What is an ETF?

What is an ETF

Exchange-traded funds are investment funds that offer the best of two popular assets. They have the diversification benefits of mutual funds mixed with the ease of trading stocks.

An exchange-traded fund, or ETF, is a collection of securities that can be bought and sold in shares on a stock exchange just like an individual stock. Like standard stocks, ETFs have tickers (e.g., SPY), are listed on stock exchanges, and can be traded by individual and institutional investors during regular trading hours.

Some ETFs are designed to track index funds like the Nasdaq Composite. Others focus on specific industries like electric vehicles or specific stock market segments like companies with high market capitalization.

While standard stocks have a set number of shares in circulation (for the most part), the number of outstanding shares of a particular ETF can change daily because new ETF shares can be created out of the fund’s underlying securities, and existing shares can be redeemed for the fund’s underlying securities. 

Main Points

  • An exchange-traded fund (ETF) trades on an exchange just like a stock does.
  • ETF share prices fluctuate all day as the ETF is bought and sold, unlike mutual funds that only trade once a day after the market closes.
  • ETFs can contain all types of investments, including stocks, commodities, or bonds.
  • ETFs offer fewer broker commissions than buying the stocks individually does.

Types of ETFs

Between two and three thousand ETFs are traded on the U.S. stock market, and between seven and eight thousand are traded worldwide. Since every ETF is a custom collection of securities, many different types have emerged to suit various investor needs. Below are some of the most common types. Note that these types may—and often do—overlap to some degree.

Bond ETFs

Bond ETFs are used to provide regular income to investors. Their income distribution depends on the performance of underlying bonds. They might include government bonds, corporate bonds, and state and local bonds—called municipal bonds. Unlike their underlying instruments, bond ETFs do not have a maturity date. They generally trade at a premium or discount from the actual bond price.

Stock ETFs

Stock ETFs comprise a basket of stocks to track a single industry or sector. For example, a stock ETF might track automotive or foreign stocks. The aim is to provide diversified exposure to a single industry, including high performers and new entrants with growth potential. Unlike stock mutual funds, stock ETFs have lower fees and do not involve actual ownership of securities.

Industry ETFs

Industry or sector ETFs focus on a specific sector or industry. For example, an energy sector ETF will include companies operating in that sector. The idea behind industry ETFs is to gain exposure to the upside of that industry by tracking the performance of companies operating in that sector. One example is the technology sector, which has witnessed an influx of funds in recent years. At the same time, the downside of volatile stock performance is also curtailed in an ETF because they do not involve direct ownership of securities. Industry ETFs also rotate in and out of sectors during economic cycles.

Commodity ETFs

As their name indicates commodity ETFs invest in commodities, including crude oil or gold. Commodity ETFs provide several benefits. First, they diversify a portfolio, making it easier to hedge downturns. For example, commodity ETFs can provide a cushion during a slump in the stock market. Second, holding shares in a commodity ETF is cheaper than physical possession of the commodity. This is because the former does not involve insurance and storage costs.

Currency ETFs

Currency ETFs are pooled investment vehicles that track the performance of currency pairs consisting of domestic and foreign currencies. Currency ETFs serve multiple purposes. They are used to speculate on the prices of currencies based on political and economic events in a country. They are also used to diversify a portfolio or hedge against volatility in forex markets by importers and exporters. Some of them are used to hedge against the threat of inflation.

Inverse ETFs

Inverse ETFs attempt to earn gains from stock declines by shorting stocks. Shorting is selling a stock, expecting a decline in value, and repurchasing it at a lower price. An inverse ETF uses derivatives to short a stock. Essentially, they are bets that the market will decline. When the demand decreases, an inverse ETF increases by a similar amount. Investors should be aware that many inverse ETFs are exchange-traded notes and not true ETFs. An ETN is a bond but trades like a stock and is backed by an issuer like a bank. 

Pros and Cons ETFs

The Pros of ETFs

Investors typically choose ETFs because of their consistency. On the scale of volatility and risk, they’re on par with mutual funds – they’re less volatile than individual securities but more prone to action than broad index funds. Here’s a look at some of the specific reasons investors choose ETFs.

  • Liquidity: Bought and sold through exchanges, ETFs allow investors to buy and sell at their discretion. This means you’re not locked into an investment for any longer than you want to be. All it takes to buy or sell ETFs is a market order.
  • Stability: Because ETFs track broader assets, they’re naturally hedged against volatility. ETFs don’t fluctuate as much as individual securities due to the aggregated price of their holdings. The more tracked assets, the less volatile the cost of the ETF.
  • Accessibility: You can purchase an ETF through its ticker symbol on an exchange, which means they’re accessible to anyone. On top of this, most ETFs have a lower cost of entry than managed funds. They’re an excellent tool for new investors and those who want a “set it and forget it” type of investment product.
  • Diversity:  Track a more extensive index, invest in only companies from a specific sector or get as granular as you want for your ETF focus. With thousands of ETFs to choose from, you’re able to capitalize on your investing thesis while diversifying your holdings through the ETF.
  • Tax efficiency: Thanks to their indexed structure, ETFs distribute capital gains differently than mutual funds and other managed funds. Even high-yield dividend funds are more favorable for tax purposes than funds that distribute gains directly to shareholders.

