Lesson 2: Classification of ETFs

Hi, everyone! 😄 Welcome to this session of the Tiger Academy, “ETFs for Beginners”

After completing the previous lessons, we learned about the concept and advantages of ETFs. ETFs not only save bother, they also save your money.

In this lesson, I’m going to tell you about the four types of ETFs, so that you can understand the big family of ETFs more clearly.

1、Classified by style of management
ETFs can be classified into index ETFs and active ETFs, according to how they’re managed.

Index ETFs

Among US stock market indices, the three most familiar are the Dow Jones, the S&P 500 and the Nasdaq. If you are particularly optimistic about one of them and you want to make money from its rising performance, what should you do?

It's simple, just find an ETF that tracks that index. For example, DIA is an ETF that tracks the Dow; QQQ is an ETF that tracks the Nasdaq; and SPY is an ETF that tracks the S&P 500.

But there may be more than one ETF tracking the same index! Let's take the S&P 500 as an example.

There are many ETFs being offered that track the S&P 500 Index, and three of the most well-known are: SPY, IVV, and VOO.


So what's the difference between the three ETFs that each track the S&P 500? The answer is that there is no difference, it's just a different issuer.

The issuer of SPY is SPDR, the world's third largest asset management company and the investment arm of State Street Group.

The issuers of IVV and VOO are renowned Vanguard and BlackRock, the world's largest asset management company.

By overlaying the trendlines of these three ETFs on the Tiger Trade app, we can see that they have basically moved in the same way over the past eight years, with very slight deviation.

Index ETFs are called ‘passive’ ETFs because their main purpose is to match the returns of an index by tracking its trend.

(Photo credit: Tiger Brokers)

Active ETFs

In addition to ETFs that track indices, there’s another type of ETF that is selected and managed by the fund managers themselves. These are called ‘active’ ETFs.

Active ETFs usually have higher management fees than passive ETFs because fund managers put more time and work into them.

However, as shown in the figure below, data from Morningstar shows that active ETFs don't always perform better than passive ETFs. Over the past ten years, the annualized excess return of active ETFs has been mostly below 0, and most active funds saw an excess return of -0.5%..

(Source: Morningstar, data as on 31/12/2019 and is for reference only. Past performace is no guarantee of future results)

2、Classified by class of assets

Classified by asset class, ETFs can be divided into stock ETFs, bond ETFs, and alternative ETFs.

Stock ETFs

Think of the stock market as a fruit market where you can pick and choose any number of different kinds of fruit. Of course, you can also buy a pre-packaged fruit basket with an assortment of goodies in it. In reality, the stock market is like the fruit market and the pre-packaged basket of fruit is an ETF!

Stock ETFs are the "fruit baskets" of financial markets. Each basket is pre-packaged with various weighting of stocks of different types and then sold to you in the form of fund shares.

Different ETFs hold different stocks, so before trading a stock ETF, be sure you know what’s in the ‘basket’ to see if it meets your investment goals and expectations.

Bond ETFs

Bond ETFs are also known as “bond exchange-traded funds.” It’s a packaged basket of bonds that tracks a bond index and tries to replicate its yield.

Although bond ETFs contain only bonds, they are traded on exchanges like stocks and have some of the same characteristics as equity securities. Compared with regular bonds, bond ETFs have the following advantages:

（1）Low risk: As with stock ETFs, a bond ETF allocates funds across a wide variety of bonds, giving it a significant quantitative advantage over buying a single bond. Bond ETFs are less sensitive to unexpected crises and the non-systemic risk is relatively small.

（2）Simplicity of trading: Through ETFs, investors can buy and sell at any time during the trading day, eliminating the complicated process of transacting bonds in the OTC market and being able to simply use your mobile phone to trade. Investors need only look at the performance of the target index to get an idea of the performance of a bond ETF.

（3）Consistent earnings: History shows that most active fund managers find it hard to beat the market over the long term. When you invest in a bond ETF, you reduce the risk of getting returns that are lower than expected because of a fund manager's poor performance. You are able to get returns that are consistent and predictable over the long term.

Alternative asset ETFs

First, let’s talk about what an alternative asset is. The range of alternative assets is very broad and includes gold and currencies, commodities, real estate, private equity, infrastructure and more.





Among them, the gold ETF is a common variety that’s traded in the market. The vast majority of these funds are open-ended funds that target gold assets, closely track gold prices, and are listed on stock exchanges.

In the same way, commodity ETFs and real estate ETFs, among others, are all open-end funds that track the performance of underlying assets that have been chosen as investment targets.

So, an alternative asset ETF is an open-end fund that tracks the performance and trend of any number of alternative assets.

The advantage of alternative asset funds is that investors can participate in what would otherwise be very costly investments in physical gold, crude oil, real estate and other such assets with a very low threshold to entry and greater liquidity than with the actual physical assets.

3、Classification by industry theme

ETFs can also be divided into industry ETFs and thematic ETFs.

