What Is an Exchange-Traded Fund - ETF?

An ETF is a type of investment vehicle that pools together assets such as stocks, bonds, or commodities, and trades on a stock exchange like a single stock. ETFs can be designed to track a variety of assets, indices, or investment strategies. They operate similar to mutual funds, but can be bought or sold on the stock exchange throughout the trading day.

The SPY ETF was the first of its kind and tracks the S&P 500 Index. It is still actively traded today.

An ETF is called exchange-traded because it is traded on a stock exchange in a similar way to stocks. The price of ETF shares fluctuates throughout the trading day as they are bought and sold. In contrast, mutual funds are not traded on an exchange and only trade once per day at the market close. ETFs also tend to have lower costs and be more liquid than mutual funds.

An ETF is a type of investment vehicle that holds a variety of underlying assets, such as stocks, commodities, bonds, or a combination of these. This diversity of holdings makes ETFs a popular choice for investors seeking to diversify their portfolio. Unlike a single stock, an ETF contains multiple assets, which can include a mix of different investment types. An ETF is a type of financial security that can be easily bought and sold on a stock exchange throughout the day and can be sold short. In the United States, most ETFs are structured as open-ended funds and are regulated under the Investment Company Act of 1940, unless modified by subsequent rules.

Types of ETFs

There are various types of ETFs that can be used by investors for income generation, speculation, risk management, and portfolio diversification. Some examples of ETFs available in the market today include:

Passive and Active ETFs

ETFs can be classified as either passive or actively managed. Passive ETFs attempt to track the performance of a particular index, such as the S&P 500, or a specific sector or trend. For example, there are several ETFs that focus on gold mining companies, which aim to replicate the performance of this sector. Passive ETFs do not try to outperform the underlying index and typically have lower fees compared to actively managed ETFs. On the other hand, actively managed ETFs seek to outperform a benchmark index through the use of skilled portfolio management and security selection.

Actively managed ETFs are different from passive ETFs in that they do not aim to replicate the performance of a particular index. Instead, they have portfolio managers who make decisions about which securities to include in the fund. These types of ETFs tend to be more expensive for investors, but they may offer some benefits over passive ETFs, such as the potential for outperformance. Actively managed ETFs are discussed in more detail below.

Bond ETFs

Bond ETFs are investment vehicles that hold a portfolio of underlying bonds and are designed to provide regular income to investors. The income paid by these ETFs is dependent on the performance of the bonds they hold, which may include government bonds, corporate bonds, and municipal bonds. Unlike individual bonds, bond ETFs do not have a maturity date and their price may trade at a premium or discount to the value of the underlying bonds. Bond ETFs are often used by investors as a way to diversify their fixed income holdings and generate income.

Stock ETFs

Stock or equity ETFs are investment vehicles that hold a basket of stocks and are designed to provide diversified exposure to a particular industry or sector. For example, a stock ETF might track the performance of the automotive or foreign stock markets. The aim of these ETFs is to provide investors with a way to access a broad range of stocks within a specific industry, including both established and newer companies with potential for growth. Stock ETFs differ from stock mutual funds in that they generally have lower fees and do not involve ownership of the underlying securities. Instead, investors in a stock ETF own a share in the fund and receive a pro-rata portion of the profits or losses generated by the underlying stocks.

Industry/Sector ETFs

Industry or sector ETFs are investment vehicles that focus on a particular industry or sector of the economy. For example, an energy sector ETF might hold stocks of companies operating in the energy industry. These ETFs are designed to provide investors with exposure to the performance of a specific industry by tracking the performance of the underlying companies. The idea behind industry ETFs is to capitalize on the potential upside of the industry by investing in a diversified basket of stocks within that sector.

The technology sector is one example of an industry that has attracted a significant amount of investment through industry ETFs in recent years. These ETFs allow investors to gain exposure to the performance of the technology sector without the need for direct ownership of individual stocks. One advantage of investing in an industry ETF is that it can help to diversify the risks associated with investing in a single industry, as the ETF holds a basket of stocks rather than just one. Additionally, industry ETFs can be used by investors to rotate in and out of sectors based on economic cycles.

