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In the ever-evolving landscape of finance and investing, it is critical to understand all the investment vehicles available to you and how each can help you grow your wealth. A well-rounded portfolio includes numerous asset classes and, through that diversification, you are able to lower your overall risk.
Of the most popular investments, one is often overlooked. Exchange-traded funds (ETFs) allow new and seasoned investors alike to gain broad market exposure through pooled resources by owning shares similar to stocks with strategies once reserved for professional fund managers.
But how do ETFs work, and how do they differ from mutual funds and individual stocks? Read on to learn what they are, their pros and cons, the different types available and whether or not an allocation of your investment portfolio towards ETFs is a good fit.
What is an exchange-traded fund (ETF)?
An ETF is an investment fund that, as its name suggests, is traded on major exchanges similar to the way shares of individual companies are sold on the stock market. ETFs are registered with and regulated by the SEC as investment companies, and they offer investors a way to pool their funds to invest in baskets of stocks, bonds or other assets. Over the past two decades, this asset class has exploded in popularity, rising from a mere 276 in 2003 to 8,754 in 2022.
Most ETFs are professionally managed by investment managers. Most are passively managed funds that seek to achieve the same return as a particular market index (i.e., index funds), while others are actively managed funds that buy or sell investments consistent with a stated investment objective.
Despite some shared characteristics, it’s important to note that ETFs are not mutual funds. Mutual funds generally carry higher fees than ETFs. While mutual funds cannot be traded before 4 p.m. EST after the markets close, ETFs trade like stocks throughout the trading day at varying price points. Additionally, ETF shares are based on market prices and must be traded as full or fractional shares whereas mutual funds are purchased in dollar amounts.
Types of ETFs
A vast variety of ETFs is available today. The following section details the categories they fall into so you can better understand which ones could be a good fit for your investment goals.
Passively managed ETFs vs. actively managed ETFs
There are two broad categories that encompass all ETFs: passively managed and actively managed. Passively managed ETFs generally attempt to mirror the performance of a benchmark index. Because they require less activity from a fund manager, these ETFs commonly charge lower expense ratios. There are also zero-fee ETFs available to investors.
Conversely, actively managed ETFs aim to outperform a benchmark index rather than mirror it. Because of this, they tend to carry higher management fees because the fund’s portfolio managers must employ more market research and analysis, which results in more frequent investment decisions.
Index-based ETFs are a type of ETF that aim to mirror the returns of a given index. These ETFs fall into two categories: those that track overall markets and those that track subsets of markets, like small-cap, mid-cap and large-cap companies. Additionally, some indexes track assets like bonds, commodities and currencies, which also have index-based ETFs seeking to replicate their returns.
One of the most popular examples of an index fund is the SPDR S&P 500 ETF Trust (SPY), the largest and oldest ETF in the world. The SPY is designed to track the S&P 500 stock market index. Another example is the BetaShares Nasdaq 100 ETF (NDQ), which tracks the performance of the Nasdaq-100, a stock index composed of the 100 largest non-financial companies listed on the Nasdaq stock exchange.
Both the SPY and NDQ are examples of passively managed ETFs, since any changes to the benchmark indexes will be reflected in changes made to the ETFs’ holdings.
Just like index ETFs track major indexes, sector ETFs track certain sectors within various indexes. For example, the S&P 500 is composed of 11 sectors, including communication services, consumer discretionary, consumer staples, energy, financials, health care, industrials, information technology, materials, real estate and utilities.
Please insert Rangey’s pie chart of the 11 S&P 500 sectors here.
Each sector has a corresponding Standard & Poor’s Depositary Receipt (SPDR) ETF with its own ticker symbol, such as the Energy Select Sector SPDR Fund (XLE). The XLE tracks the performance of top S&P 500 companies involved in the production, transportation and refinement of oil and natural gas as well as other energy-related services.
Like the XLE, whose holdings include most of the oil majors (e.g., ExxonMobil, Chevron, ConocoPhillips, Marathon Petroleum), each of the SPDR sector ETFs are weighted to the top companies in their respective sectors. This type of ETF provides investors with an option of purchasing shares representing an industry and gaining broad exposure without having to choose individual stocks.
Equity ETFs and thematic ETFs
Equity ETFs — also known as stock ETFs — allow investors to access a basket of stocks without having to purchase the securities individually. These are the most common ETFs, and they can be passively or actively managed. Most are passively managed; however, an increasing number of them are actively managed, resulting in them carrying higher expense ratios.
Equity ETFs often have themes that direct their investment strategies and holdings. For instance, if you’re interested in aerospace and defense, the Invesco Aerospace & Defense ETF (PPA) holds a basket of defense contractors like Lockheed Martin, Raytheon and Northrop Grumman. If you want to invest in electric vehicles and lithium battery technologies, the Amplify Lithium & Battery Technology ETF (BATT) holds some of the leading companies in that space, including Tesla, LG Energy Solution and Rivian Automotive.
