What is an ETF?
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Updated: December 09, 2021
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We adhere to strict standards of editorial integrity to help you make decisions with confidence. Please be aware that some (or all) products and services linked in this article are from our sponsors.
An ETF, or exchange traded fund, is a popular investment fund that makes it easy for investors to diversify their portfolios while enjoying the benefit of flexible trading. ETFs come in many forms but share the same basic characteristics. ETFs can be an excellent addition to any investment portfolio, but it’s important to understand exactly how they work. In this article, you’ll learn what is an ETF, how they work, and how you can trade them.
What is an ETF (Exchange-Traded Fund)?
An ETF is an investment vehicle that bundles many securities into a single investment. ETFs are designed to track the price of their underlying assets, which can include stocks, bonds, commodities, and more. Unlike other similar investment products, ETFs are traded on stock exchanges, similar to individual stocks. However, shareholders don’t own the assets themselves, but a portion of the ETF.
How do ETFs work?
A fund provider will buy the assets, then design a fund to track the performance of the asset and sell the securities to investors. Because they are based on specific assets, the ETF will often perform similarly to the underlying asset.
ETFs combine the benefits of both mutual funds and stocks. How?
- First, like mutual funds, ETFs are an easy way to diversify your portfolio because they follow many underlying assets and combine them into a single basket.
- When you invest in an ETF, you are exposed to all of the investments within the basket. This diversification helps to mitigate the risks from any individual security.
- ETFs also have one of the key benefits of stock in that they can be traded throughout the day anytime the exchanges are open. If you decide you want to buy or sell shares of an ETF, you don’t have to wait until the end of the day. You can complete the transaction immediately.
What are the different types of ETFs?
There’s no shortage of options for investing in ETFs. Each ETF has a unique collection of underlying assets, which often represent a particular asset class, sector, or location.
Stock ETFs — A stock ETF is made up of a variety of underlying stocks. Stock ETFs are often designed to track a particular index, like the S&P 500, Dow Jones, or Nasdaq-100.
Commodities ETFs — Commodities are physical assets that are traded as investments. Commodities ETFs might have underlying assets like corn, crude oil, natural gas, and gold. Some commodities ETFs invest in the underlying commodities themselves, while others invest in companies that produce or transport the commodities.
Bond ETFs — A bond ETF holds underlying assets that are all bonds. This type of ETF could hold various types of bonds, including government bonds, corporate bonds and municipal bonds. An ETF might specialize in holding bonds of a particular risk level of maturity. These bonds often pay interest like the bonds themselves.
International ETFs — An international ETF specifically invests in foreign markets, allowing investors to further diversify their portfolios beyond domestic stocks. An international ETF might invest in companies from a particular country, region or economic status.
Sector ETFs —A sector ETF is one that specifically invests in companies within a particular sector. Sector ETFs include those that invest in energy, healthcare, real estate and others.
Style ETFs — A style ETF tracks underlying investments of a particular style or size. Some style ETFs might focus on a particular size of the company, such as small-cap, medium-cap, or large-cap. Others might differentiate between value and growth stocks, then invest in one or the other.
Inverse ETFs — Inverse ETFs are a unique type of fund that specifically profit from declines in the market or the underlying indices they track. Some inverse ETFs profit by shorting stocks, while others invest in derivatives that are profitable if the underlying assets decline in value.
Actively managed ETFs — Most ETFs passively track a basket of underlying assets. An actively managed ETF has a fund manager who selects investments designed to outperform a particular index or the market overall.
ETNs — An exchange-traded note (ETN) is like an ETF in that it trades on a stock exchange and tracks a particular index. However, ETNs differ from ETFs in that they are unsecured debt security that’s issued by a bank and is linked to the performance of an underlying benchmark or index.
How to trade ETFs
Trading an ETF is quite similar to trading an individual stock. You can buy and sell shares throughout the day, as long as the stock exchange is open. As a result, you can trade ETFs through the same method you would invest in stocks.
If you work with a broker, you can contact your broker to facilitate the trade for you. If you trade through an online brokerage account, you purchase the number of shares you want in just a few steps — often with low or no trading fees.
Some brokers make it easy by issuing their own ETFs. For example, brokers such as Vanguard and Fidelity issue their own ETFs, making it easy and inexpensive for customers to purchase shares.
How do ETFs fit in your portfolio?
One of the reasons that ETFs are so attractive is because they help investors to achieve one of the core tenets of investing: diversification. Diversification reduces risk in that, if one of your investments performs poorly, it doesn’t negatively impact your entire portfolio.
ETFs make it easy to diversify your portfolio and gain exposure to new markets without taking on the risk of investing in individual companies. Given the wide variety of ETFs and their passive nature, you could easily build a portfolio entirely around ETFs. By investing in a variety of ETFs, you can gain exposure to several different asset classes, industries and market capitalization.
ETFs vs stocks: What are the differences?
ETFs and stocks have one very important characteristic in common: both trade on major stock exchanges, so you can buy and sell whenever the exchange is open. Just like stocks, ETFs have their own ticket symbols so you can track their performance.
The major difference between the two is that when you purchase a stock, you’re buying ownership in a single company. When you buy shares in an ETF, you’re purchasing many underlying assets.
What are the differences between ETFs and mutual funds?
ETFs and mutual funds are both investment vehicles designed to hold many underlying investments. When you buy shares in these funds, you’re investing in each of its underlying assets. Both can specialize in different asset classes, sectors and styles, and both can be an effective way of diversifying your portfolio.
There are two critical differences between ETFs and mutual funds.
- 1.
First, unlike ETFs, mutual funds don’t trade throughout the day. Instead, no matter when during the day you place your order, all trades are completed at the end of the day based on the closing price for that trading day.
- 2.
Fees are the other major difference between ETFs and mutual funds. ETFs are generally passively managed and designed to track a particular index. As a result, they come with relatively low management fees. Mutual funds are usually actively managed and designed to beat the market; this results in higher management fees.
Pros
- Diversification: ETFs make it easy to invest in many underlying securities across different asset classes, therefore reducing your exposure risk.
- Low management fees: Because most ETFs are passively managed, they have lower management fees than a typical mutual fund.
- Easy to trade: ETFs trade on major exchanges throughout the day, just like stocks. As a result, you get real-time pricing without waiting until the end of the day.
- Tax efficiency: Mutual fund investors may pay capital gains taxes while they still hold their shares, while ETF investors don’t pay taxes until they sell their investment.
Cons
- Possible trading fees: Depending on the brokerage firm you use, you might pay commissions or trading fees when buying or selling ETF shares.
- Illiquidity: Some ETFs can be relatively illiquid, meaning you may have a difficult time selling at the price you would hope.
- Management fees: Most ETFs are passively managed, resulting in low management fees. But if you’re not paying attention, you could inadvertently invest in an actively managed fund and pay a higher management fee than you expect.
The bottom line
ETFs combine many underlying assets into a single investment. These funds make it easy for investors to diversify their portfolios while gaining exposure to multiple asset classes, industries, and market capitalizations. As with any investment, it’s important to do your research and ensure you’re putting your money into investments appropriate for your risk tolerance and financial goals.
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