Exchange-traded funds (ETFs) were introduced in the early 1990s and have proven extremely popular with all kinds of investors. As a result, they have expanded greatly in number and focus over time.
An ETF is a financial instrument that's both similar to and distinct from mutual funds. They are bought by beginning and experienced individual investors as well as institutional investors. If you find the time-consuming tasks of analyzing companies and picking stocks daunting, ETFs may be right for you.
Let's take a look at some of the basics of ETFs and some of the types that you can invest in.
Key Takeaways
- Exchange-traded funds are investments that are similar to mutual funds but trade like stocks.
- They offer investors broad diversification in line with the indexes that they track.
- The many types of ETFs available can help meet an investor's specific financial needs and investment goals.
- ETF investors can consider funds that target specific sectors or industries, such as energy ETFs, or investment styles such as inverse investing.
- Most ETFs have lower fees than actively managed mutual funds.
What Is an Exchange-Traded Fund (ETF)?
Like a mutual fund, an exchange-traded fund (ETF) invests in a basket of securities such as stocks and bonds. Most ETFs are designed to reproduce the performance of an index. So the securities that an ETF buys will be the same as those found in the index that it tracks.
For example, certain ETFs track the S&P 500 or the Barclays Capital U.S. Aggregate Bond Index. They have invested in the securities in those indexes.
But an ETF isn't a mutual fund. Rather, it trades like the shares of a company stock on a public exchange. And, unlike a mutual fund that has its net asset value (NAV) calculated at the end of each trading day, an ETF's price changes throughout the day, fluctuating with supply and demand.
While ETFs attempt to replicate the return on indexes that they track, there is no guarantee that they will do so exactly. It isn't uncommon to see a small difference between the actual index's year-end return and that of an ETF.
ETF Advantages
Diversification: ETFs offer investors instant diversification, whether across the broad market, asset classes, market sectors, or specific industries.
Accessibility and flexibility: Because ETFs trade like stocks, you can buy and sell them anytime during a trading session. In addition, you can short-sell them and buy them on margin.
Low fees: The expense ratios of most ETFs are lower than that of the average mutual fund. The average expense ratio for an index ETF was 0.16% in 2022. As of 2024, the SPDR S&P 500 ETF (SPY) had an expense ratio of 0.0945%.
Liquidity: Popular ETFs normally are highly liquid. This means they can be sold easily, and at a narrow bid-ask spread.
Tax efficiency: Due to their passive management, ETFs usually have fewer capital gains, which means investors may pay less in taxes. In addition, in-kind (as opposed to cash) exchanges for an ETF's securities also result in less capital gains.
ETF Disadvantages
Additional costs: While ETFs may have low expense ratios, you may have other charges related to buying and selling ETFs, such as broker commissions/transaction costs. Moreover, you can expect higher expense ratios if you invest in an actively managed ETF. In addition, the bid-ask spread for an ETF presents a hidden cost for investors.
Excess trading: Because ETFs can be bought and sold intraday, investors may forget their investment objectives and trade them unnecessarily in reaction to attention-grabbing news reports or unsupported rumors.
Potentially lower returns: The diversification that makes ETFs (and mutual funds) a smart way to reduce risk can also mean that returns might be less than those obtained by actively selecting and owning individual stocks.
ETFs have come a long way. From $204 billion in AUM in 2003, the global ETF industry grew to $9.6 trillion AUM by 2022.
Types of ETFs
The first ETF that traded in the United States was the SPY. It began trading on the American Stock Exchange (AMEX) in 1993.
Thousands of ETFs trade globally. These vehicles track a wide variety of sector-specific, asset-type-specific, country-specific, and broad-market indexes.
You can find an ETF for just about any sector of the market. For example, if you were interested in gaining exposure to some European stocks through the Austrian market, you might consider the iShares MSCI Austrian Index fund (EWO).
Some of the more popular ETFs have nicknames such as "cubes" and "diamonds". Many are passively managed (saving investors money on management fees).
The world's first ETF was called the Toronto35 Index Participation Units. It was launched in 1990 by the Toronto Stock Exchange (TSX).
Below, we've highlighted some well-known ETFs available to investors.
Invesco QQQ (QQQ)
Invesco QQQ (QQQ) ETF tracks the Nasdaq 100, an index that consists of the 100 largest and most actively traded non-financial domestic and internationalcompanies on the Nasdaq. It offers investors broad exposure to the tech sector.
Because QQQ curbs the risk that may come with investing in individual stocks, it is a great way to invest in the long-term prospects of the technology industry.
Its diversification can be a big advantage when there's volatility in the markets. If one tech company falls short of projected earnings, it will likely be hit hard, but owning a piece of a hundred other companies can cushion that blow.
