What Is an Exchange-Traded Fund, or ETF?
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Exchange-traded funds (ETFs) are baskets of securities such as stocks or bonds that can be traded throughout the day on an exchange like a stock. Because ETFs hold hundreds, or even thousands, of different securities, buying ETF shares can be a cheap and easy way to instantly build a diversified investment portfolio.
Most ETFs are index funds — merely aiming to deliver returns that match those of the overall market, or a certain slice of it — so ETFs tend to have lower investment management fees than traditional mutual funds. What’s more, since most major brokerages now offer free stock trading, you don’t need to pay commissions when you trade ETFs either. Read on to learn all about ETFs and how they may benefit your portfolio.
- What is an Exchange-Traded Fund (ETF)
- How Do ETFs Work?
- Types of ETF
- How to Invest in ETFs
- Exchange-Traded Funds FAQ
What is an ETF?
An ETF invests in assets like stocks, bonds or commodities. Unlike mutual funds, ETFs trade on a stock exchange like a stock. Therefore, an ETF's price can change throughout the day, as opposed to a mutual fund’s price, which is set at the end of each trading day.
How do ETFs Work?
ETFs typically track the performance of a particular stock- or bond-market benchmark, like the S&P 500, Russell 3000, or Bloomberg US Aggregate Bond Index. Other ETFs track commodity prices by owning futures contracts or even physical commodities like gold. You can buy ETF shares through a brokerage or investing app in the same way you would buy stocks.
ETFs trade on exchanges like the New York Stock Exchange (NYSE), just as individual stocks of companies do. The investment returns of an ETF depend on the performance of the underlying assets held by the ETF.
- Instant diversification
- Generally lower fees than mutual funds
- Commission-free trades through most brokerages
- Actively managed ETFs tend to have higher fees than their passively managed counterparts
- Some ETFs track narrow or even gimmicky slices of the stock market and can be more volatile than the broader market
- ETFs that promise leveraged or inverse market returns are volatile, complex and can be dangerous for small investors
Types of ETFs
Stock ETFs are a convenient way to buy a basket of stocks, without having to purchase hundreds of individual securities. Many popular stock ETFs like the SPDR S&P 500 ETF Trust and others tracking benchmark indexes like the Russell 3000 or the MSCI EAFE (a popular market index of foreign stocks) own thousands of names, while others are more narrowly focused on a particular industry. While most stock ETFs are index funds, which aim to merely deliver market returns, a growing number are run by active managers who try to select winning stocks. Actively managed ETFs tend to have higher fees than their passively managed counterparts. The average net expense ratio for actively managed ETFs is 0.71% as opposed to 0.51% for passive funds, according to the investment research firm Morningstar. You can find an ETF’s expense ratio in the fund's prospectus, available online or through your brokerage account. The fund prospectus also outlines the fund’s investment objectives.
Bond ETFs own fixed-income investments such as corporate bonds and U.S. Treasury securities. Like stock ETFs, most bond ETFs track market benchmarks such as the broadly focused Bloomberg U.S. Aggregate Bond Index. Since bonds tend to be less volatile than stocks, many investors, especially those close to retirement, tend to own bonds to make their portfolios less risky.
Industry ETFs invest in the stocks of companies in specific industries such as healthcare, energy or biotechnology. Examples include the Materials Select Sector SPDR Fund. Also called sector ETFs, industry ETFs benefit when these industries are booming, but can lag far behind the rest of the stock market when they struggle.
While most ETFs aim to deliver returns that match those of a swath of the stock or bond markets, a growing number of funds employ portfolio managers who try to pick winning stocks, hopefully delivering returns that beat the rest of the market. While that’s an appealing prospect, these funds tend to charge higher investment fees, and research has shown professional investors rarely deliver market-beating returns after fees are taken into account. But if you want to take a stab at active ETF investing, here’s a list of active ETFs with the largest total net assets as of 1/31/2022, according to research by Morningstar Direct.
Commodity ETFs track the prices of physical goods such as wheat or oil. In some cases, ETFs don’t own these physical assets, but instead invest in futures contracts backed by these commodities. Some commodity ETFs focus on one commodity, while others such as the Invesco DB Commodity Index Tracking Fund follow the prices of several commodities like oil, corn and zinc, a precious metal. Because some futures contracts expire every month, commodity futures ETF returns don’t always match those of the commodity they target.
