What kind of ETFs are right for you？

Choosing an ETF that is suitable for you can be daunting, especially with over 3,000 options available in the U.S. market alone. That's why it's important to understand the different types of ETFs and how they're classified. ETFs can be classified by asset class, fund attributes, leverage ratios, and more.ETFs invest in a diverse array of asset classes, which can include stocks, commodities, bonds, foreign currencies, real estate, volatility, and mixed assets.

Within each asset class, there are many subcategories. For example, under the stock asset class, some ETFs specialize in market indices, industry sectors, stock options, and preferred stocks. To help narrow down your choices, you can start by selecting your desired asset class when you visit an ETF summary page.

ETFs are classified into two types: passive and active, each with different investment objectives. Passive ETFs aim to track the performance of a specific index, meaning that investing in a passive ETF is similar to investing in the index it follows.

·        Passive ETFs can track various indices, including market or industry indices, as well as bond or commodity indices.

·        In contrast, active ETFs strive to outperform the market or benchmark index and achieve higher returns.

As a result, fund managers of active ETFs are typically more actively involved in managing their investment portfolios. Although active ETFs may offer higher potential risks and returns than passive ETFs, they also tend to have higher management fees.  

When going through an ETF list, you might notice some ETFs with names containing "short/inverse (negative leverage)" or "1.5X/2X/3X".These are leveraged ETFs.

You don't need to use your margin account. By investing in these ETFs, you can invest in related indices or assets with leverage. For instance, if you invest in a 3x leveraged ETF on the Nasdaq 100 index and the index closes up by 1% for the day, the ETF would rise by 3%.Conversely, a 3x short ETF on the Nasdaq 100 index would drop by 3% under similar conditions.

The potential return of leveraged ETFs may sound tempting, but they might not be the right fit if you lack the familiarity of exactly how they work or are not comfortable with the high level of risk associated with them.

Because leveraged ETFs operate on a mechanism known as rebalancing, which implies that the ETF's leverage is based on the daily performance of the related index or asset.

For example, let's say that Index A initially begins at 100 and experiences continuous growth of 10% over three days, resulting in a total increase of 33.1%. If there were a 2x leveraged ETF for Index A with a starting value of 100, the ETF would increase by 20% each day due to its rebalancing mechanism, resulting in a total increase of 72.8%.

Therefore, leveraged ETFs can help amplify returns in a situation where an index or asset is experiencing extreme strength. However, such scenarios are relatively rare. Market trends aren't always so clearcut, and the future is unpredictable.

During times of market volatility, how would leveraged ETFs perform?

Actually, they can just as easily increase the risk of losses. For instance, suppose Index B started at 100 and experienced alternating gains of 10% and losses of 10% over six days, resulting in a decline of 2.97%.If there were a 2x leveraged ETF for Index B with a starting value of 100, it would experience a decline of 11.53% over the same period.

Furthermore, leveraged ETFs often include futures or swap contracts in their portfolios.

To avoid significant deviations from their underlying benchmarks, fund managers must frequently trade these contracts, which can result in fees that are deducted from the ETF's net assets. This is why we just said that if you invest in ETFs to save time and effort, leveraged ETFs may not be suitable for you because they are not designed to be held for a long period of time.

However, if your goal is to capture short-term trading opportunities, leveraged ETFs can be a tool to help magnify potential returns.

There is another similar investment instrument to ETFs called ETN (ExchangeTraded Note) that can easily be confused with ETFs due to their similar names. However, it's essential not to trade ETNs as if they were ETFs because they are fundamentally different investment products.

Both ETFs and ETNs track the performance of an underlying asset and are traded in the securities market. The primary difference between them lies in the fact that ETFs hold corresponding assets or related futures and options, while ETNs do not hold any underlying assets. But the question is, how do ETNs track their underlying assets?

ETNs are unsecured debt instruments where the issuer commits to making payments based on the price of the underlying asset during a specific period. In other words, they are more similar to bonds than stocks.

So which choice is more suitable for you, ETFs or ETNs?

Since ETNs don't own physical assets, their prices are calculated purely based on the current price of the underlying asset, resulting in almost zero tracking error compared to ETFs.

Moreover, ETNs allow investors to invest in smaller and more niche assets that aren't accessible through ETFs.

However, due to their lack of physical assets, ETNs don't pay dividends to investors. Additionally, ETNs generally carry higher potential risks than ETFs.

When the market fluctuates dramatically (which could trigger delisting conditions in some ETN contracts) or the issuer faces bankruptcy risks, your ETNs may become worthless after being forced to redeem or delisted.

Considering these risks, for investors who don't necessarily have time to evaluate individual stocks, choosing ETFs might be a viable option.

ETFs on the market can meet many investors needs depending on their investment goals and risk tolerance. However, if the underlying asset you want to invest in is only available through ETN, it is recommended that you spend more time carefully reading the prospectus regulations and monitoring the issuer's credit rating before considering an investment.