What is ETF (Exchange Traded Fund)? Explained Simply

  

What Is an Exchange-Traded Fund (ETF)? 



An exchange-traded fund (ETF) is a type of pooled investment security that operates much like a mutual fund. Typically, ETFs will track a particular index, sector, commodity, or other assets, but unlike mutual funds, ETFs can be purchased or sold on a stock exchange the same way that a regular stock can. An ETF can be structured to track anything from the price of an individual commodity to a large and diverse collection of securities. ETFs can even be structured to track specific investment strategies. 


The first ETF was the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index, and which remains an actively traded ETF today. 


KEY TAKEAWAYS:

- An exchange-traded fund (ETF) is a basket of securities that trades on an exchange just like a stock does.

- ETF share prices fluctuate all day as the ETF is bought and sold; this is different from mutual funds, which only trade once a day after the market closes. 

- ETFs can contain all types of investments, including stocks, commodities, or bonds; some offer U.S.-only holdings, while others are international. 

- ETFs offer low expense ratios and fewer broker commissions than buying the stocks individually.



How Is an ETF Different From an Index Fund?

An index fund usually refers to a mutual fund that tracks an index. An index ETF is constructed in much the same way and will hold the stocks of an index, tracking it. However, an ETF tends to be more cost-effective and liquid than an index mutual fund. You can also buy an ETF directly on a stock exchange throughout the day, while a mutual fund trades via a broker only at the close of each trading day.

How Do ETFs Work?

An ETF provider creates an ETF based on a particular methodology and sells shares of that fund to investors. The provider buys and sells the constituent securities of the ETF's portfolio. While investors do not own the underlying assets, they may still be eligible for dividend payments, reinvestments, and other benefits.

What Is an ETF Account?

In most cases, it is not necessary to create a special account to invest in ETFs. One of the primary draws of ETFs is that they can be traded throughout the day and with the flexibility of stocks. For this reason, it is typically possible to invest in ETFs with a basic brokerage account.

What Does an ETF Cost?

ETFs have administrative and overhead costs which are generally covered by investors. These costs are known as the "expense ratio," and typically represent a small percentage of an investment. The growth of the ETF industry has generally driven expense ratios lower, making ETFs among the most affordable investment vehicles. Still, there can be a wide range of expense ratios depending upon the type of ETF and its investment strategy.



  Understanding Exchange-Traded Funds (ETFs) 


An ETF is called an exchange-traded fund because it’s traded on an exchange just like stocks are. The price of an ETF’s shares will change throughout the trading day as the shares are bought and sold on the market. This is unlike mutual funds, which are not traded on an exchange, and which trade only once per day after the markets close. Additionally, ETFs tend to be more cost-effective and more liquid compared to mutual funds. 

 

An ETF is a type of fund that holds multiple underlying assets, rather than only one like a stock does. Because there are multiple assets within an ETF, they can be a popular choice for diversification. ETFs can thus contain many types of investments, including stocks, commodities, bonds, or a mixture of investment types. 

An ETF can own hundreds or thousands of stocks across various industries, or it could be isolated to one particular industry or sector. Some funds focus on only U.S. offerings, while others have a global outlook. For example, banking-focused ETFs would contain stocks of various banks across the industry. 

An ETF is a marketable security, meaning it has a share price that allows it to be easily bought and sold on exchanges throughout the day, and it can be sold short. In the United States, most ETFs are set up as open-ended funds and are subject to the Investment Company Act of 1940 except where subsequent rules have modified their regulatory requirements. 2 Open-end funds do not limit the number of investors involved in the product. 


Types of ETFs 

Various types of ETFs are available to investors that can be used for income generation, speculation, and price increases, and to hedge or partly offset risk in an investor’s portfolio. Here is a brief description of some of the ETFs available on the market today. 


Passive and Active ETFs 

ETFs are generally characterized as either passive or actively managed. Passive ETFs aim to replicate the performance of a broader index—either a diversified index such as the S&P 500 or a more specific targeted sector or trend. An example of the latter category is gold mining stocks: as of February 18, 2022, there are approximately eight ETFs which focus on companies engaged in gold mining, excluding inverse, leveraged, and funds with low assets under management (AUM). 

Actively managed ETFs typically do not target an index of securities, but rather have portfolio managers making decisions about which securities to include in the portfolio. These funds have benefits over passive ETFs but tend to be more expensive to investors. We explore actively managed ETFs below. 

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 (equity) 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, one that includes high performers and new entrants with potential for growth. Unlike stock mutual funds, stock ETFs have lower fees and do not involve actual ownership of securities.


Industry/Sector ETFs 

Industry or sector ETFs are funds that 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 are also used to 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 can be used to speculate on the prices of currencies based on political and economic developments for a country. They are also used to diversify a portfolio or as a hedge against volatility in forex markets by importers and exporters. Some of them are also used to hedge against the threat of inflation. There’s even an ETF option for bitcoin. 