Commodity ETFs

Commodity ETFs are investment vehicles that hold a portfolio of commodities such as crude oil or gold. These ETFs offer several benefits to investors. First, they provide diversification to a portfolio, making it easier to hedge against market downturns. For example, investing in a commodity ETF can provide a cushion during a downturn in the stock market. Second, owning shares in a commodity ETF is generally cheaper than physically holding the commodity, as it does not involve the costs of insurance and storage. Commodity ETFs can provide investors with exposure to the performance of various commodities without the need for direct ownership.

Currency ETFs

Currency ETFs are investment vehicles that track the performance of currency pairs, which consist of a domestic and foreign currency. These ETFs serve several purposes. They can be used by investors to speculate on the prices of currencies based on political and economic developments in a particular country. Currency ETFs can also be used to diversify a portfolio or as a hedge against volatility in the forex markets by importers and exporters. Some currency ETFs are used to hedge against the risk of inflation. There are also currency ETFs that invest in bitcoin and other cryptocurrencies.

Inverse ETFs

Inverse ETFs are investment vehicles that aim to generate returns from stock price declines by using derivatives to short sell stocks. Short selling involves selling a stock with the expectation that its price will fall, and then buying it back at a lower price to profit from the difference. Inverse ETFs use derivatives, such as futures contracts or options, to achieve this short position. Essentially, these ETFs are bets that the market will decline, and they can be used by investors as a way to hedge against potential market downturns or to speculate on falling stock prices.

Inverse ETFs are designed to increase in value when the market declines. These ETFs use derivatives to achieve short positions in stocks and aim to profit from falling stock prices. It is important to note that many inverse ETFs are actually exchange-traded notes (ETNs), which are debt securities that trade like stocks, but are issued by banks and other financial institutions. ETNs do not hold any underlying assets and their value is based on the performance of an underlying benchmark or index. Investors should consult with their broker to determine if an ETN is suitable for their portfolio.

Leveraged ETFs

An leveraged exchange-traded fund (ETF) is a type of investment vehicle that aims to amplify the returns of the underlying assets it tracks. For example, a leveraged ETF that tracks the S&P 500 index might aim to provide two or three times the return of the index. This can be achieved through the use of derivatives such as options or futures contracts. There are also inverse leveraged ETFs, which aim to provide the opposite of the multiplied return of the underlying assets. For instance, if the S&P 500 index rises by 1%, a leveraged inverse ETF that aims to provide a -2x return on the index would lose 2%.

How to buy ETFs

Due to the availability of various platforms, investing in ETFs has become convenient for traders.ETFs can be purchased through many online investing platforms, retirement account providers, and investing apps such as Robinhood. Many of these platforms offer commission-free trading, which means you won't be charged fees by the platform provider when you buy or sell ETFs.

While commission-free trading may be available on some platforms, it's important to note that this doesn't necessarily mean that there will be no associated costs for accessing a particular ETF. Platforms can differentiate themselves based on factors such as convenience, services offered, and the variety of products available. For example, some smartphone investing apps make it easy to buy ETF shares with just a few taps on the screen. Other brokerages may require investors to complete paperwork or follow a more complicated process. Some well-known brokerages also offer a wealth of educational resources to help new investors learn about and research ETFs.

The key to successful ETF investing is thorough research. There is a wide variety of ETFs to choose from, and it's important to keep in mind that ETFs are different from individual securities like stocks or bonds. To find the right ETF for you, it's essential to conduct research and consider your investment goals and risk tolerance. 

When choosing an ETF, it's important to consider the broader context, including the sector or industry. During the research process, you may want to consider the following questions:

• What is your time frame for investing?
• Are you investing for income or growth?
• Are there particular sectors or financial instruments that excite you?

If you are new to investing in ETFs, it may be helpful to use a strategy called dollar-cost averaging. This involves investing a fixed amount of money at regular intervals over a period of time. This can help smooth out returns and ensure a disciplined approach to investing, rather than making haphazard or volatile decisions.

