Takeaways
- ETFs are investment securities that provide diversification to your portfolio.
- ETFs can be bought and sold on any major exchange like individual stocks.
- ETFs offer transparency to investors because you can easily see ETF holdings.
- ETFs come in many varieties catering to different investment preferences and risk appetites.
- ETFs differ from mutual funds in management style, trading liquidity, fees, and more.
What is an Exchange-Traded Fund (ETF)?
An Exchange-Traded Fund, or ETF, is an investment security that tracks the performance of an index, sector, commodity, or asset. A share of an ETF represents a claim to the basket of underlying assets making up the ETF. Unlike other pooled investments, such as mutual funds, ETFs can be bought and sold on any major exchange, just like individual stocks.
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Investing in an ETF is like investing in a micro-portfolio with one purchase. An ETF portfolio holds a range of assets based on the fund’s objectives. For example, some ETFs focus on large market capital companies, while others concentrate on high-yielding bonds. What attracts investors to invest in ETFs is that an ETF provides diversity to your portfolio in one fell swoop. An ETF allows you to buy, manage, and sell those shares efficiently.
ETFs gained popularity and momentum in the 1990s and have taken off as bedrock investments in Traditional IRAs, Roth IRAs, 401(k) plans, and online stock brokerage accounts. ETFs offer investors a fresh and flexible way to quickly inject diversity into portfolios, making it easy for new and experienced investors to gain exposure to a broader array of asset classes.
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How Does an ETF Work?
You’re probably wondering how an ETF works, so let’s break it down. First, an ETF is created by a fund manager who identifies an index or a set of assets to track. Usually, the fund manager has a high level of experience investing in this asset class. For example, a fund can focus on growth stocks, high-yield dividend stocks, corporate bonds, or high-yield bonds.
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The fund manager then pools capital from investors to buy the underlying assets. The manager then packages this pool of assets and splits it into shares that you (as the investor) can buy and sell on an exchange. If you can’t afford a whole share of an ETF, that is not a problem. Many ETFs offer fractional shares, where you can buy a partial share.
The idea with an ETF is that you are purchasing a slice of a big investment, where all the component assets make up the investment. You are not buying all the shares of everything in the fund. Instead, you are exposed to the whole fund's performance.
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Investments like mutual funds get priced at the end of each trading day, but since ETFs are exchange-traded, their market value fluctuates throughout the trading day according to the supply and demand of the market. You can buy or sell shares of ETFs anytime during trading hours like you would with stocks. Since the pricing and trading occur in real-time, the fund manager and you can respond quickly to significant market changes.
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Finally, ETFs offer a crucial transparency benefit. Instead of having opaque access and wondering what is in the ETF portfolio, you can easily see what assets ETFs hold. Access to fund holdings allows you to see the changes fund managers make so that you can make an informed decision.
5 Common Types of ETFs
There are many classes of ETFs, and finding the right one can significantly impact your overall investment results. Let’s look at five of the most popular types of ETFs, how they differ from each other, and what they can offer to your investment journey.
Stock ETF
These funds invest in a range of stocks, often tracking a specific index like the S&P 500 or Dow Jones. One of the best things about a stock ETF is that it has baked-in diversification, and instead of betting on individual stocks, you get a slice of a broader market. Instead of investing in individual stocks, you can spread your investment capital around, catching the rising tide.
Commodity ETF
Commodity ETFs offer a path to investing in physical goods like gold, oil, or agricultural products. This type of ETF can be a smart move for diversifying your portfolio with assets that are less directly coupled to the market or act as an investment hedge against inflation.
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Instead of owning the physical goods themselves, an ETF allows you to track the performances of select commodity classes. Exposure to commodities holds a place in any well-diversified investment portfolio.
Sector ETFs
By investing in a sector ETF, you are betting on the performance of that sector. Sector ETFs can be a powerful tool for capitalizing on trends or industries you believe are poised for growth and often include companies ranging in size from small to mega capitalization companies.
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For example, if you are very bullish on the biotechnology sector, instead of buying stocks in individual biotechnology companies, you can buy a biotechnology ETF. This biotechnology ETF gives you exposure to a basket of the best companies.