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 market declines, an inverse ETF increases by a proportionate amount. Investors should be aware that many inverse ETFs are exchange-traded notes (ETNs) and not true ETFs. An ETN is a bond but trades like a stock and is backed by an issuer such as a bank. Be sure to check with your broker to determine if an ETN is a good fit for your portfolio. 


Leveraged ETFs 

A leveraged ETF seeks to return some multiples (e.g., 2× or 3×) on the return of the underlying investments. For instance, if the S&P 500 rises 1%, a 2× leveraged S&P 500 ETF will return 2% (and if the index falls by 1%, the ETF would lose 2%). These products use derivatives such as options or futures contracts to leverage their returns. There are also leveraged inverse ETFs, which seek an inverse multiplied return. 


How to Buy ETFs 


With a multiplicity of platforms available to traders, investing in ETFs has become fairly easy. 

Follow the steps outlined below to begin investing in ETFs:

Find an Investing Platform 

ETFs are available on most online investing platforms, retirement account provider sites, and investing apps like Robinhood. Most of these platforms offer commission-free trading, meaning that you don’t have to pay fees to the platform providers to buy or sell ETFs. 

 However, a commission-free purchase or sale does not mean that the ETF provider will also provide access to their product without associated costs. Some areas in which platform services can distinguish their services from others are convenience, services, and product variety. 

For example, smartphone investing apps enable ETF share purchasing at the tap of a button. This may not be the case for all brokerages, which may ask investors for paperwork or a more complicated situation. Some well-known brokerages, however, offer extensive educational content that helps new investors become familiar with and research ETFs. 

Research ETFs 

The second and most important step in ETF investing involves researching them. There is a wide variety of ETFs available in the markets today. One thing to remember during the research process is that ETFs are unlike individual securities such as stocks or bonds. 

You will need to consider the whole picture—in terms of sector or industry—when you commit to an ETF. Here are some questions you might want to consider during the research process: 

What is your time frame for investing? 

- Are you investing for income or growth? 

- Are there particular sectors or financial instruments that excite you? 


Consider a Trading Strategy 

If you are a beginning investor in ETFs, dollar-cost averaging or spreading out your investment costs over a period of time is a good trading strategy. This is because it smooths out returns over a period of time and ensures a disciplined (as opposed to a haphazard or volatile) approach to investing. 

It also helps beginning investors learn more about the nuances of ETF investing. When they become more comfortable with trading, investors can move out to more sophisticated strategies like swing trading and sector rotation. 



Online Brokers vs. Traditional Brokers 




ETFs trade through both online brokers and traditional broker-dealers. You can view some of the top brokers in the industry for ETFs with Investopedia’s list of the best brokers for ETFs. You can also typically purchase ETFs in your retirement account. One alternative to standard brokers is a robo-advisor like Betterment and Wealthfront, which make extensive use of ETFs in their investment products. 

A brokerage account allows investors to trade shares of ETFs just as they would trade shares of stocks. Hands-on investors may opt for a traditional brokerage account, while investors looking to take a more passive approach may opt for a robo-advisor. Robo-advisors often include ETFs in their portfolios, although they choice of whether to focus on ETFs or individual stocks may not be up to the investor. 


What to Look for in an ETF 

After creating a brokerage account, investors will need to fund that account before investing in ETFs. The exact ways to fund your brokerage account will be depend on the broker. After funding your account, you can search for ETFs and make buys and sells in the same way that you would shares of stocks. One of the best ways to narrow your ETF options is to utilize an ETF screening tool. Many brokers offer these tools as a way to sort through the thousands of ETF offerings. You can typically search for ETFs according to some of the following criteria: 

 Volume: 

Trading volume over a particular period of time allows you to compare the popularity of different funds; the higher the trading volume, the easier it may be to trade that fund. 

Expenses: 

The lower the expense ratio, the less of your investment that is given over to administrative costs. While it may be tempting to always search for funds with the lowest expense ratios, sometimes costlier funds (such as actively managed ETFs) have strong enough performance that it more than makes up for the higher fees. 

Performance: 

While past performance is not an indication of future returns, this is nonetheless a common metric for comparing ETFs. 

Holdings: 

The portfolios of different funds often factor into screener tools as well, allowing customers to compare the different holdings of each possible ETF investment. 

Commissions: 

Many ETFs are commission-free, meaning that they can be traded without any fees to complete the trade. However, it is worth checking if this is a potential dealbreaker. 


Examples of Popular ETFs 




Below are examples of popular ETFs on the market today. Some ETFs track an index of stocks, thus creating a broad portfolio, while others target specific industries. 

The SPDR S&P 500 (SPY): 

The “Spider” is the oldest surviving and most widely known ETF that tracks the S&P 500 Index. 


