What is an Exchange Traded Fund (ETF)?

Investing
Updated: 15th Jan 2021
Written by Sean Graytok
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Exchange traded funds (ETFs) are loved by those learning how to start investing and experienced investors.

Traditionally, ETFs provide investors with diversification, peace of mind, and healthy returns. Find out what an ETF is, how they work, and whether you should invest in one or not.

What is an ETF?

An exchange-traded fund (ETF) is a basket of securities that typically track an index, such as the S&P 500 or Nasdaq Composite.

ETFs have all the good qualities of mutual funds without the account minimums or high management fees. They are available on exchanges and trade just like stocks.

There has been a massive shift into Exchange Traded Funds since the 2008 financial crisis. Investors realized that their mutual funds couldn’t protect them on the downside, even though they were paying high fees for active management.

Why pay advisors to manage a fund when you can invest in an ETF that nets better return and fewer fees? Let’s continue to explore the magic of Exchange Traded Funds.

Next Steps: Best Online Stock Brokers

How does an ETF Work?

An ETF provider, such as iShares or Vanguard, selects individual securities to put in the exchange-traded fund they’re creating.

The provider determines the type of weighting for the ETF: market-cap weighted, equal-weighted, or fundamental weighted.

The most common is the market-capitalization weighting, where the stocks with the highest market-caps will have a higher allocation in the fund.

Investors can buy shares of that fund just like they’d buy individual stocks. ETFs have their own unique ticker, which is sometimes comical like ProShares Pet Care ETF “PAWZ.”

Furthermore, investors buy and sell the ETF during trading hours on an exchange and the price of the fund changes throughout the day.

Different Types of ETFs

ETFs, combine the trading qualities of stocks with the holding structure of mutual and index funds. The underlying holdings of the fund determine the “type” of the ETF.

The following list shows the different kinds of exchange-traded funds. Note that the classifications are not mutually exclusive, considering that individual stocks compose Stock ETFs, Thematic ETFs, Industry ETFs, and International ETFs.

Stock ETFs

This is a broad category of ETFs where many different kinds of stocks can be under the same roof.

For example, the S&P 500 is composed of several different sectors of stocks, such as technology, consumer staples, and energy.

Stock ETFs can provide diversification that protects investors when a certain industry gets smashed.

Moreover, energy could be getting killed, but you may still be in the green if technology and financials are rising.

Industry ETFs

Industry ETFs – also known as Sector ETFs – are baskets of funds specific to an industry, such as technology, healthcare, or financials. These ETFs allow investors to bet on specific sectors that may be ripe for growth.

While the S&P 500 provides exposure to all 11 industries, this type of ETF enables Investors to pick and choose the industries they’re bullish on.

This feature comes at a price as expense ratios are typically higher than broad market benchmarks.

Learn More: Sector ETFs 

Bond ETFs

Bond ETFs are often considered lower risk than stock ETFs because they are less volatile. Additionally, the bond ETF does not have a maturity date like individual bonds. Investors rely on bond ETFs for regular cash payments and protection during high market volatility.

Recently, bonds have become less desirable due to interest rates being near zero. Historically, capital flows into stocks and out of bonds when interest rates are low.

Commodity ETFs

Commodities are bulk goods and raw materials, such as grains, oil, and metals. While they are a good way for investors to diversify their portfolio, commodities are vulnerable to many unpredictable variables such as strange weather patterns, pandemics, and man-made or natural disasters.

Before Commodity ETFs, investors had to buy futures contracts or trade options to gain exposure to commodities. You can even buy a Water ETF from Invesco to stay hydrated!

International ETFs

Another way to diversify your U.S. exposure is to allocate money abroad in international stock or bond ETFs. Some of these funds include a mix of U.S. and international companies, while others are solely international.

There is certainly a home-team bias when it comes to investing, but investors will miss out on gains if they only invest within their borders.

Inverse ETFs

Inverse ETFs enable investors to bet against the market or an underlying index without having to short the stock. These funds are composed of various derivatives to profit when the underlying benchmark declines in value.

