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Unlike with mutual funds, exchange-traded funds (ETFs) are readily tradable while the stock exchanges are open with live pricing. As such, on the surface, they appear to function in much the same way that stocks do.
Because of the accessibility and usefulness of ETFs in general, there are several ways of trading them using several different strategies. Some of these are for more advanced, experienced traders but there are also those best used by beginners. It is these latter options that we cover in this article to help people new to both investing and ETFs too.
An ETF is a security that is traded on the stock market. They were first introduced in Canada back in 1990 and have become popular listed securities across the world.
Related to ETF Trading Strategies for Beginners:
Instead of purchasing a mutual fund that requires a period to make a new purchase or to complete a sale of a position in that fund, ETFs are bought and sold similarly to how common stocks are acquired or divested. This makes them very practical for trading, either for a long-term investment or as a very short-term trading strategy including day trading at the faster end of the process.
ETFs can be thought of a little like a mutual fund in the sense that they own a collection of investments or securities. If it’s an S&P 500 index fund, then they likely own every stock in that index or some approximation of it.
Whole markets, sectors, categories, and styles among other options are all contained within specific ETFs. Therefore, investors with a strong opinion on the retail sector or premium offices can pick an ETF with only that focus and invest their money there.
Therefore, ETFs are not only quickly tradable, making them more liquid, but they allow traders to make bets or take positions for the short, medium, or long-term on indices, sectors, styles like large-cap value or growth investing, rather than being restricted to trading common stocks, bonds, or dabbling in other tradable investments.
To better understand exchange-traded funds Canada and elsewhere, check out this article from Wealthsimple. They provide the ability to trade stocks, ETFs, and more from their mobile platform at zero cost to the retail investor.
Investing in sector funds is interesting for beginner investors. It can provide a sense of comfort that isn’t present when owning the far broader Wilshire 5000 index or the S&P 500 index.
Rather than owning a piece of almost every major U.S. company, it’s possible to purchase a sector ETF like the ProShares Pet Care ETF. If you are hot on this sector, an avid pet lover, or you see either a low price or major growth opportunity in pets, then buying into this ETF (ticker: PAWZ) might be just what the vet ordered.
There are now scores and scores of industry-related ETFs that narrow the field to a handful or a hundred companies in a particular sector. When it makes sense for you, this is an excellent way to invest with your heart, or to strike when you see a profitable opportunity.
Be aware that sector index funds tend to have higher expense ratios or TERs than broader indexing options like the S&P/TSX Composite Index in Canada or the S&P 500 index in America. Some ETFs are actively managed when there’s no reputable index to use as a composite, where the fees are considerably higher on average. Therefore, an investing thesis must account for these higher holding costs.
One word of warning for beginners here - while it’s possible to be right and do very well, it’s also possible to do the opposite. For instance, back in the days of the first Ford motor vehicle, investing in buggy whips in the age of the horse and cart would have been a bad investment. Similarly, investing in “railroad stocks and other sundry investments” as one U.S. college endowment fund once phrased it in their endowment report is likely to produce poor results across the industry today.
Sectors and industries can and sometimes do go heavily out of favor and occasionally die off entirely, leaving investors empty-handed.
Instead of looking at sectors, it’s possible to look at the style of investing and use that as a trading strategy.
There are different styles to use. The main ones are either growth or value systems, but there are other ETF options that focus on momentum and other strategies too.
Growth investing is usually based around an ETF that owns faster-growing companies compared to the average observed in the market.
There’s also another growth-oriented strategy based on dividend growth investing where companies not only grow faster than average, but pass some of these extra earnings onto investors by increasing their cash dividend significantly faster than the rate of inflation.
It’s important to distinguish between these two.
With growth investing, usually the income or dividend component is small or smaller than the market’s average yield. The aim is to buy companies that grow in value over the years and can be sold later by the ETF for a healthy profit. Income is a low priority.
Growth tends to work well with larger companies, but the small-cap growth style tends to underperform the market. Most companies don’t become large-cap stocks. Also, the excess profits have often been wrung out of start-ups by venture capitalists making their post-IPO growth unimpressive.
However, there are low returning small-cap growth periods that are often followed by those with excess returns, which is something to watch out for as a trading option for beginners.
Value investing is the idea of buying something worth $1 for 50 cents, i.e., buying companies when they’re on sale. They might be discounted because of recent bad news like a legal judgment (or one expected in the future), a bad trading period, or just a period of poor returns.
Value investors sometimes invest in the long-term. Other times, they look for periods of poor performance for the value style and pick their moments to dive in. Value stocks tend to perform less well in difficult economies when the companies are on the shakier economic ground and better with good economies, overall.
There’s what is referred to as a “value premium” above the general market return due to the uplift in the depressed prices of value stocks which, after returning to their fair value, are traded for the newly cheap stocks of other companies. This process helps to maintain a value premium over the years – at least, that’s the hope.
In Canada, one ETF worth looking at is the iShares Canadian Value Index ETF which is based on the Dow Jones Canada Select Value Index. In the U.S., there’s the Vanguard Value Index ETF which tracks the CRSP US Large Cap Value Index that aims to capture 85% of the market. The fees are a minuscule 0.04%.
The momentum style is a popular one too. This tends to be on the actively managed side of ETFs, but there are plenty to choose between.
Momentum is when a stock or ETF has been moving up rapidly compared to either its recent past or when looking at other similar stocks or ETFs. These types of investors hope to capture the ride while it’s happening and jump out when they perceive it’s coming to an end (and before any sharp correction).
There are numerous momentum ETFs are this point, many from major providers and some smaller players too. Not only can this capture fast-moving stocks in the market, but many momentum ETFs also niche down to individual sectors for greater granularity.
There are leveraged ETFs that take your initial investment and leverage it up several times. The ETFs will state that they are 2X or 3X that sector or the market.
There’s an additional risk factor here. Should the market move against you, the value of your investment can shrink several times faster.
On the flip side, if you have a strong belief that the market or sector is trending upwards, then this is an easy way to play that out in the short term.
Like leveraged ETFs, there are also inverse ones, including multiplying the effect. As you’d expect, inverse ETFs aim to deliver approximately the opposite of the results that a given index delivers. So, it’s betting against something.
Some of the inverse ETFs are also leveraged to provide a multiple of the inverse effect.
Once again, this is a valid strategy for a small part of your portfolio. There is the risk of predicting the market or sector poorly. In which case, your stake can shrink to nothing. Because of this, beginners should either wait until they’re more skilled as investors or only place a small percentage of their total portfolio in this strategy.
There are many ETF trading strategies, but few are suitable for beginners. While sectors can be highly profitable – Cloud Computing ETFs have done especially well in 2020 – it’s not all sunshine and rainbows. With many of the trading strategies, it’s necessary to pick your moment and to be highly selective. Also, always keep a good eye on both broker trading costs and expense ratios of the ETFs to avoid seeing profits disappear due to the drag from fees.
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