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Exchange-Traded Funds - Common ETFs

From an investment strategy standpoint, traditional exchange-traded funds (ETFs) are designed to track indexes. ETFs are available in hundreds of varieties, tracking nearly every index you can imagine; they offer all of the benefits associated with index mutual funds, including low turnover, low cost and broad diversification, plus their expense ratios are significantly lower.

Commodities are a separate asset class from stocks and bonds, so investing in commodity ETFs can provide extra diversification in a portfolio. Because they are hard assets, these ETFs can also provide protection against unexpected inflation.

Commodity ETFs can be divided in three types:

  1. ETFs that track an individual commodity like gold, oil or soybeans,
  2. ETFs that track a basket of different commodities and
  3. ETFs that invest in a group of companies that produce a commodity.

Commodity ETFs either hold the actual commodity or purchase futures contracts. ETFs that use futures contracts have uninvested cash that is used to purchase interest-bearing government bonds. The interest on the bonds is used to cover the expenses of the ETF and to pay dividends to the holders.

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Currency ETFs are designed to track the movement of a currency in the exchange market. The underlying investments in a currency ETF will be either foreign cash deposits or futures contracts. ETFs based on futures will invest the excess cash in high-quality bonds, typically U.S. Treasury bonds. The management fee is deducted from the interest earned on the bonds.

Several choices of currency ETFs are available in the marketplace. An investor can purchase ETFs that track individual currencies such as the Swiss franc, the euro, the Japanese yen or a basket of currencies; however, currency ETFs should not be considered a long-term investment. Investors who are looking to diversify their U.S. dollar assets are generally better off investing in foreign stock or bond ETFs; however, currency ETFs can help investors to hedge their exposure to foreign currencies.

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An exchange-traded fund (ETF) that uses financial derivatives and debt to amplify the returns of an underlying index. Leveraged ETFs are available for most indexes, such as the Nasdaq-100 and the Dow Jones Industrial Average. These funds aim to keep a constant amount of leverage during the investment time frame, such as a 2:1 or 3:1 ratio.

A leveraged ETF does not amplify the annual returns of an index, it follows the daily changes, instead. For example, let's examine a leveraged fund with a 2:1 ratio. This means that each dollar of investor capital used is matched with an additional dollar of invested debt. If one day the underlying index returns 1%, the fund will theoretically return 2%. The 2% return is theoretical, as management fees and transaction costs diminish the full effects of leverage.

The 2:1 ratio works in the opposite direction as well. If the index drops 1%, your loss would then be 2%.

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With the advent of inverse ETFs, investors can easily bet against the market. Inverse ETFs are designed to move in the opposite direction of their benchmarks. For example, if the S&P 500 rises by 1%, the inverse S&P 500 ETF should drop by 1% and vice versa. There are also leveraged inverse ETFs, which are designed to provide double the opposite performance of the underlying index, so, if the S&P 500 drops by 1%, a leveraged inverse S&P 500 ETF should increase by 2%.

An inverse ETF can either use short positions of the underlying stocks or futures. ETFs that use futures contracts can have the excess cash invested in bonds, which covers the expenses of the ETF and can pay dividends to the owners.

There are a number of reasons to use inverse ETFs. For example, while speculators can easily make a bearish bet on the market, for investors who have positions that they do not want to sell because of unrealized capital gains or illiquidity, this is not so easy. In this case, they can buy an inverse ETF as a hedge.

In fact, many investors prefer to use inverse ETFs instead of selling short the index. Inverse ETFs can be purchased in tax-deferred accounts, but shorting stocks is not allowed because in theory, it exposes the investor to unlimited losses. However, the most an investor in an inverse ETF can lose is the entire value of the inverse ETF.

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