Standard & Poor's Depositary Receipts (SPDRs)
Standard & Poor's depositary receipts (SPDRs) are commonly known as spiders. These investment instruments bundle the stocks covered by the benchmark S&P 500, essentially giving you ownership of the index.
Imagine the trouble and expenses involved in trying to buy all 500 stocks in the S&P 500. SPDRs allow individual investors to own the index's stocks with a single, convenient, easy, and cost-effective purchase.
Another feature of SPDRs is that they divide up various sectors of the S&P 500 and sell them as separate ETFs. There are dozens of these types of ETFs.
For instance, the technology select sector index contains around 64 different holdings covering products developed by companies such as defense manufacturers, telecommunications equipment, hardware, software, and semiconductors. One such ETF, the SPDR Select Sector Fund - Technology (XLK), trades on the NYSE ARCA.
iShares and Vanguard
iShares is asset manager BlackRock's brand of ETFs. The firm offers more than 800 ETFs globally and has $2 trillion dollars in assets under management.
BlackRock has a number of iShares ETFs that track many of the major indexes around the world, including the Nasdaq, New York Stock Exchange (NYSE), Dow Jones, and Standard & Poor's. All of these ETFs trade on the major exchanges in the U.S. just like stocks.
Vanguardalso has its own branded of ETFs, including hundreds of ETFs that track different areas of the market including the financial, healthcare, and utility sectors.
Diamonds ETF
Contrary to what you may think, this ETF has nothing to do with diamonds. Rather, it's a nickname for the SPDR Dow Jones Industrial Average (DIA) ETF. This fund tracks the Dow Jones Industrial Average and is structured as a unit investment trust. DIA trades on the NYSE ARCA.
Although ETFs are tax efficient investments, you are taxed on any income, such as dividends and capital gains that you earn while you hold the fund and after you sell it.
ETF Investment Styles
For novice and experienced investors, there are ETFs that can meet different investment needs and styles.
If you're interested in specific sectors, investing in ETFs can alleviate the pressure of having to find and invest in the individual stocks of relevant companies. Here are just a few of the categories you will discover when looking into ETFs.
Natural Resources
These ETFs can provide an easy way to invest in natural resources. For instance, if you think that natural gas companies may provide investment opportunities, you may want to consider a fund like the United States Natural Gas Fund (UNG).
An ETF such as UNG can replicate natural gas prices after expenses. It may also try to track the prices of natural gas by buying natural gas futures contracts.
As with all the funds, you need to understand the total expense ratio before investing.
Emerging Market
ETFs that focus on emerging markets attempt to mimic the returns of the iShares MSCI Emerging Markets Index (EEM). This ETF was created as an equity benchmark for international security performance. If you seek exposure to international equities, and specifically to emerging markets, an ETF like this one may be right for you.
Inverse/Opposite Movers
Not every ETF is designed to move in the same direction or even in the same amount as the index it tracks. The prices of inverse ETFs go up when the markets go down and vice versa. They can be very useful to those investors interested in hedging portfolio risk.
The Direxion Daily Financial Bear 3x Shares (FAZ) is a triple bear fund. It attempts to move 300% in value in the opposite direction of the Financial Select Sector Index. It uses derivatives and other types of leverage to boost its performance returns. This fund became popular when the financial crisis placed downward pressure on financial stocks.
What Is an ETF Expense Ratio?
An ETF expense ratio is the fee that ETF issuers charge investors for running the fund. A fund's expense ratio is determined by dividing its expenses by its total assets and is expressed as a percentage. You can find an ETF's expense ratio in the fund prospectus, on a company's website, or online at a market information site such as Yahoo! Finance.
What's the Difference Between an ETF and a Mutual Fund?
An ETF and mutual fund both pool money from investors and invest that capital in a basket of related securities. They can be actively or passively managed. But unlike mutual funds, ETFs trade like stocks and you can buy and sell them on stock exchanges.
Another key difference between ETFs and mutual funds is the associated cost. Mutual funds generally charge higher management fees than ETFs. In fact, ETF expense ratios are generally lower than other investment vehicles.
Are There Any Downsides to Investing in ETFs?
ETFs are generally considered to be safe investments, but they have risks. The key risk that ETF investors face is market risk. There's also the chance that a fund may not be successful, which means it could be shut down.
The Bottom Line
A great reason to consider ETFs is that they simplify index and sector investing in a way that is easy to understand. If you feel that a market upswing is in the offing, go long. If, however, you think ominous economic clouds will drag the market down, you have the option of going short.
ETFs' combination of instant diversification, low cost, and flexibility makes these investments highly attractive to a wide range of investors.