Commodity ETFs either track the price of physical goods such as corn, natural gas or lumber, invest in derivatives — like futures contracts — for their underlying assets or, as is the case with many precious metals and gold ETFs, hold physical assets.
Using the lumber example above, the iShares Global Timber & Forestry ETF (WOOD) gives investors exposure to companies that produce forest products, agricultural products, and paper and packaging products by targeting timber and forestry stocks from around the world.
Currency ETFs track the price of a specific country’s government-issued currency (also known as fiat currency) or a basket of currencies like the U.S. dollar, the British pound or the European Union’s euro. These funds are also referred to as forex ETFs and are typically used by experienced traders who use them to speculate about foreign currency exchange rates.
Since they can be impacted by numerous factors including geopolitical turmoil, global supply chain disruptions, interest rate changes and economic downturns, currency prices are very difficult to predict. Generally, this type of ETF is not ideal for novice investors.
Inverse ETFs and leveraged ETFs
For investors with highincreased risk tolerance, leveraged and inverse ETFs provide a way to increasemeans of increasing upside potential. However, that upside potential is proportionate to the downside risk they carry. Inverse ETFs are designed to move in the opposite direction of a targeted index. For example, the ProShares Short S&P500 ETF (SH) is inversely correlated to the S&P 500 index, meaning when the S&P 500 rises or falls the SH moves in the opposite direction.
In some instances, inverse ETFs can also be leveraged ETFs, meaning they look to double or triple the returns of the indexes they’re tracking. For example, the ProShares UltraPro Short Dow30 ETF (SDOW) offers 3x daily short leverage to the Dow Jones Industrial Average, meaning that for each point the Dow rises or falls, the SDOW moves 3x in the opposite direction. Whereas traditional ETFs track indexes on a 1:1 basis, leveraged ETFs aim for increased returns with 2:1 or 3:1 ratios.
Because of their inherent volatility and the advanced market knowledge they require, inverse ETFs and leveraged ETFs are often used by experienced investors and investment professionals.
Bond ETFs and fixed-income ETFs
Bond ETFs own fixed-income investments, such as corporate bonds and U.S. Treasurys. As index ETFs, most bond ETFs track bond market benchmarks like the Bloomberg U.S. Aggregate Bond Index. This type of ETF is particularly appealing for fixed-income investors because they typically pay dividends. Bond ETFs pay distributions monthly.
Since bonds tend to be less volatile than stocks, many conservative investors or those nearing retirement are drawn to bond and fixed-income ETFs.
Environmental, social and governance (ESG) ETFs
ETFs that focus on ESG factors provide people with opportunities to invest in issues they find important. This type of ETF involves companies that align with environmental, social and corporate governance objectives, which the fund’s holdings will reflect. ESG investing is commonly referred to as values-based investing, impact investing, socially responsible or sustainable investing.
An ESG ETF could feature companies that make concerted efforts to decrease their environmental impact, promote sustainable practices, embrace renewable energy, or hire and train workers from disadvantaged demographics or backgrounds.
For example, the Vanguard ESG US Stock ETF (ESGV) holds about 1,500 stocks and excludes companies involved in the production, supply or retail of civilian firearms, nuclear tobacco, cannabis, fossil fuels, alcohol, gambling and adult entertainment, among other criteria.
Bitcoin ETFs and cryptocurrency ETFs
The newest type of ETFs, Bitcoin and cryptocurrency ETFs, consist of digital currency prices, indexes or baskets of assets (e.g., crypto coins or tokens). Similar to their cryptocurrency benchmarks, these ETFs experience elevated volatility and, by extension, elevated risk.
For example, two of the most popular Bitcoin-leveraged ETFs, the Grayscale Bitcoin Trust (GBTC) and the ProShares Bitcoin Strategy ETF (BITO), have volatility measures that exceed those of traditional ETFs.
Like index funds, Bitcoin ETFs and cryptocurrency ETFs are significantly impacted by their benchmarks. Therefore, it is recommended that investors become well versed in the crypto landscape before considering ETFs that track it.
Pros and cons of ETFs
- Help create a diversified portfolio
- Carry lower risk than individual stocks
- Provide tax advantages
- Annual expense ratios
- Lower returns than individual stocks
- Lower liquidity than individual stocks
No investment is without its advantages and disadvantages. The following section surveys some of the pros and cons of owning ETF shares.
Pros of ETFs
Help create a diversified portfolio
By adding ETFs to your portfolio, you are adding a layer of protection by hedging against your other holdings. Additionally, ETFs provide a way to increase your exposure to various financial instruments. For example, bond ETFs can help you add exposure to corporate bonds or Treasurys, Bitcoin ETFs can help you gain exposure to cryptocurrency and commodity ETFs can help you add precious metals to your portfolio.
