An exchange-traded fund (ETF) is a type of pooled investment security that operates much like a mutual fund. Typically, ETFs will track a particular index, sector, commodity, or other assets, but unlike mutual funds, ETFs can be purchased or sold on a stock exchange the same way that a regular stock can. An ETF can be structured to track anything from the price of an individual commodity to a large and diverse collection of securities. ETFs can even be structured to track specific investment strategies.
The first ETF was the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index, and which remains an actively traded ETF today.
An ETF is called an exchange-traded fund because it’s traded on an exchange just like stocks are. The price of an ETF’s shares will change throughout the trading day as the shares are bought and sold on the market. This is unlike mutual funds, which are not traded on an exchange, and which trade only once per day after the markets close. Additionally, ETFs tend to be more cost-effective and more liquid compared to mutual funds.
An ETF holds multiple underlying assets, rather than only one like a stock does. Because there are multiple assets within an ETF, they can be a popular choice for diversification. ETFs can thus contain many types of investments, including stocks, commodities, bonds, or a mixture of investment types.
An ETF can own hundreds or thousands of stocks across various industries, or it could be isolated to one particular industry or sector. Some funds focus on only U.S. offerings, while others have a global outlook. For example, banking-focused ETFs would contain stocks of various banks across the industry.
Passive and Active ETFs
ETFs are generally characterized as either passive or actively managed. Passive ETFs aim to replicate the performance of a broader index—either a diversified index such as the S&P 500 or a more specific targeted sector or trend. An example of the latter category is gold mining stocks: as of February 18, 2022, there are approximately eight ETFs which focus on companies engaged in gold mining, excluding inverse, leveraged, and funds with low assets under management (AUM).
Actively managed ETFs typically do not target an index of securities, but rather have portfolio managers making decisions about which securities to include in the portfolio. These funds have benefits over passive ETFs but tend to be more expensive to investors. We explore actively managed ETFs below.
Bond ETFs
BondETFs are used to provide regular income to investors. Their income distribution depends on the performance of underlying bonds. They might include government bonds, corporate bonds, and state and local bonds—called municipal bonds. Unlike their underlying instruments, bond ETFs do not have a maturity date. They generally trade at a premium or discount from the actual bond price.
Stock ETFs
Stock (equity) ETFs comprise a basket of stocks to track a single industry or sector. For example, a stock ETF might track automotive or foreign stocks. The aim is to provide diversified exposure to a single industry, one that includes high performers and new entrants with potential for growth. Unlike stock mutual funds, stock ETFs have lower fees and do not involve actual ownership of securities.
Industry/Sector ETFs
Industry or sector ETFs are funds that focus on a specific sector or industry. For example, an energy sector ETF will include companies operating in that sector. The idea behind industry ETFs is to gain exposure to the upside of that industry by tracking the performance of companies operating in that sector.
One example is the technology sector, which has witnessed an influx of funds in recent years. At the same time, the downside of volatile stock performance is also curtailed in an ETF because they do not involve direct ownership of securities. Industry ETFs are also used to rotate in and out of sectors during economic cycles.
Commodity ETFs
As their name indicates, commodity ETFs invest in commodities, including crude oil or gold. Commodity ETFs provide several benefits. First, they diversify a portfolio, making it easier to hedge downturns.
For example, commodity ETFs can provide a cushion during a slump in the stock market. Second, holding shares in a commodity ETF is cheaper than physical possession of the commodity. This is because the former does not involve insurance and storage costs.
Currency ETFs
Currency ETFs are pooled investment vehicles that track the performance of currency pairs, consisting of domestic and foreign currencies. Currency ETFs serve multiple purposes. They can be used to speculate on the prices of currencies based on political and economic developments for a country. They are also used to diversify a portfolio or as a hedge against volatility in forex markets by importers and exporters. Currency ETFs are also used to hedge against the possibility of inflation. There’s even an ETF option for bitcoin.
Inverse ETFs
Inverse ETFs attempt to earn gains from stock declines by shorting stocks. Shorting is selling a stock, expecting a decline in value, and repurchasing it at a lower price. An inverse ETF uses derivatives to short a stock. Essentially, they are bets that the market will decline.
If a market declines, an inverse ETF increases by a proportionate amount. Investors should be aware that many inverse ETFs are exchange-traded notes (ETNs) and not true ETFs. An ETN is a bond but trades like a stock and is backed by an issuer such as a bank. Be sure to check with your broker to determine if an ETN is a good fit for your portfolio.
Leveraged ETFs
A leveraged ETF seeks to return some multiples (e.g., 2× or 3×) on the return of the underlying investments. For instance, if the S&P 500 rises 1%, a 2× leveraged S&P 500 ETF will return 2% (and if the index falls by 1%, the ETF would lose 2%). These products use derivatives such as options or futures contracts to leverage their returns. There are also leveraged inverse ETFs, which seek an inverse multiplied return.
What to Consider In ETFs
- Volume: Trading volume over a particular period of time allows you to compare the popularity of different funds; the higher the trading volume, the easier it may be to trade that fund.
- Expenses: The lower the expense ratio, the less of your investment that is given over to administrative costs. While it may be tempting to always search for funds with the lowest expense ratios, sometimes costlier funds (such as actively managed ETFs) have strong enough performance that it more than makes up for the higher fees.
- Performance: While past performance is not an indication of future returns, this is nonetheless a common metric for comparing ETFs.
- Holdings: The portfolios of different funds often factor into screener tools as well, allowing customers to compare the different holdings of each possible ETF investment.
- Commissions: Many ETFs are commission-free, meaning that they can be traded without any fees to complete the trade. However, it is worth checking if this is a potential issue.
Examples of ETFs
- The SPDR S&P 500 (SPY): The “Spider”is the oldest surviving and most widely known ETF that tracks the S&P 500 Index.
- The iShares Russell 2000 (IWM) tracks the Russell 2000 small-cap index.
- The Invesco QQQ (QQQ) (“cubes”) tracks the Nasdaq 100 Index, which typically contains technology stocks.
- The SPDR Dow Jones Industrial Average (DIA) (“diamonds”) represents the 30 stocks of the Dow Jones Industrial Average.
Pros of ETFs
- Access to many stocks across various industries
- Low expense ratios and fewer broker commissions
- Risk management through diversification
- ETFs exist that focus on targeted industries
Cons of ETFs
- Actively managed ETFs have higher fees
- Single-industry-focused ETFs limit diversification
- Lack of liquidity hinders transactions