Beginner's guide to ETF - Which type of ETF is suitable for you?

What are the types of ETFs?

The types of ETFs vary slightly in different markets. In the following pages, we will focus on U.S. ETFs. Why? Because the U.S. market is currently one of the most complete and mature markets, with a wide variety of ETF types and relatively active trading, making it easier for everyone to choose investment targets. There are more than 3,000 ETFs in the U.S. market (Source: etfdb.com, as of October 10, 2023). How can we find the ETF we need? This requires an understanding of the different types of ETFs.

There are many ways to classify ETFs, including by asset class, fund attributes, and leverage multiples.

1. Asset Class

The asset classes that ETFs invest in are very wide-ranging and commonly include stocks, commodities, bonds, currencies, real estate, volatility, and mixed assets.

There are many detailed branches under each asset class, such as market index, global sector, options of a certain stock, and ETF types of preferred stocks under the stock branch. When we enter an ETF's summary page, we can first select the ETF direction we want to invest in based on the asset class.

2. Fund Attributes

ETF fund attributes can be divided into two categories: passive and active, with different investment goals for the two types of ETFs.

The investment goal of a passive ETF is to track the performance of a certain relevant index. You can simply understand that investing in a passive ETF is equivalent to investing in the index it tracks. Passive ETFs track different relevant indexes, including market or industry indexes as well as bond or commodities indexes.

Active ETFs, on the other hand, aim to outperform the market or their benchmark index and obtain higher returns. Therefore, compared to passive ETFs, fund managers of active ETFs usually take a more proactive approach to managing investment portfolios. Generally speaking, the potential risks and returns of active ETFs are higher than those of passive ETFs, but the management fees are also higher.

3. Leverage Multiples

When viewing an ETF list, you may find some ETFs with names containing "short" or "1.5X/2X/3X". Yes, these ETFs are ETFs with leverage multiples. You don't need to use financing to invest in these ETFs to achieve short-selling or multiple buying of relevant indexes or assets.

Assuming you invest in a 3x long Nasdaq 100 index ETF, when the Nasdaq 100 index closes up 1% on the day, this ETF will rise 3%; under the same conditions, a 3x short Nasdaq 100 index ETF will fall 3%.

This sounds great, but if you invest in ETFs because you don't have the time and energy, then leveraged ETFs may not be suitable for you.

Why? This brings us to the principle of operation of leveraged ETFs — a mechanism called "rebalancing", which means that the leverage of ETFs is based on the performance of relevant indexes or assets on the day.

For example, let's take a simple example. Assume that the initial value of Index A is 100. In three consecutive days, the index rose by 10% each day, with a total increase of 33.1% over three days. If there is a 2x long Index A ETF here, with the same initial value of 100, what would happen after three days? Due to the rebalancing mechanism of leveraged ETFs, this ETF will rise by 20% each day, with a total increase of 72.8% over three days.

As we can see from this, in a strong and one-sided market trend of a certain index or asset, leveraged ETFs can help amplify returns. However, as experienced investors know, such situations are relatively rare, and market trends are often difficult to predict in most cases. So, how will leveraged ETFs perform in a volatile market?

Let's take a simple example. Assuming that the starting value of index B is 100. This index maintained a trend of rising 10% on the previous day and falling 10% on the following day within 6 days. After 6 days, it fell by 2.97%. The operating income of 10-30 billion yuan products is 401/1288/60 million yuan, respectively.

There is also a 2x bullish index B ETF here, with an initial value of 100 and a 11.53% decrease after 6 days.

Did you see that? In volatile markets, leveraged ETFs may amplify the risk of losses.

In addition, leveraged ETFs often add futures or swap contracts to their portfolios. In order to avoid too much deviation from the tracking target, fund management companies need to frequently trade these contracts, which may result in losses that are also deducted from the net asset value of ETFs.

This means that if you want to hold a leveraged ETF for a long time, you need to consider whether the expected return can cover these losses; if not, holding a leveraged ETF for a long time is not cost-effective.

The difference between ETFs and ETNs.

In the market, there is also a close relative of ETFs called ETN (Exchange-traded Note). In addition to the name ETN, it looks particularly easy to confuse with ETFs. But you better not trade ETNs as ETFs, because they are fundamentally different things.

ETNs and ETFs are similar in that they both target tracking a certain underlying asset and can be traded in the securities market. The main difference between the two is that ETFs hold corresponding assets or related futures and options, while ETNs do not actually hold the underlying assets.

Without assets, how does ETN track the underlying assets? ETN is an unsecured debt instrument, and the issuer promises to pay based on the price of the underlying asset within a certain period of time. In simple terms, it is actually more similar to bonds.

So which is better, investing in ETFs or ETNs? Since ETN does not hold physical assets, its price is only a number calculated based on the current price of the underlying asset. Therefore, compared with ETFs, its tracking error is almost zero; in addition, ETNs can also allow you to invest in some more niche and updated underlying assets that ETFs do not have.

But due to the characteristics of not holding physical assets, ETNs do not distribute dividends to investors.

Another more important factor is that relative to ETFs, ETN has higher potential risks. In case of a serious market risk (which may trigger the delisting conditions in some ETN contracts), or if the issuer faces the risk of bankruptcy, your ETN may be forcibly redeemed or delisted, and instantly became a worthless piece of paper.

Considering the above risks, for investors who do not have time to select stocks, choosing ETFs may be relatively more secure. In fact, for ordinary investors, the ETFs on the market can already cover most investment needs. However, if you want to invest in an underlying asset that only has ETNs, it is recommended that you spend more time carefully reading the regulations in the prospectus and paying attention to the issuer's credit rating.