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An Exchange-Traded Fund (ETF) is a type of security that is traded on an exchange and is structured to track an index, a commodity, or a group of specific assets. The security that an EFT tracks is known as the benchmark, and is used to measure the effectiveness of a fund’s behavior and its performance through time.

 

Funds are professionally-managed portfolios where investors pool their funds to be invested in specific types of assets. Even though an index ETF includes part of that index basket of securities, they still may differ in their composition. In addition to trying to replicate the index benchmark, they are aimed at obtaining higher returns.

One of the best-known ETFs is the SPDR S&P500 ETF, which tracks the S&P500 index with holdings in companies with high market capitalization, such as Apple (5.9%), Microsoft (5.6%), and Amazon (4.0%), among others. In terms of sectors, as seen in Chart 1, over 60% of its holdings pertain to four industries: Technology, Financial Services, Healthcare, and Cyclic sectors.

Chart 1. Own elaboration. Data: Bloomberg and Yahoo Finance

The chart on the left shows the relation between the behavior of the S&P500 shares (in blue) and the SPDR (in orange) during the past five years. The correlation is so evident that both the decline caused by the start of the pandemic in March 2020 and the subsequent recovery seen in the past two years can be observed in the graph. Both have had similar returns of near 27% during last year.

 

Considering the US stock market, this year’s initial outlook is for growth, mainly driven by the current excess liquidity. Although a change in the FED’s stance regarding interest rates could affect investors’ perception, the continuous injection of dollars during the last two years has created a momentum that should remain visible in stock prices during the first half of 2022. Two underlying trends that will continue to influence this scenario are the speed of microprocessors’ manufacturing process in terms of sales projections, and the Omicron variant impact on the reactivation of the global economy.

In terms of fixed income, the scenario for the first part of the year reflects the inflation fears of central banks, once again revealing how relevant monetary policy is to investors’ decision-making. The recent publication of the FED’s minutes is a clear example of this phenomenon. The minutes made clear that the possibility of a rate increase in 2022 was a central part of the Federal Open Market Committee debate, where March was mentioned. This situation triggered a sell-off, not only of US 10-year bonds but of German, Japanese and Australian bonds as well.

 

As was mentioned regarding stocks, passive investing in fixed income can be done through an EFT that replicates the bond market behavior. An example of this, shown in Chart 2, is the ProShares Ultra 20+ Year Treasury, a fund that seeks to replicate the performance of the ICE US Treasury 20+ Year Index, mainly focused on long-term Treasury bonds. Another peculiarity of these funds is that they may be leveraged ETFs, in this case at 200%, implying greater risk. It can lead to significant gains, but it can also lead to significant losses.

Chart 2. Own elaboration. Data: Bloomberg

Now, the dotted area in Chart 2 shows the relation between the share price as compared to the 30-years Treasury bond yield. During this period, higher inflation expectations led to a sell-off, causing the yield to rise and the fund’s shares to decrease, especially after the publication of January 5 minutes.

 

After understanding how this type of security operates, the next question is why should investors incorporate them in their investment strategy. The answer is that ETFs offer the possibility of higher exposure to a sector or a type of asset through passive management. In other words, investing in shares of the SPDR does not mean buying US stocks, but the behavior of the most representative stocks. On the other hand, by investing in the Proshares 20+, investors gain exposure to long-term US government securities.

But the range of ETFs surpasses bonds and stocks. Some focus on a particular type of assets, such as gold, crude oil, or even bitcoin. Through these, investors can gain exposure to different industries through passive management and have a clear point of reference. In addition, their structure may encompass various characteristics, such as the level of leverage and whether they move with the index or against it, taking short positions.

It must be understood, though, that regardless of the security tracked, ETFs will be subject to the inherent risks of such security. In other words, when investing in shares of an ETF that tracks a gold index, if the demand for gold falls and causes its price to decline, the share price of the fund will also fall. Therefore, the exercise of investing in this type of security must be executed at two levels: understanding the risks associated with the underlying assets, and thoroughly choosing your investment manager. Both elements are decisive in the future behavior of your investment.

 

This report was written by Gandini Analysis for SupraBrokers only as content. It shall in no case be considered an investment recommendation.

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