Exchange-Traded Fund (ETF) Explained

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Exchange-traded funds (ETFs) are an investment vehicle that new and seasoned investors alike are taking advantage of to grow their wealth. While ETFs have been around since the 1990s, they experienced rapid growth after the 2008 financial crisis. Bloomberg states this is because many banks had to get rid of large inventories to boost their balance sheets, and retailers had to search for ways to diversify in an effort to minimize risk.

But what is an ETF? Below, we’ll go over the ETF definition, how ETFs work, different types of ETFs, the pros and cons, and more. Read through for a greater understanding of exchange-traded funds, or use the links below to navigate to a section of your interest.

What is an ETF?

The definition of an ETF, provided by the U.S. Securities and Exchange Commission, says exchange-traded funds are SEC-registered investment companies that offer investors opportunities to pool their money in a fund that invests in bonds, stocks, and other securities.

ETFs are traded on a stock exchange, similar to how stocks are traded, and allow you to diversify your investment portfolio by putting your money into a basket of securities. The price of an ETF fluctuates throughout the day as investors buy and sell them on the market, and aim to reflect the performance of major market indexes, such as the Dow Jones Industrial Average and S&P 500.

 

How ETFs Work

Exchange-traded funds work in a relatively simple way. An ETF provider owns a variety of assets, such as stocks, bonds, or commodities. The provider then creates a basket of these assets in the form of an exchange-traded fund and sells shares to investors. Most ETFs are passively-managed funds that aim to gain the same return as a specific market index, these are typically the most affordable ETFs. Some ETFs are actively-managed funds that buy and sell shares based on a stated investment objective.

Difference Between ETFs, Mutual Funds, and Stocks

As we mentioned, exchange-traded funds are similar to both stocks and mutual funds, which are investment types we hear about when we scroll through the news or watch coverage on the economy. But what is stock, exactly? Stocks are a type of security that give shareholders partial ownership of a company. For more information on how stocks work, refer to our guide on stocks for beginners.

Exchange-traded funds are similar to stocks in that they are traded on a stock exchange. ETFs also have unique ticker symbols that allow you to track the ETFs’ price activity, such as SPY, which is the ETF ticker symbol for the S&P 500. However, stocks only represent one company and one company only. ETFs on the other hand, are like a basket of stocks and assets from a variety of sources. Having a mix of investment types and sources allows investors to diversify their portfolio, and therefore, mitigate risk and make more room for reward. ETFs use the same kind of logic as the old saying, “don’t put all your eggs in one basket.”

Exchange-traded funds and mutual funds are similar in that both are a type of investment fund where a group works together to invest capital toward a common goal. However, there are multiple aspects where they differ. ETFs can be bought or sold at any time during the market hours, just like a stock. Mutual funds, on the other hand, can only be bought at the end of the day when the price has been set.

Additionally, passively-managed ETFs typically have lower fees compared to mutual funds. Mutual funds have a broker or a fund manager in charge of the fund, while ETFs don’t, which means no brokerage fees. Keep in mind, both ETFs and mutual funds have active and passively-managed options. Active funds are more expensive to manage while passive funds are considered more affordable. Finally, ETFs have a lower tax burden.

Types of ETFs

A popular draw for ETFs is that there are numerous types available that can be used to diversify a portfolio and generate income. Some popular types of ETFs include:

Index ETFs

An index ETF is a basket of securities that is designed to follow benchmarks from major stock exchanges such as the S&P 500, Nasdaq 100, and the Dow Jones Industrial Average.Index ETFs are passively-managed, low-cost, and can be a good way for investors to diversify their profiles.

Bond ETFs

Bonds are a type of debt security where investors lend money to borrowers, such as corporations or government entities. Over time, the bond will mature, and the investor can earn money through interest. With bond ETFs, an investor can invest in a basket of bonds, such as government bonds, state bonds, municipal bonds, and corporate bonds.

Industry ETFs

If you’re interested in a particular industry, such as technology or banking, you can invest in an industry ETF. An industry ETF tracks 11 broad industry sectors listed by the Global Industry Classification Standard (GICS), as well as a few unique and ad hoc industries.

Commodity ETFs

A commodity ETF invests in physical commodities, such as oil, gold, agricultural goods, and natural resources. A commodity ETF can focus on a single commodity, such as precious metals, or it can focus on investments in future contracts, which are legal agreements that determine when a particular commodity asset will be bought or sold.

Commodity ETFs can also track the performance of a commodity index. A commodity index tracks the price of a basket of multiple commodities. An example is the United States Commodity Index fund which tracks mostly metals, such as gold, lead, zinc, copper, and lead, along with energy and agricultural products like cotton.

