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.
- 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.
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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.
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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. 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 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 (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 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.
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 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 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.
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.
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.
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
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.
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.
ETF Creation and Redemption
The supply of ETF shares is regulated through a mechanism known as creation and redemption, which involves large specialized investors called authorized participants (APs).
When an ETF wants to issue additional shares, the AP buys shares of the stocks from the index—such as the S&P 500 tracked by the fund—and sells or exchanges them to the ETF for new ETF shares at an equal value. In turn, the AP sells the ETF shares in the market for a profit. When an AP sells stocks to the ETF sponsor in return for shares in the ETF, the block of shares used in the transaction is called a creation unit.
Creation When Shares Trade at a Premium
Imagine an ETF that invests in the stocks of the S&P 500 and has a share price of $101 at the close of the market. If the value of the stocks that the ETF owns was only worth $100 on a per-share basis, then the fund’s price of $101 is trading at a premium to the fund’s net asset value (NAV). The NAV is an accounting mechanism that determines the overall value of the assets or stocks in an ETF.
An AP has an incentive to bring the ETF share price back into equilibrium with the fund’s NAV. To do this, the AP will buy shares of the stocks that the ETF wants to hold in its portfolio from the market and sells them to the fund in return for shares of the ETF.
In this example, the AP is buying stock on the open market worth $100 per share but getting shares of the ETF that are trading on the open market for $101 per share. This process is called creation and increases the number of ETF shares on the market. If everything else remains the same, then increasing the number of shares available on the market will reduce the price of the ETF and bring shares in line with the NAV of the fund.
Conversely, an AP also buys shares of the ETF on the open market. The AP then sells these shares back to the ETF sponsor in exchange for individual stock shares that the AP can sell on the open market. As a result, the number of ETF shares is reduced through the process called redemption.
The amount of redemption and creation activity is a function of demand in the market and whether the ETF is trading at a discount or premium to the value of the fund’s assets.
Redemption When Shares Trade at a Discount
Imagine an ETF that holds the stocks in the Russell 2000 small-cap index and is currently trading for $99 per share. If the value of the stocks that the ETF is holding in the fund is $100 per share, then the ETF is trading at a discount to its NAV.
To bring the ETF’s share price back to its NAV, an AP will buy shares of the ETF on the open market and sell them back to the ETF in return for shares of the underlying stock portfolio. In this example, the AP is able to buy ownership of $100 worth of stock in exchange for ETF shares that it bought for $99. This process is called redemption, and it decreases the supply of ETF shares on the market. When the supply of ETF shares is decreased, the price should rise and get closer to its NAV.
ETFs vs. Mutual Funds vs. Stocks
Comparing features for ETFs, mutual funds, and stocks can be a challenge in a world of ever-changing broker fees and policies. Most stocks, ETFs, and mutual funds can be bought and sold without a commission. Funds and ETFs differ from stocks because of the management fees that most of them carry, though they have been trending lower for many years. In general, ETFs tend to have lower average fees than mutual funds. Here is a comparison of other similarities and differences.
|Exchange-Traded Funds||Mutual Funds||Stocks|
|Exchange-traded funds (ETFs) are a type of index funds that track a basket of securities.||Mutual funds are pooled investments into bonds, securities, and other instruments that provide returns.||Stocks are securities that provide returns based on performance.|
|ETF prices can trade at a premium or at a loss to the net asset value (NAV) of the fund.||Mutual fund prices trade at the net asset value of the overall fund.||Stock returns are based on their actual performance in the markets.|
|ETFs are traded in the markets during regular hours just like stocks are.||Mutual funds can be redeemed only at the end of a trading day.||Stocks are traded during regular market hours.|
|Some ETFs can be purchased commission-free and are cheaper than mutual funds because they do not charge marketing fees.||Some mutual funds do not charge load fees, but most are more expensive than ETFs because they charge administrative and marketing fees.||Stocks can be purchased commission-free on some platforms and generally do not have charges associated with them after purchase.|
|ETFs do not involve actual ownership of securities.||Mutual funds own the securities in their basket.||Stocks involve physical ownership of the security.|
|ETFs diversify risk by tracking different companies in a sector or industry in a single fund.||Mutual funds diversify risk by creating a portfolio that spans multiple asset classes and security instruments.||Risk is concentrated in a stock’s performance.|
|ETF trading occurs in-kind, meaning they cannot be redeemed for cash.||Mutual fund shares can be redeemed for money at the fund’s net asset value for that day.||Stocks are bought and sold using cash.|
|Because ETF share exchanges are treated as in-kind distributions, ETFs are the most tax-efficient among all three types of financial instruments.||Mutual funds offer tax benefits when they return capital or include certain types of tax-exempt bonds in their portfolio.||Stocks are taxed at either ordinary income tax rates or capital gains rates.|
The ETF space has grown at a tremendous pace in recent years, reaching $4 trillion in invested assets by 2019. The dramatic increase in options available to ETF investors has complicated the process of evaluating which funds may be best for you. Below are a few considerations you may wish to keep in mind when comparing ETFs.
The expense ratio of an ETF reflects how much you will pay toward the fund's operation and management. Although passive funds tend to have lower expense ratios than actively managed ETFs, there is still a wide range of expense ratios even within these categories. Comparing expense ratios is a key consideration in the overall investment potential of an ETF.
Nearly all ETFs provide diversification benefits relative to an individual stock purchase. Still, some ETFs are highly concentrated—either in the number of different securities they hold or in the weighting of those securities. A fund that concentrates half of its assets in two or three positions may offer less diversification than a fund with fewer total portfolio constituents but broader asset distribution, for example.
ETFs with very low AUM or low daily trading averages tend to incur higher trading costs due to liquidity barriers. This is an important factor to consider when comparing funds that may otherwise be similar in strategy or portfolio content.
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.
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.
The Bottom Line
Exchange-traded funds, or ETFs, represent a cost-effective way to gain exposure to a broad basket of securities with a limited budget. Instead of buying individual stocks, the investor can simply buy shares of a fund that targets a representative cross-section of the wider market. However, there are some additional expenses to keep in mind when investing in an ETF.