What are ETFs?

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Exchange-Traded Funds are one of the most popular investment methods on the market, also known as ETFs. Its main differential feature is its tendency to replicate the operation of stock indices in their different types, such as equities, fixed income, commodities, among other financial assets.

These instruments do not resemble typical mutual funds, where administrators manage the money with active buy and sell strategies, ETFs do not have these managers who decide what to buy or sell with the investors’ money. In this way, ETFs do not seek to break the market to make a profit, but the opposite, they seek to replicate the performance of a given index in the market, therefore, the ETFs’ behaviour is directly proportional to the indices’ performance. 

For example, if during the year 2020 the Standard & Poor’s 500 index increases its value by 8%, likewise, ETFs based on the aforementioned index will increase their earnings by 8% as well.

The theory of efficient markets is behind these instruments since people regularly tend to believe that the methods that seek to break the market are the most appropriate to generate profits. However, it is a fact that a large part of these instruments underperforms the market, so an instrument that attempts to replicate the bourse behaviour might be an interesting alternative.

The main benefits of trading with ETFs are:

  • Having access to different stocks in different industries.
  • Risk reduction through portfolio diversification.
  • Low commissions charged by brokers.
  • The possibility of investing in several stocks at once by making a single operation, which reduces costs and risks.

As for the disadvantages, these are the most obvious:

  • On an eventual crack in the market, these ETFs tend to replicate that negative behaviour, representing losses.
  • It differs from traditional funds, as it cannot be transferred.
  • More processes in the case that you want to make a change, firstly you must sell the listed fund, cover the extra cost, then open a new one, also paying the sale commission. 

There are two ways in which ETFs reproduce the market, those are the physical replication and synthetic replication. The first one recreates the profitability of an index by investing in all or part of its constituent securities. In the synthetic methodology, financial swap contracts are used, which means that they have a basket of securities that does not need to be related in all cases to the index in question, exchanging the profitability of the aforesaid basket for the index’s one, usually through a swap contract with the opposite party, commonly an investment bank.

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