The Cons of ETFs

Despite offering some hedge against risk, ETFs aren’t immune to volatility. Moreover, many of the benefits they offer come with trade-offs. Here are some of the reasons ETFs might not be for you.

  • Fees: ETFs have an expense ratio, which is the cost of maintaining the fund. While they’re typically low (less than a percent), actively managed ETFs with high expense ratios. Pay attention to fees – they can eat into your returns! 
  • Index obfuscation: Some ETFs track indices or assets that aren’t proven or don’t have an excellent track record of stability. Moreover, highly leveraged ETFs can complicate your investment. It’s always best to thoroughly review the assets tied to an ETF.

ETFs vs Index Funds

Exchange-traded funds and index funds combine many individual securities into a single investment, such as stocks or bonds. That gives you a ton of diversification from the get-go. Both funds are usually passively managed, providing cost savings and long-term solid returns. 

  • An ETF is a type of security that tracks an underlying asset like an index, individual commodity, or a mixture of assets.
  • An index fund is a type of mutual fund or exchange-traded fund that typically tracks the performance of a target index. 

One significant difference between ETFs and index funds is how they’re traded. ETFs can be bought and sold throughout the day, while index funds are traded at the price point set at the end of the trading day. Additionally, ETFs may require a lower upfront investment and offer tax savings compared to index funds. 

ETFs vs. mutual funds

Since ETFs and mutual funds are both curated collections of securities, both instruments allow investors to diversify their portfolios by buying multiple securities with a single investment. Because they comprise many different securities, ETFs and mutual funds are less risky than individual stocks. Additionally, mutual funds and ETFs are designed to track specific stock indexes or industries.

There are, however, several notable differences between these two types of assets. While ETF shares are traded whenever the market is open, mutual funds shares are only traded after financial markets close at 4 p.m. EST. Since mutual funds only trade once per day, every trader who buys or sells on a given day does so at the same price.

ETFs VS Mutual Funds

ETFsMutual Funds
Can be traded whenever the market is openCan only be traded at the final price after market close
No minimum investment amount (aside from share price if fractional shares not available on a particular broker)May have a minimum investment amount
Can be shorted; can be bought on margin; stop and limit orders possibleCan only add or remove capital (i.e., invest/disinvest)

How to Begin Investing in ETFs

Investors interested in ETFs should start by figuring out what they want from their portfolios. Slow and steady growth? A focus on emerging technologies? A commitment to companies dedicated to socially and environmentally responsible practices? Thousands of ETFs with different focuses exist. Some track stock indexes, some focus on particular industries or market segments, and some are based on specific investment strategies.

Once investors know what they want from their portfolio, they can conduct research and identify one or more ETFs that are a good fit for their needs. Because ETFs trade on stock exchanges, they can be bought and sold quickly on popular trading platforms like eTrade, Fidelity, and Robinhood. Dollar-cost averaging may be a sustainable and straightforward ETF investment strategy for those looking to invest passively and consistently.

Advantages and Disadvantages of ETF Investing

ProsCons
Easy way to build a diversified portfolioNot ideal for day traders or those who prefer to trade individual stocks
Lower fees than mutual fundsMay come with fees
Allow for exposure to asset classes not otherwise available on centralized exchanges
Many types exist for different investment strategies

Frequently Asked Questions (FAQ)

Do ETFs Have Fees? 

Like mutual funds, ETFs typically carry fees known as expense ratios, although the fees for ETFs tend to be lower than those for mutual funds. These fees cover the costs associated with the fund’s management and administration. ETF expense ratios tend to average around 0.4 to 0.5% (or 40 to 50 cents per $100 investment) annually. These fees are deducted automatically, so ETF investors don’t need to remember to pay them.

It’s important to look at the expense ratio of any ETF (or mutual fund) you’re interested in investing in, as this fee will take a small bite out of your gains (or slightly increase your losses) each year.

Who Creates and Manages ETFs? 

Fund managers, or “sponsors,” create ETFs by filing proposals with the Securities and Exchange Commission (SEC). Another party, known as an “authorized participant,” then borrows the stock shares that the ETF will represent and places them in a trust, which then converts them into ETF shares that the authorized participant can sell to the public. In the case of actively managed ETFs, this process may happen again and again as securities are added to or removed from the fund based on its manager’s strategic decisions.

How Do ETFs Affect Investors’ Taxes? 

When investors sell stocks that have risen in value since they were purchased, they are taxed on their capital gains. These gains are considered short-term and taxed at a higher rate if the stocks were held for less than one year. Gains are considered long-term and taxed at a lower rate if the stocks were held for more than one year. These same rules apply to ETF shares since they are traded on centralized exchanges like stocks.

The transactions that go into the creation and management of ETFs are considered “in-kind,” meaning they are exempt from taxes, so the only tax implications individual ETF investors need to worry about are those that come with selling shares.

Conclusion

ETFs are a great vehicle if you want diversity focusing on a specific sector. If you’re looking for rapid growth or want broad exposure, individual stocks or index funds may be a better play. It all comes down to factors like focus, risk, investing habit, and cost. As with anything investment-related, it is best to research the available information and base your decisions on your personal financial goals.

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