Currency ETFs

A currency ETF invests in global currencies, such as the Euro, U.S. Dollar, or Japanese Yen. You can invest in a single country’s currency, or in a basket of currencies to get exposure to the foreign exchange market without the risk of placing individual trades.

Inverse ETFs

Inverse ETFs, also known as bear ETFs and short ETFs, use a variety of derivatives to make a profit from a decline in the value of a stock by shorting them. Shorting stocks refers to the practice of selling stocks with the hope of repurchasing them in the future at a lower price.

Note: This is a veryrisky strategy, typically not recommended for beginning or intermediate investors.

How to Invest in ETFs

Now that you know what exchange-traded funds are and the different types of ETFs available, are you ready to start investing? As stated, one of the main advantages of ETFs is that you can buy or sell them at any point during market hours.

  • Step 1: Determine what type of ETF you want to invest in, whether currency ETFs, bond ETFs, or industry ETFs. You should also create a budget to decide how much money you want to invest.
  • Step 2: Open a brokerage account. Online brokers could be a viable option for investors who want a more hands-on experience, or you might want to consider a robo-advisor for a hands-off approach.
  • Step 3: Consult with your broker or set your online preferences on where you’d like to allocate your money. For example, you may want to put 50 percent of your money toward a bond ETF, 30 percent toward a commodity ETF, and 20 percent toward an industry ETF.
  • Step 4: If you want to sell your ETF for cash, all you have to do is place a sell order with your brokerage dealer. To sell an ETF, place a market order, which sells your share at the next available price, or a limit order, which tells your broker that it must sell at or below the price you want to set.

Pros and Cons of ETFs

As with any security, there can be bountiful gains and harsh losses. Understanding the pros and cons of exchange-traded funds can help you determine whether this investment vehicle is right for you.

Pros of Exchange-Traded Funds

  • Lower costs: ETFs are relatively cheap compared to actively-managed mutual funds and other investment funds. Unlike mutual funds that may charge higher management fees, service fees, and board of director wages—due to the research and staff needed to actively manage accounts—ETFs have lower fees when they are passively managed.
  • Diversification and risk management: When you invest in an ETF, you invest in multiple securities, such as bonds, commodities, or currencies, which diversifies your portfolio.
  • Tax benefits: Because ETFs are passively managed portfolios, fewer capital gains are realized compared to actively managed mutual funds. Additionally, capital gains tax is typically only collected when you sell your ETF, though it is rarely collected while you own the fund. Conversely, capital gains tax for mutual funds is often incurred throughout its lifetime.
  • Easy to trade: You can use your ETFs ticker symbol to easily look up the estimated daily price change and compare it to its commodity or indexed sector.

Cons of Exchange-Traded Funds

  • Potentially higher costs: Although a majority of ETFs are cheaper than investing in mutual funds, they’re often more costly than investing in individual stocks. This is because you may have to pay brokerage fees and ongoing management charges.
  • Limited control: When you buy stock, you have control over what stock you choose. When you purchase an exchange-traded fund, you have no control over what securities are bought or sold. Don’t worry—if you buy an ETF that tracks the environmental sector, it won’t switch to an ETF that tracks financial companies.
  • Tracking error: Because ETFs hold cash, there is some room for (rare) tracking error. This means your ETF won’t perform exactly the way its underlying benchmark or securities perform, which can result in some extra cost to investors.

Key Takeaways

  • An exchange-traded fund allows investors to pool their money into a fund that invests in bonds, stocks, and other securities. ETFs are traded on a stock exchange and can be bought or sold at any time during market hours.
  • An exchange-traded fund is different from a stock in that stocks give shareholders partial ownership of a company, and ETFs are a basket of stocks, bonds, and other securities that shareholders can invest in.
  • Exchange-traded funds are different from mutual funds in that they can be bought or sold at any point during market hours. Mutual funds, on the other hand, can only be bought at the end of the day and have a broker or fund manager in charge of the fund.
  • There are numerous types of exchange-traded funds, including bond ETFs, industry ETFs, Commodity ETFs, currency ETFs, and inverse ETFs.
  • To invest in an exchange-traded fund, you need to open a brokerage account or use a robo-advisor and determine where you want to allocate your money. To sell, place a sell order with your brokerage dealer.
  • There are many pros and cons of exchange-traded funds. Make sure to weigh these advantages and disadvantages to determine if investing in ETFs is right for you.

Sources

Bloomberg | U.S. Securities and Exchange Commission | Fidelity | United States Commodity Funds

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