Classification of ETFs

Before moving on to the practical side of building a portfolio of ETFs according to your goal, I would like to show you a classification of ETFs based on the benchmark that the basket of securities replicates. Typically, they are divided into:

Monetary. They are not a proper investment instrument but arise from the need to manage the liquidity in your account. They typically hold a basket of short-term and very short-term bonds, usually with a maturity of 12 months or less.

Investing isn’t the purpose; the aim is to earn a minimal return on the liquidity sitting in your account. Even so, with interest rates currently at or near zero all over the world during this historical period, the yield of these ETFs is nil, if not negative.

Bonds. They invest in bonds and allow for broad diversification across several levels:

• Geographical (Europe, the US, emerging countries, etc.);
• Issuer (government bonds, corporate bonds);
• Maturity (short, medium, long term);
• Currency (euro, dollar, exchange rate hedging, etc.);
• Income (accumulation, distribution).

As you can see, each level can be further diversified.

The advantage offered by bond ETFs is that they enable you to invest small amounts while diversifying your portfolio efficiently. However, as you have seen with bonds, a key concept remains the link between interest rates and the price of the individual bonds that make up an ETF’s basket.

In 2021, this is not a factor to be underestimated, especially given the low level of interest rates. An increase in rates would lead to a drop in the price of individual bonds, and as a result, a depreciation of the ETF.

Equities. They are characterised by replicating a basket of stocks. They offer numerous advantages:

• Low commissions. With a single transaction you can buy all the shares that make up the basket.
• Lower risk. Buying an ETF rather than a single stock has undoubted advantages in terms of lower volatility and therefore lower risk.
• Diversification. As with bond ETFs, equity ETFs can also be diversified geographically (Europe, America, Asia, emerging countries, etc.), by sector (banks, industry, telecommunications, real estate, etc.), by theme (allowing you to invest in a specific theme, generally environmental, social or energy-related), etc.

As you have already seen, individual stocks are certainly not an ideal investment as they require adequate knowledge of the company you intend to invest in, as well as experience, which most of you do not possess. ETFs are definitely a better alternative for investing in the stock market.

Structured. Structured ETFs deserve a separate mention. They are synthetically replicated ETFs which invest in a basket of derivative instruments (typically swaps) and which allow the replication of complex strategies (which until a few years ago were the exclusive prerogative of hedge funds) or non-linear strategies, i.e., returns that do not simply follow the performance of the reference benchmark.

The main types of structured ETFs are:

• Short. They allow the investor to take the opposite position to the benchmark. In concrete terms, these ETFs increase in value when the benchmark falls in price. They are therefore a way of speculating on the downside of financial markets.
• Leveraged. They allow the investor to realise an additional return (but also a loss) compared with the benchmark. The additional return is determined by the leverage effect, which allows the performance of the benchmark to be amplified. For example, if the benchmark earns 1.5% today, a “3x leveraged ETF” earns 4.5% (1.5% × 3 = 4.5%). If tomorrow the benchmark achieves -2%, the same ETF will lose 6% (-2% × 3 = -6%). Keep in mind that the leverage applies to the daily return: over longer periods the result is not simply three times that of the benchmark.

They are therefore instruments that need to be treated with care and only by experienced people. Moreover, they are much more suitable for speculation (trading) than for investment. This is why I do not recommend the use of structured ETFs and why you won’t find them mentioned again in this course.

In conclusion, you have seen how ETFs are very versatile tools that allow you to invest with low costs and low risks, even with little capital, diversifying in many ways and in different markets. They are the ideal tools for those who want to set up an accumulation plan.