For example, an investor predicts that the S&P 500 is overvalued and is due for a correction. He purchases shares in ProShares Short S&P 500 (SH) and will profit if the S&P takes a dip.

Currency ETFs

A Currency ETF tracks the relative value of a currency or a basket of currencies.

Similar to commodities, investors may use Currency ETFs to get exposure to markets that otherwise would be intimidating to navigate. Investors often use currency ETFs to hedge against exchange risks.

For example, if you have exposure to an Australian ETF but want to hedge your exposure, you may short Australia’s currency relative to the dollar through Invesco’s CurrencyShares Australian Dollar Trust (FXA). These currency ETFs equip investors with instruments to create a more robust portfolio.

Leveraged ETFs

These are aggressive ETFs that use leverage to provide multiple times with the return of the index they track. For example, TQQQ, or “Triple QQQ,” is 3X leveraged to deliver three times the daily return of the Nasdaq 100 Index (QQQ).

So, if the Nasdaq goes up by 2% today, TQQQ will go up 6%. However, losses are also amplified by three as well.

Benefits of ETFs

Investors flocked to ETFs for a good reason! Let’s discuss a few:

Instant Diversification

Diversification is a healthy part of any portfolio, and ETFs make it easier than ever to diversify.

As we showed in the previous section, there are many types of ETFs to accommodate any investing strategy. The shift into passive funds sparked demand, and the ETF providers responded with the supply.

Now, instead of just an “International ETF,” there are specific kinds such as developed, emerging, and frontier international ETFs that apply down to the country. There are levels to diversification! More on that later.

No Minimum Investment

ETFs’ cousin, the Mutual Fund, often requires minimum deposits between $3,000-$10,000 to begin investing. Since ETFs trade like stocks, there’s no gatekeeper to keep you from putting your money to work!

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Lower Costs

On top of mutual funds’ minimum ante, they require high management fees because they are actively managed. This means that you will pay somewhere between 1%-2% for an advisor’s oversight on the fund.

ETFs are passively managed, so their fees are much lower compared to their actively managed counterparts.

Depending on the type of ETF, annual expense ratios can be as little as 0.03 (VOO). This means that you will pay the brokerage $3 annually for every $10,000 you have in the fund.

Liquidity

Since ETFs trade like stocks on an exchange, they can be bought and sold intraday. They have real-time pricing, unlike mutual funds that reveal their price at the end of the trading day.

Having liquidity may give investors peace of mind during times of high volatility.

Tax Benefits

Owners of ETFs control when they execute taxable events, which typically occurs only at the sale.

When funds are exchanged within the ETF by its provider, only shares are transacted and never cash. This allows ETFs to avoid capital gains tax when securities are redeemed or created.

Owners of mutual funds are subject to their advisor’s priorities and not in complete control of when taxable events occur.

Downsides to ETFs

While their advantages outweigh their disadvantages, it is still important to understand the shortcomings of ETFs and how to mitigate their downside.

Too Much Diversification?

While some investors welcome the multi-sector diversification of large index funds, others don’t want to be weighed down by underperforming industries.

Investors with a higher risk tolerance may try to maximize their gains by choosing the individual stocks or sectors that lead the index.

Finding the right balance of diversification is key to optimizing your portfolio. Learn more on asset allocation here.

Infrequent Rebalancing

ETFs track indexes that are often market-cap weighted. This means that the stocks that rise in price carry more weight in the index, resulting in too much exposure to particularly overvalued stocks and not enough allocation to undervalue bargain stocks.

Again, some may see this as a benefit because they benefit from the winners, and they get less exposure to the losers. However, this may violate their initial reason for getting into ETFs: diversification.

Learn More: Small Cap vs Large Cap Stocks

How to Invest in ETFs (Our Recipe)

#1. Choose a Broker

You can start your ETF journey with several different brokerages, but some are more limited in their ETF offerings than others.

We recommend Vanguard, also known as the pioneer of passive investing!

Vanguard’s founder, Jack Bogle, bet on passive investing and introduced the first index fund available to retail investors in 1976.