Industry ETFs

What is an industry ETF? In the previous course, "US Stock Financial Statements for Beginners", I said:

In the United States, the common industry classification standard is mainly the GICS industry classification.

According to this classification standard, US stocks can be divided into 11 main industries, namely energy, raw materials, industrials, discretionary consumption, major consumption, health care, finance, information technology, communications, public utilities, and real estate.

If you are particularly optimistic about a certain industry and want to participate through investment, buying a corresponding industry ETF is the best way to do that.

All 11 major sectors of the US stock market are covered by ETFs and even in the sub-sectors we can actually find corresponding passive ETFs for investment.

Let’s take the healthcare sector as an example. Its tertiary sub-sectors, healthcare equipment, healthcare services, pharmaceuticals, biotech and life sciences also have corresponding ETF tracking.

* Note: ARKG is an actively managed ETF issued by ARK Innovation Fund, which focuses on investments in the genetics industry.

Thematic ETFs

Now that we've covered industry ETFs, let's take a look at thematic ETFs.

Many investors may think that GICS's way of dividing industries into groups is too narrow, since they cannot tell which industry segment a familiar company belongs to.

Or if you are not optimistic about a particular industry segment but rather about a certain investment theme or concept, then certain thematic ETFs are good choices.

For example, the cloud computing industry, which has achieved breakthrough development, is tracked by the ETF SKYY. Its holdings include Amazon, Alibaba, Microsoft, Google and other giants with a certain scale of cloud computing business, as well as companies like Kingsoft Cloud and upstarts such as MongoDB.

Investors who have a soft spot for clean energy will want to look at ICLN, a global clean energy ETF issued by iShares that tracks the S&P Global Clean Energy Index.

(Source: Morningstars data as of 30/12/2020. Data is for reference only. Past performance is no guarantee of future results.)

Picking industries and sectors and then buying the best players in that entire sector through ETFs helps diversify your investing portfolio and helps to potentially decrease the risks.

4、ETFs can be divided into leveraged ETFs and inverse ETFs.

Leveraged ETFs

A leveraged ETF, also known as a ‘long’ ETF (or bull ETF), can be leveraged one and a half, two, or even three times more than open-end exchange-traded index funds.
That is to say, when the target index income changes by 1%, the change in the fund's net value can reach 1.5%, 2% or 3%. When the leverage ratio is 1x, the return on a leveraged ETF is actually equivalent to that of a traditional ETF.

For example, a 2x S&P 500 ETF (SSO) means that if the S&P 500 rises by 2%, the S&P 500 ETF with 2x leverage will rise 2 X 2% = 4%. If the S&P 500 falls by 2%, the 2x leveraged S&P 500 ETF would fall by 4%.

Inverse ETFs

The inverse ETF, also called a short ETF or bear ETF, uses leveraged investment tools such as stock index futures and swap contracts to achieve daily tracking of inverse multiples of targeted index returns, for example -1 time, -2 times or even -3 times that of open-end exchange-traded index funds. When the target index returns change by 1%, the change in the net value of the fund reaches the agreed -1%, -2% or -3%.

The role of the inverse ETF is to allow investors to short the stock market through a fund. The logic of an inverse ETF is simple. Assuming a 5% gain in the S&P 500, the result for an inverse ETF should be a 5% decline. Conversely, if the S&P 500 falls 5%, an inverse ETF would expect to achieve a 5% gain.

In the chart below, I have listed some common leveraged and inverse ETFs for your reference:

(Source: Internal Prospectus, TQQQ Prospectus; Data is for informational purposes only and does not represent any forecast or investment advice regarding future earnings)

Leveraged ETFs offer the potential for significant gains that exceed the underlying index. Whereas Inverse ETFs can help investors hedge their investment portfolio.

But, as they say, there’s no such thing as a free lunch. Leveraged or inverse ETFs give you leverage , but you also have the chance of losing money, and the management fees are higher than for regular passive ETFs.

Investors need to pay special attention to product specifications and know themselves, and their adversaries, before they can invest with confidence. Otherwise, when market conditions become extreme, they may face the risk of forced liquidation.

And so ends our session on ETF classification. After studying this lesson, you’ll have discovered that, from indices to new ideas, there’s an ETFs that tracks them!

In the following courses, you will gain more knowledge of ETFs, and I believe that you will gradually get a handle on how they work and how to trade them. This will help you make more effective and profitable investments!

In the next lesson,  I'll show you how to choose the ETF that’s right for you.

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See you in the next class!

Disclaimer: The information herein was prepared for educational purposes, and does not constitute an offer, recommendation or solicitation, nor does it constitute any prediction of likely future stock performance. In preparing this information, we did not take into account the investment objectives, financial situation or particular needs of any person or affiliated companies. Before making an investment decision, you should speak to a financial adviser to consider whether this information is appropriate to your needs, objectives and circumstances. Tiger Brokers assumes no fiduciary responsibility or liability for any consequences financial or otherwise arising from trading in securities if opinions and information in this document may be relied upon.This advertisement has not been reviewed by the Monetary Authority of Singapore.