Dollar-cost averaging can also be a good way for beginner investors to learn about the intricacies of ETF investing. As investors become more comfortable with trading, they may choose to move on to more advanced strategies such as swing trading and sector rotation.

Online Brokers vs. Traditional Brokers

ETFs can be traded through online brokers and traditional broker-dealers. Investopedia has a list of the top brokers for ETFs if you're looking for some options. ETFs can also often be purchased through retirement accounts. Another option is to use a robo-advisor such as Betterment or Wealthfront, which use ETFs extensively in their investment products.

A brokerage account enables investors to buy and sell shares of ETFs in a similar way to buying and selling stocks. Active investors may prefer to use a traditional brokerage account, while those who want a more passive approach may opt for a robo-advisor. Robo-advisors often include ETFs in their portfolios, although the specific ETFs or stocks included in the portfolio may not be selected by the investor.

What to Look for in an ETF

After setting up a brokerage account, investors need to fund the account before they can start investing in ETFs. The specific methods for funding a brokerage account will depend on the broker. Once the account is funded, you can search for ETFs and make trades in a similar way to buying and selling stocks. One way to narrow down your options is to use an ETF screening tool offered by many brokers, which allows you to filter through the thousands of ETFs based on criteria such as:

• Volume: Trading volume can be used to compare the popularity of different funds and can affect the ease of trading the fund.
• Expenses: The expense ratio is the percentage of your investment that goes towards administrative costs. Lower ratios may be more desirable, but higher-priced options with strong performance may be worth considering.
• Performance: Past performance, while not necessarily indicative of future results, can be a useful metric for comparison.
• Holdings: The holdings of a fund can be evaluated using screener tools to compare the different portfolios of potential ETF investments.
• Commissions: Some ETFs may have commissions associated with trading them, so it is important to check if this is a potential deal breaker.

Examples of Popular ETFs

There are many popular ETFs available on the market, including those that track broad indices, such as:

• SPDR S&P 500 (SPY): Tracks the S&P 500 Index.
• iShares Russell 2000 (IWM): Tracks the Russell 2000 small-cap index.
• Invesco QQQ (QQQ): Tracks the Nasdaq 100 Index, typically containing technology stocks.
• SPDR Dow Jones Industrial Average (DIA): 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, including China (MCHI), Brazil (EWZ), Japan (EWJ), and Israel (EIS). Some also track emerging market economies (EEM) and developed market economies (EFA).

Advantages and Disadvantages of ETFs

One of the benefits of investing in ETFs is their lower average costs compared to buying individual stocks. This is because it would be expensive for an investor to purchase all the stocks held in an ETF portfolio individually. ETFs allow investors to make fewer trades and pay fewer broker commissions, as they only need to execute one transaction to buy and one transaction to sell.

Investors typically have to pay a commission to their broker for each trade. However, some brokers offer no-commission trading on certain low-cost ETFs, which can help to reduce costs for investors.

An ETF's expense ratio is the percentage of the fund's assets that goes towards operating and managing the ETF. Many ETFs, especially those that track an index, have low expenses because they are passively managed. For example, an ETF that tracks the S&P 500 Index might contain all 500 stocks in the index, requiring less time and effort to manage. However, not all ETFs are passively managed, and these may have higher expense ratios.

Pros

• Access to numerous stocks across industries
• Reduced expense ratios and broker commissions.
  
• Managing risk through diversification
  
• There are ETFs that concentrate on specific industries.
  

Cons

1. Actively managed ETFs incur greater expenses.
2. Single-sector ETFs restrict diversification.
   
3. Insufficient liquidity impedes transactions
   

There are also actively managed ETFs, in which portfolio managers are more involved in purchasing and selling company shares and altering the fund's holdings. Actively managed funds are typically associated with a higher expense ratio than passively managed ETFs.

To determine whether an ETF is worth holding, investors must determine how the fund is managed, whether it is actively or passively managed, the resulting expense ratio, and the costs relative to the rate of return.