Bond ETFs
Bond ETFs are your gateway to the world of fixed income. Bond ETFs invest in an assortment of bonds, including corporate, municipal, and government. Bond ETFs fit in your portfolio if you want to build a steady income stream or balance out some of the risk created by other portions of your portfolio.
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Leverage ETFs
Leveraged ETFs are very high-risk and use derivatives and debt to amplify the returns of a specific underlying asset or index. Leveraged ETFs attempt to return specific multiples of the daily performance of the index they track. For example, if the index increases by 1%, a 2x leveraged ETF increases by 2%. Leveraged ETFs are best used in high-volatility markets.
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Pros and Cons of ETFs
As with any investment, there are advantages and disadvantages to investing in a particular security. The best type of investment is one that aligns with your overall investment strategy, risk profile, and investment time horizon. Here are several pros and cons of investing in an ETF.
Pros of Investing in ETFs
- Focused Diversification: One of the biggest advantages of ETFs is being able to diversify while maintaining a focus on a sector or industry. With just one ETF, you're spreading your investment across various assets, reducing your risk compared to investing in a single stock.
- Flexibility and Liquidity: ETFs trade like stocks, offering the flexibility to buy and sell shares throughout the trading day. This liquidity is a big plus, especially if you need to make quick investment decisions.
- Lower Fees: Generally, ETFs have lower expense ratios compared to mutual funds. This means you are paying less in management fees, leaving more of your money to grow.
- Transparency: ETFs typically provide daily disclosure of their holdings, so you always know what you're invested in.
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Cons of Investing in ETFs
- Market Risks: Even though ETFs are managed by some of the leading investment firms in the world, like any other asset coupled with the stock market they are subject to risks.
- Potential for Overtrading: Since ETFs are so easy to trade, there is the risk of overtrading, which can lead to elevated costs and negative tax effects.
- Tracking Error: Not all ETFs track their assets perfectly, which can lead to lower correlation and cause actual performance to differ significantly from the asset group they are trying to mirror.
- Complexity in Certain Types: Most ETFs are straightforward, but some, like inverse ETFs or leveraged ETFs, can be more complex or come with elevated risks that take them outside of your investment strategy.
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ETF vs. Mutual Fund
Most finance professionals say that choosing between investing in an ETF or a Mutual Fund is a matter of degrees. However, there are serious differences between each investing approach. Both offer terrific opportunities to add diversity to your portfolio, just how they go about doing that makes all the difference. Here are the major ways that ETFs differ from mutual funds.
- Management Style: ETFs are often passively managed, which means they are not designed to beat the market by instead tracking an index like the S&P 500. This passive approach generally leads to lower fees. On the other hand, mutual funds are often actively managed by fund managers who handpick investments to beat the market, which can result in higher expense ratios and higher returns.
- Trading Liquidity: ETFs trade like stocks, which gives you the benefit of buying and selling shares at market price throughout the trading day. This contrasts with mutual fund shares, which are priced at the end of each trading day based on the net asset value. This difference means ETFs offer more liquidly, allowing you to move in and out of your position quickly.
- Fees and Expenses: ETFs typically have lower expense ratios than mutual funds, partly due to their passive management style. ETFs also have the added benefit of low or no minimum investment amount, which makes them more accessible to beginner investors. Mutual funds often require a high minimum investment and may charge sales loads or other fees. For example, the Vanguard 500 Index Fund Admiral Shares (VFIAX) has a $3,000 minimum investment, whereas the Vanguard S&P 500 ETF (VOO) can be bound for the ETF share market price ($437.99 as of 1/12/2024)
- Tax Efficiency: ETFs are generally more tax-efficient than mutual funds. Their unique structure allows investors to buy and sell shares without triggering capital gains taxes, a feature particularly attractive for those in higher tax brackets.
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Smart Summary
Investments in ETFs provide your portfolio exposure to many asset classes that can help diversify your holdings and increase your overall investment returns. Determining if an ETF is best for you depends on what type of investor you are and your overall financial goals. An ETF might be the perfect match for more active traders seeking tax efficiency.