At the time, this fundraised $11 million in its initial underwriting. Today, the Vanguard S&P 500 Index manages more than $560 billion in assets.

#2. Fund Your Account

It is easy to connect your bank to Vanguard and start investing. Their security protocols give investors peace of mind.

#3. Purchase your ETFs

Vanguard offers a suite of low-cost ETFs that will satisfy most investors. They offer plenty of resources on their website and mobile app so investors can do their homework on a specific ETF before purchasing.

How to Pick Your ETFs

Start by asking yourself, “Why am I investing in ETFs?” Are you seeking diversification? Are you looking to bet on the growth of a specific industry or country?

The answers to these questions will direct your early investment decisions. Remember to consider an ETFs expense ratio as they can vary from .03% to more than .75%. Depending on the amount of capital you’re investing, these ratios can add up!

ETFs vs Mutual Funds

We touched on the differences between mutual funds and ETFs in the “Pros” section of this article, but let’s iron some of them out:

  • They passively track index funds while mutual funds are actively managed.
  • ETFs have lower management fees than mutual funds.
  • Exchange-Traded Funds do not have account minimums like mutual funds.
  • ETFs can be bought and sold intraday while mutual funds can only sell at the end of the trading day.
  • They have real-time price quotes while mutual funds update their prices at the close.
  • Exchange Traded Funds are more tax-efficient than mutual funds due to their structuring, which enables them to avoid some taxable events that mutual funds cannot avoid.

ETFs vs Stocks

ETFs and stocks are closely related, considering most exchange-traded funds are composed of individual stocks. The pros and cons of each are largely determined by the goals of the investor.

Some argue that a small number of stocks within an ETF do most of the heavy lifting and it’s better to individually own them compared to the entire index.

The counter argues that having exposure to stocks that haven’t yet rallied is worth it. This balance enables investors to benefit from the established winners without missing out on the stocks of the future.

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Bonus Insight: Thematic ETFs

This information could be included in the “Types of ETFs” earlier in the article, but it is worthy of its own section.

While thematic ETFs are just another kind of stock ETF, they present some exciting opportunities for investors!

The wave of indexes has resulted in more and more granular ETFs. Initially, we just had the broad market S&P 500 Index.

Then, we could choose specific industries within the S&P. Now, thematic ETFs allow us to pick subsections within an industry.

For example, you’re predicting that technology has more room to run in the next decade. But you want to make a more granular bet. You decide that of the many fields that compose the tech sector, cloud computing specifically will lead the charge.

Unfortunately, there are too many cloud companies to pick from, and you’re not sure which individual stock will come out on top.

Luckily, you can invest in a cloud-specific ETF that allows you to make a bet on the sub-sector without having to put all your eggs into one basket.

There are levels to diversification! Thematic ETFs walk the fine line of risk-to-reward that many investors seek. Obviously, there’s a catch.

Thematic ETFs often come with much higher expense ratios than general ETFs. Annual expense ratios on thematics are typically in the range of 0.5 to .75.

ETF providers have gotten creative with these instruments, and we may be in the bottom of the first inning when it comes to their development.

For example, the “White Girl Index” first surfaced on Reddit in 2018 and has since been tracked by M1 Finance. The index has holdings in Starbucks, Lululemon, Netflix, and Target, among others, and is up more than 140% since its inception.

The opportunities are endless with the ever-shifting landscape of media. For example, imagine iShares partners with a social media influencer that has 50 million followers.

The influencer’s interests are captured in the holdings of the fund and trades under its own unique ticker.

Talk about activist investing! The influencer funnels millions of novice investors into their fund at the great satisfaction to iShares.

Bottom Line: Exchange Traded Funds

ETFs are a useful instrument for any dynamic portfolio. They allow you to execute strategic plays in the market without casting diversification to the curb.

Today, exchange-traded funds remain a fan favorite amongst both new and experienced investors. They are relatively safe and offer immediate diversification.

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Sean Graytok
Sean Graytok
Sean is a lifelong student of the financial, media, and marketing industries. He is a Generation Z investing expert and is on a mission to empower investors to make the most of their money.