio to hold: Take 100 and subtract your age, what you get is just how many shares you should have. Are you 25 years old? 100-25=75 % shares.
It is obviously not that easy, but the principle behind this calculation is that as you get older, your risk should also decrease.
A 70-year-old person is unlikely to endure a decade similar to that between 2000 and 2010, which was characterised by two financial market crashes: the tech company crisis in the early 2000s and the subprime mortgage crisis of 2008.
People moving towards retirement might need to withdraw their savings in a shorter period of time and therefore reduce the risk by increasing their bonds and reducing other shares.
Bond ETFs or individual bonds
What needs to be made clear is that there is a difference to classic bonds.
If you buy a single bond, you will have a specific maturity, e.g. 10 years. This means that after that period you will be paid back the capital lent. For ETFs, however, this is not the case. In fact, bond ETFs do not mature but maintain a constant financial duration.
What does this mean?
Imagine an ETF with maturity of 3–5 years. This fund must continually exclude all bonds that approach maturity, i.e. once they fall below 3 years. Consequently, new bonds have to be continuously bought and sold.
This implies that the bonds of the ETFs in the portfolio are constantly changing, and there will be no end date when the ETF expires, and we get our invested funds back.
This does not mean that we cannot sell our ETF and get our money back. To do this, we simply open the broker and place a sell order. However, the selling price will depend on market performance.
This makes financial planning difficult. In fact, often those who invest in bonds do so because they know that in, let's say, 10 years they will need that capital. Rather than leaving it in their bank account they invest it, knowing that at maturity, barring various defaults, they will get back the capital invested plus the interest generated.
This is a very important detail to keep in mind when buying bond ETFs. However, it should be pointed out that recently, so-called maturity bond ETFs have been launched that contain bonds with specific maturity. That means they contain bonds that all mature in the same year, e.g. in 2026.
Still not convinced? Maybe you prefer the last type of ETF we will look at: ETCs.
What are ETCs?
ETC stand for Exchange Traded Commodities. These are instruments that allow us to invest in many commodities without physically owning them.
Unless you want to have barrels of oil or pigs in your garage, these instruments can be very useful for investing in commodities. But first, what are they?
ETCs are financial instruments that can be issued in two ways.
The first, most classic and intuitive one, is not to physically hold the commodity, but the issuer holds the asset (in this case they are called physical ETCs). These are common for gold, for example.
In the second option, ETCs invest in derivative contracts on commodities.
Here we get more technical and there are some important dynamics that you need to look into if you are interested in this type of ETC.
Another factor to keep in mind is that 90 % of commodities are quoted in dollar, so in our case, the EUR/USD or USD/GBP rate can impact returns.
Additionally, you should look into the meaning of the Contango Effect and Backwardation if you want to invest in ETCs.
As we have seen, ETCs are more complex, but once you understand them, they can be very useful, if inserted judiciously, to increase the diversification of a portfolio that is perhaps already composed of stocks and bonds.
In this article, we have given a good overview of these three types of ETFs. Which one do you prefer?
ETFs for Beginners
Ready to dive into the world of ETFs? In just 5 simple steps, we'll guide you on how to invest your money in ETFs affordably and securely, without gambling and an expensive fund manager.