Currency ETFs track the price of a specific country’s currency or a basket of different currencies such as the dollar, yen and pound. Also called forex ETFs, some currency ETFs are backed by bank deposits of foreign currencies, while others are tied to derivative contracts that lock in the exchange rate of a certain currency. Sophisticated traders use currency ETFs to speculate on foreign exchange rates. But currency prices can be hard to predict, since they are impacted by dozens of financial and political factors, ranging from interest rates to trade imbalances to political unrest.
Inverse ETFs are designed to move in the opposite direction of a target stock or bond index, typically over a defined period such as one day. So if the S&P 500 declines by 3% on a particular day, an S&P 500 inverse ETF would be designed to rise by 3%. Some inverse ETFs even aim to multiply this return, rising, say, 6% on a day the market is down 3%. Inverse ETFs, which achieve their aims using futures contracts, are some of the most complicated investments available on the market and generally not recommended for individual investors. While inverse ETFs typically promise to rise when the stock market falls over a single day, over longer periods fund returns can vary widely from the inverse return of the target index, depending on the market’s volatility.
How to Invest in ETFs
You can invest in ETFs with just a few clicks through a trading platform or robo-advisor. Here’s a step-by-step guide on how to invest in ETFs.
- Open a brokerage or robo-advisor account: You can sign up for a brokerage account online within minutes and begin trading ETFs. If you’re using a robo-advisor, you’d likely answer a few questions about your goals and finances and an algorithm would recommend a portfolio with multiple low-cost ETFs.
- Select ETFs: Many brokerages offer screeners that help you filter ETFs by criteria such as expense ratios, indexes, sectors and more. If you already know the ticker or name of the ETF you want to buy, simply look it up in the search bar.
- Buy ETFs: Once you decide on an ETF, decide the number of shares you want to buy or how much money you want to invest in it and place your order with a few clicks. You can choose a market order, which allows you to purchase the ETF at the current market price. Or you can place a limit order, which means you set a price and the trade is executed if the ETF reaches that price.
Are ETFs a Good Investment?
ETFs have become immensely popular over the past decade with everyone from institutional investors to retirement savers because they are a fast, cheap and convenient way to build a diversified portfolio of stocks and bonds.
Because ETFs offer exposure to hundreds or even thousands of securities, owning an ETF (or a small handful) is an easy way to build a well-rounded investment portfolio with a single purchase.
Most ETFs are index funds, so they tend to have low investment fees. With many brokerages offering commission-free stock trades, ETFs are also free to buy and sell.
While traditional index mutual funds offer many of the same advantages as ETFs, traditional mutual funds can only be bought or sold once a day, unlike ETFs that can be traded whenever the stock market is open. ETFs also have some tax advantages that make it easier for them to avoid saddling investors with unwanted capital gains tax bills.
Of course, because an ETF’s investment performance is tied to the performance of the stocks and bonds the ETF owns, ETFs can be volatile and investors can lose money if, for instance, the stock market declines.
How are ETFs taxed?
When you sell an ETF for more than you purchased it for, you may owe capital gains tax on your profits. If you owned the ETF shares for less than a year, these profits are taxed at the same rates as your ordinary income. If you held the fund shares for longer than one year, you will be taxed at more favorable capital gains rates. (The federal rate is 15% for most middle-income households.)
In some cases, investors may owe capital gains tax, even without selling ETF shares, based on distributions of the fund’s own stock or bond trades. However, this is comparatively rare, and funds strive to avoid it.
In addition to capital gains tax, stock market ETF investors may owe taxes on dividends (even if they are reinvested) and bond market investors owe tax on interest paid. Most stock ETF dividends are “qualified” and taxed at similar rates to capital gains. Bond interest is typically taxed like income, except for interest paid by municipal bonds, which usually is not subject to federal income tax.
Commodity, currency and precious metals ETF investors face different ETF tax rules.
How to evaluate ETFs
With thousands of ETFs available, it can be difficult to find one that meets your investment philosophy. So consider these points before buying an ETF.
- Choose your investment strategy: Passively managed ETFs tend to have lower expense ratios than actively managed ETFs. The former are supposed to outperform the market, but studies show this is difficult even for professional fund managers.
- Use an ETF screener online or through your brokerage account to find ETFs based on your preferences on things like benchmark index, fees, industry sectors, etc.
- Look for an expense ratio you’re comfortable with. An expense ratio is the management fee the fund charges. So if you invest $10,000 in an ETF with an expense ratio of 0.03%, your fees are $3 per year (typically deducted in fractions on a quarterly basis from your account). Betterment’s Head of Investing Mychal Campos says a basic portfolio should aim for an overall expense ratio of 0.15% to 0.22%.
