How do ETFs stack up against CFDs? Seven things you should know

Summary 

• An ETF is an investment fund that is listed and freely traded on a recognised stock exchange.
• CFDs are generally traded with high leverage which helps traders to profit from even a small difference.
• While an ETF is an exchange traded product, CFDs are traded in an OTC market.

There are many financial products available to trade in the market. From plain vanilla stocks to complex products such as derivatives, each product has its own financially engineered structure making it suitable for different groups of investors.

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For example, long-term investors might prefer to hold stocks while more aggressive and high-risk appetite investors might prefer derivative products with some leverage. ETFs (Exchange traded funds) and CFDs (Contracts for difference) are also very common to this list of financial instruments available to trade. However, selecting one between the two depends on the risk to reward structure as well as on the knack for investing or trading/investing skills of an investor. Let’s have a detailed look at both of them.

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What is an ETF?

An ETF or exchange traded fund is an investment fund that is listed and freely traded on a recognised stock exchange, just as shares. They do not have a value of their own but derive their value from the underlying asset upon which that ETF has been created. For example, an index-based ETF such as iShares Core S&P/ASX 200 ETF, which tracks the ASX 200 index, derives its value from the ASX 200.

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An ETF could be based on an index, commodity, currency etc. or a basket of them. They are different from mutual funds as they are freely traded on an exchange and investors can even trade intraday based on the current market price.

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What is a CFD?

A CFD or Contract for difference is a financially engineered product which essentially is a contract between two parties with an obligation to exchange the difference between the current market price of the respective contract and its price on the expiry date.

CFDs are generally traded with high leverage which helps traders to profit from even a small difference. Just like ETFs, a trader trading CFDs never actually owns the underlying asset but profits (or loses) from the movement in the price of the underlying. However, one thing is to be noted that the structure of a CFD contract is such that it does not consider the underlying asset's value, but only the price difference between the underlying’s current value and the value at expiry.

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So, which one is better to trade?

Both financial instruments have different purposes to solve and serve different group of investors/traders. Let’s look at some key differences to better understand which one is better for which type of investor.

1. Time horizon

CFDs are generally suited for short-term aggressive trading. Traders with speculative mind and very short-term view generally go for CFDs. On the other hand, an ETF is suited for a “buy and hold” policy and is one of the best options for long-term investors.

2. Risk Appetite

Traders having a high-risk appetite prefer CFDs as the returns are also amplified due to additional leverage. Conversely, ETFs are suited for low-risk investors, who are satisfied with decent gains.

3. Holding value of the underlying

While buying an ETF, an investor needs to pay the full price of the underlying (sometimes on a proportionate basis). While trading a CFD, an investor does not need to pay the entire value of the underlying. He is only obligated to pay the difference price between the contract’s current price and closing date.

4. Legal Structure

While an ETF is listed on an exchange and therefore is an exchange-regulated product. A CFD belongs to the Over the counter (OTC) market. This simply means CFDs have generally lesser regulations than an ETF, which is a highly regulated product.

5. Simplicity

An ETF is a relatively simpler product with no leverage, contract specifications, etc. and can be bought the same way as one buys shares of a company. For CFDs, one needs to be acquainted with the intricacies of a derivative market along with the OTC market.

6. Accessibility

While many brokers nowadays offer a host of financial instruments and markets to trade, quite a few of them still do not offer trading ins CFDs. This is not so in case of an ETF, as it is a more popular, regulated and demanded product, even with large institutions.

7. Flexibility

As a CFD is an OTC market traded product, it offers a host of flexibility such as being able to adjust the position size using leverage etc. ETFs are stringently regulated by the authorities and therefore do not offer flexibility.     

Read More: CFD trading explained