The iShares Russell 2000 (IWM)

tracks the Russell 2000 small-cap index. 


The Invesco QQQ (QQQ) (“cubes”) 

tracks the Nasdaq 100 Index, which typically contains technology stocks. 


The SPDR Dow Jones Industrial Average (DIA) (“diamonds”) 

represents the 30 stocks of the Dow Jones Industrial Average. 


Sector ETFs 

track individual industries and sectors such as oil (OIH), energy (XLE), financial services (XLF), real estate investment trusts (IYR), and biotechnology (BBH). 


Commodity ETFs 

represent commodity markets, including gold (GLD), silver (SLV), crude oil (USO), and natural gas (UNG). 


Country ETFs 

track the primary stock indexes in foreign countries, but they are traded in the United States and denominated in U.S. dollars. Examples include China (MCHI), Brazil (EWZ), Japan (EWJ), and Israel (EIS). Others track a wide breadth of foreign markets, such as ones that track emerging market economies (EEM) and developed market economies (EFA). 


Advantages and Disadvantages of ETFs 


ETFs provide lower average costs because it would be expensive for an investor to buy all the stocks held in an ETF portfolio individually. Investors only need to execute one transaction to buy and one transaction to sell, which leads to fewer broker commissions because there are only a few trades being done by investors. 

Brokers typically charge a commission for each trade. Some brokers even offer no-commission trading on certain low-cost ETFs, reducing costs for investors even further. 

An ETF’s expense ratio is the cost to operate and manage the fund. ETFs typically have low expenses because they track an index. For example, if an ETF tracks the S&P 500 Index, it might contain all 500 stocks from the S&P, making it a passively managed fund that is less time-intensive. However, not all ETFs track an index in a passive manner, and may therefore have a higher expense ratio. 

Pros:

- Access to many stocks across various industries 

- Low expense ratios and fewer broker commissions 

- Risk management through diversification 

- ETFs exist that focus on targeted industries 


Cons:

- Actively managed ETFs have higher fees 

- Single-industry-focused ETFs limit diversification 

- Lack of liquidity hinders transactions 



Actively Managed ETFs 

There are also actively managed ETFs, wherein portfolio managers are more involved in buying and selling shares of companies and changing the holdings within the fund. Typically, a more actively managed fund will have a higher expense ratio than passively managed ETFs. 

To make sure that an ETF is worth holding, it is important that investors determine how the fund is managed, whether it’s actively or passively managed, the resulting expense ratio, and the costs vs. the rate of return. 


Special Considerations 

Indexed-Stock ETFs 

An indexed-stock ETF provides investors with the diversification of an index fund as well as the ability to sell short, buy on margin, and purchase as little as one share because there are no minimum deposit requirements. However, not all ETFs are equally diversified. Some may contain a heavy concentration in one industry, or a small group of stocks, or assets that are highly correlated to each other. 


Dividends and ETFs 

Though ETFs provide investors with the ability to gain as stock prices rise and fall, they also benefit from companies that pay dividends. Dividends are a portion of earnings allocated or paid by companies to investors for holding their stock. ETF shareholders are entitled to a proportion of the profits, such as earned interest or dividends paid, and may get a residual value if the fund is liquidated. 


ETFs and Taxes 

An ETF is more tax-efficient than a mutual fund because most buying and selling occur through an exchange and the ETF sponsor does not need to redeem shares each time an investor wishes to sell or issue new shares each time an investor wishes to buy. 

Redeeming shares of a fund can trigger a tax liability, so listing the shares on an exchange can keep tax costs lower. In the case of a mutual fund, each time an investor sells their shares, they sell it back to the fund and incur a tax liability that must be paid by the shareholders of the fund. 


ETFs’ Market Impact 

Because ETFs have become increasingly popular with investors, many new funds have been created, resulting in low trading volumes for some of them. The result can lead to investors not being able to easily buy and sell shares of a low-volume ETF. 

Concerns have surfaced about the influence of ETFs on the market and whether demand for these funds can inflate stock values and create fragile bubbles. Some ETFs rely on portfolio models that are untested in different market conditions and can lead to extreme inflows and outflows from the funds, which have a negative impact on market stability. 

Since the financial crisis, ETFs have played major roles in market flash-crashes and instability. Problems with ETFs were significant factors in the flash crashes and market declines in May 2010, August 2015, and February 2018. 


What Was the First Exchange-Traded Fund (ETF)?

The first exchange-traded fund (ETF) is often credited to the SPDR S&P 500 ETF (SPY) launched by State Street Global Advisors on Jan. 22, 1993. There were, however, some precursors to the SPY, notably securities called Index Participation Units listed on the Toronto Stock Exchange (TSX) that tracked the Toronto 35 Index that appeared in 1990.


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