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What is an Exchange-Traded Fund (ETF)?
An Exchange-Traded Fund (ETF) is a type of investment fund and exchange-traded product, i.e., it is traded on stock exchanges. ETFs own financial assets such as stocks, bonds, currencies, debts, futures contracts, and/or commodities such as gold bars. They are designed to track a particular index, sector, commodity, or other assets. Unlike mutual funds, ETFs can be purchased or sold on a stock exchange the same way that a regular stock can.
ETFs offer many benefits and, if used wisely, are an excellent vehicle to achieve an investor’s investment goals. They are a popular choice for diversification as they can 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.
History of ETFs
Types of ETFs
There are several types of ETFs available to investors that can be used for income generation, speculation, price increases, and to hedge or partly offset risk in an investor’s portfolio. Here are a few common ones:
- Index ETFs: Designed to track a particular index like the S&P 500 or NASDAQ.
- Fixed Income ETFs: Designed to provide exposure to virtually every type of bond available.
- Sector and Industry ETFs: Designed to provide exposure to a particular industry, such as oil, pharmaceuticals, or high technology.
- Commodity ETFs: Designed to track the price of a commodity, such as gold, oil, or corn.
- Style ETFs: Designed to track an investment style or market capitalization focus, such as large-cap value or small-cap growth.
- Foreign Market ETFs: Designed to track non-US markets, such as Japan’s Nikkei Index or Hong Kong’s Hang Seng index.
- Inverse ETFs: Designed to profit from a decline in the underlying market or index.
- Leveraged ETFs: Designed to use leverage to amplify returns.
- Actively Managed ETFs: Designed to outperform an index.
Buying and Selling ETFs
Investors can trade ETFs on margin just like stocks. 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.
Risks Associated with ETFs
As with any investment, ETFs can expose investors to any number of risks, so understanding the products and how they work is important. The value of investments can go up as well as down and you may get back less than you invested.
Regulations on ETFs
What to look for in ETFs
- Investment Strategy: Determine why you are interested in buying an ETF. Are you looking for broad market exposure, investing in a certain industry, or looking to hedge a segment of your portfolio?
- Investment Goals: Consider your investment horizon. Are you planning for long-term or short-term investment? ETFs allow for liquidity, but since they track an underlying index, investors will likely see a larger return on their investment over a longer period.
- Understanding the ETF and Its Assets: Research your chosen ETF and all of its holdings. Even though you are looking for overall exposure, that doesn’t mean you shouldn’t examine the equities in an ETF.
- Costs, Commissions, and Fees: ETFs can be a cost-effective investment in most cases, but you still have to weigh the related costs of an ETF against similar investments like indexes and mutual funds.
- Underlying Index: Look at the ETF’s underlying index to determine the exposure you’re getting. Evaluate tracking differences to see how well the ETF delivers its intended exposure.
- Liquidity: Look for higher volumes and tighter spreads as an indication of liquidity and ease of access.
- Risk Level: Understand the risk level of the ETF. This can be determined by looking at the volatility of the ETF, the stability of the underlying assets, and the diversification of the ETF.
Pros of ETFs
- Diversification: ETFs can provide exposure to many stocks from a particular industry, investment category, country, or a broad market index.
- Lower Fees: ETFs, which are passively managed, tend to have significantly lower expense ratios than the mostly actively managed mutual funds.
- Flexibility: ETFs trade at a market-based price updated throughout the trading day.
- Tax Efficiency: ETFs can be more tax-efficient compared to mutual funds.
Cons of ETFs
- Market Risk: ETFs that live by an index can die by an index with no nimble manager to shield performance from a downward move.
- Trading Costs: Since ETFs trade like stocks, you’ll be paying trade commissions to your broker every time you buy or sell.
- Liquidity Risk: Some ETFs may not be as liquid as others, which could impact your ability to buy or sell them when you want.
How to Buy ETFs
You can start investing in ETFs by opening a brokerage account.
ETFs trade like stocks on major exchanges such as the NYSE and Nasdaq.
You choose how many shares you want to purchase.
Because they trade like stocks, ETF prices continuously fluctuate throughout the trading day, and you can buy shares of ETFs whenever the stock market is open.
Most Popular ETFs
- SPDR® S&P 500 ETF Trust (SPY)
- Invesco QQQ Trust Series I (QQQ)
- iShares MSCI Emerging Markets ETF (EEM)
- Vanguard S&P 500 ETF (VOO)
- iShares Russell 2000 ETF (IWM)
Conclusion
ETFs are a versatile and accessible investment option for many investors. They offer the potential for diversification, flexibility, and a range of investment opportunities. However, like all investments, they come with risks and it’s important to understand these risks before investing. Always do your own research or consult with a financial advisor to ensure that any investment aligns with your financial goals and risk tolerance.
Frequently Asked questions on ETFs
An Exchange-Traded Fund (ETF) is a pooled investment vehicle with shares that trade intraday on stock exchanges at a market-determined price.
An Authorized Participant (AP) is typically a large financial institution that enters into a legal contract with an ETF distributor to create and redeem shares of the fund.
ETFs can provide exposure to many stocks from a particular industry, investment category, country, or a broad market index.
ETFs use data from a questionnaire you fill out to understand your current finances, financial goals, and risk tolerance. Based on this data, it offers advice and automatically invests for you.
An AP may redeem ETF shares in creation unit increments in exchange for a “redemption basket” of securities, cash, or both.
ETFs are unique; they provide exposure to a diversified collection of assets, like a mutual fund, but trade on exchange, like a stock. This structure makes the liquidity of ETFs unique, too.
ETF shares are created by “authorized participants” or APs—typically, large financial institutions—providing a specified basket of securities, cash, or both—often called a “creation basket”—to the ETF.