- Check its liquidity: It may benefit you to make sure the ETF you’re investing in has been around for several years and has several hundred million dollars in assets. Campos also recommends checking the bid-and-ask spread (the difference between prices at which you can and buy and sell). Ideally, he says it should not be more than three cents.
ETFs vs Mutual Funds
Both ETFs and mutual funds invest in a variety of assets such as stocks or bonds. However, an ETF trades on a stock exchange like a regular stock and its price can fluctuate throughout normal trading hours. A mutual fund sets its price or net asset value (NAV) once a day based on the market’s 4 p.m. closing price. Here are some basic points to compare when considering mutual funds vs index funds.
|Fees||Expense ratios||Expense ratios|
|Investment management fee (if bought through financial advisor)||Brokerage platform fees (if bought through a broker-dealer)|
|Bid/ask spreads||Investment management fee or load (if bought through financial advisor)|
|Investment Minimums||One share of an ETF (or a fractional share if allowed by brokerage)||Some mutual funds require investment minimums anywhere from $500 to $5,000|
|Where to buy||Through online brokerage accounts||Directly from a mutual fund company, in a 401(k), or brokerage mutual fund store|
|Liquidity||You can redeem ETF shares throughout the day.||Buy and sell once a day|
|Tax efficiency||Special mechanism to avoid recognizing capital gains.||More likely to distribute capital gains to holders|
|401(k)s||Not typically available through most plans||Generally available through most plans|
|Investment strategy||Mostly index funds||Mix of index and active funds|
How do ETFs make money?
ETFs make money by investing in assets such as stocks or bonds. ETF investors make money when assets within the fund such as stocks grow in value or pass on profits to investors in the form of dividends or interest.
Exchange Traded Funds FAQ
How do ETFs work?
While ETFs are simple for investors to use, their mechanics are complicated. Because ETFs trade through the day like stock, ETFs don’t guarantee investors will always be able to buy in at prices that match the value of the ETF’s holdings. But unlike, closed-end funds which can trade at significant premiums or discounts to their underlying securities, ETFs rarely deviate by more than a few pennies.
That’s because ETF providers allow institutional investors (known as authorized participants), such as broker-dealers, to buy a basket of securities (known as a creation unit) that matches a slice of the ETF's holdings and exchange it with the ETF issuer for ETF shares. This arbitrage opportunity means any price premiums or discounts are quickly eliminated.
How Many ETFs Are there?
By 2020, there were more than 2,000 ETFs on the market, according to the Investment Company Institute, a trade group. That’s about 500 more than there were in 2019. Some recently-launched ETFs focus on “gimmicky” sectors of the market. For instance in 2021, investors were introduced to meme stock ETFs, which invest in stocks that receive plenty of chatter on social media channels and forums like Reddit’s WallStreetBets. In 2022, investors saw “metaverse” ETFs that invest in companies embracing web 3.0. The popularity of cryptocurrency has also raised the prospect of Bitcoin ETFs, although so far the SEC has yet to allow one.
ETF providers "just throw fistfuls of spaghetti at the wall,” says Ben Johnson, director of global exchange-traded fund research for Morningstar. “And investors should be aware of the fact that they are playing the role of the wall in this scenario.”
ETFs in the U.S. can trace their roots back to 1993, when the SPDR S&P 500 ETF Trust was launched. It remains the largest ETF with more than $455 billion in assets under management, according to the ETF Database, an ETF research and analytics provider.
What is the difference between a mutual fund and an ETF?
Unlike a mutual fund, the price of an ETF can change throughout the day. A mutual fund’s price is set once at the end of each trading day. Mutual funds have been around since the 1920s, while the first ETFs were launched in the 1990s.
Do ETFs prices match the price of their holdings?
While ETFs are simple for investors to use, their mechanics are complicated. Because ETFs trade through the day like stock, ETFs don’t guarantee investors will always be able to buy in at prices that match the value of the ETF’s holdings. But unlike, closed-end funds which can trade at significant premiums to their underlying securities, ETFs rarely deviate by more than a few pennies.
That’s because ETF providers allow institutional investors like broker-dealers known as authorized participants to buy the ETFs to buy a basket of securities (known as a creation unit) that matches those of the ETF and exchange it with the ETF issuer for ETF shares. This arbitrage opportunity means any price premiums or discounts are quickly eliminated.
How to buy ETFs?
To buy ETFs, you need to open an investing account through a brokerage like Fidelity or Robinhood. After you’ve funded your account with a linked checking account, you can begin buying ETF shares.
What are the benefits of investing in an ETF?
The benefits of investing in an ETF include instant diversification, generally low fees compared to mutual funds and liquidity, which means you can easily sell your ETF shares for cash.
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