Carry lower risk than individual stocks
Because ETFs spread out your investment (i.e., across a basket of stocks or an entire index), they are considered lower-risk securities than individual stocks. Because of their diverse holdings and how they are weighted, ETFs are better suited to absorb individual company losses, meaning one company’s poor performance won’t adversely affect an entire fund or, by extension, your portfolio.
Provide tax advantages
ETFs have a reputation for tax efficiency — especially passively managed ETFs. That’s because they tend not to realize a lot of capital gains. Additionally, if you held shares of an ETF for over a year before selling them, they are taxed at a more favorable federal capital gains tax rate, as opposed to being taxed as ordinary income if you sell them before the one-year mark. Long-term capital gains can be taxed anywhere from 0%–20%. However, it should be noted that investors who receive income from ETFs, either in the form of dividends or interest, will owe tax on those distributions.
Cons of ETFs
Annual expense ratios
Expense ratios are the annual fees charged by an ETF to cover administrative, management and marketing expenses. Actively managed ETFs generally have higher expense ratios than passively managed ETFs, and it’s recommended to avoid ETFs with expense ratios of 1% or higher as they can erode growth potential.
According to Morningstar, these costs have been falling for two decades. As of 2022 (the last year data was available), the average expense ratio for ETFs and mutual funds was 0.37%, which is half of the average investors paid in 2022. Therefore, if you invest $1,000 into an ETF with the average expense ratio, you can expect to pay $3.70 per year.
Lower returns than individual stocks
Higher risk is associated with the probability of higher returns, and lower risk is associated with the probability of lower returns. Because ETFs have lower risk than individual stocks, they also have lower potential returns. However, among the various categories of ETFs, some are higher risk than others (e.g., Bitcoin ETFs vs. bond ETFs), meaning they have the potential to produce greater returns.
Lower liquidity than individual stocks
Based on average daily trading volume, ETFs have comparatively lower liquidity than individual stocks. For example, in Q3 2023, Tesla (TSLA) had an average daily trading volume of 117.62 million, according to YCharts. By comparison, over the same period:
- The SPY, an ETF that tracks the S&P 500, averaged 89.59 million.
- The Vanguard Total Bond Market ETF (BND) averaged 7.9 million.
- The GBTC, an ETF that tracks Bitcoin futures, averaged 3 million.
If an ETF is thinly traded, you could have trouble entering or exiting a position, particularly if you’re looking to buy or sell a larger number of shares.
How to buy ETFs
The following section discusses the steps to take when purchasing shares of an ETF.
Research the types of ETFs
Because of the wide variety of ETFs available to investors, you should research which ones are the best fit for your overall investment goals. If you’re looking for income, perhaps bonds ETFs and high-dividend ETFs would be appropriate. If you’re looking to invest in a particular subset of the market, sector ETFs and equity ETFs can provide you with that exposure. The funds you decide on will be based on your personal investing preferences.
Find a brokerage or investment app
Before opening a brokerage account or downloading an investing app, determine whether it offers ETFs as one of its investment products. The best investment apps allow you to get started with as little as $1, offer commission-free trades, provide you with advanced research tools, and track your performance. They also provide educational resources to help newbies develop a strategy and get started. Get to know the best online stock trading platforms to learn more.
Analyze ETF holdings and expense ratios
A good way to analyze whether or not an ETF is a good fit for your investment strategy is to drill down into an ETF’s holdings and see how they’re weighted. Typically, the top 10 holdings in a fund will provide you with a stronger understanding of how the ETF invests its pooled resources.
Additionally, read an ETF’s prospectus, which includes information about its objectives, investment strategies, risks, costs and past performance. Last, be mindful of how the fund’s net asset value and expense ratio will impact your investment. Low-cost expense ratios are ideal, and it’s generally recommended that you avoid ETFs with expense ratios of 1% or more, as those costs can eat away at your potential earnings.
Ensure the ETF aligns with your investment strategies
Be sure that the ETFs you are targeting align with your personal financial goals and investment strategies. For example, if you have a higher risk tolerance and want exposure to cryptocurrency, Bitcoin ETFs could be a good fit for your portfolio. On the other hand, if you’re nearing retirement age and want to transition into more conservative strategies, bond ETFs could be a good option. If your focus is generating income, consider high-dividend ETFs and using a dividend reinvestment plan.
What is an ETF FAQs
What is the difference between index funds and ETFs?
What is the average ETF expense ratio?
Can you hold ETFs in a retirement account?
Do ETFs pay dividends?
What’s the difference between ETFs and ETNs?
Summary of Money's What Is an ETF?
Exchange-traded funds (ETFs) are a type of investment fund that can help you diversify your portfolio; lower your overall risk exposure; help you focus your investments on certain industries, indexes, sectors or strategies; and in some instances, produce income. These funds provide another means of adding equities to your portfolio, with a lower risk profile than individual stocks, but also typically lower potential returns. Be cognizant of ETFs’ expense ratios, holding and weightings, investment strategies, risks and past performance. Remember to conduct your own due diligence or speak with a financial advisor before investing.