An exchange traded fund (ETF) is a type of security that tracks an index, sector, commodity, or other asset, but which can be purchased or sold on a stock exchange the same way 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.
A well-known example is the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index. ETFs can contain many types of investments, including stocks, commodities, bonds, or a mixture of investment types. An exchange traded fund is a marketable security, meaning it has an associated price that allows it to be easily bought and sold.
An exchange traded fund (ETF) is a basket of securities that trade on an exchange just like a stock does.
ETF share prices fluctuate all day as the ETF is bought and sold; this is different from mutual funds that only trade once a day after the market closes.1
ETFs can contain all types of investments including stocks, commodities, or bonds; some offer U.S.-only holdings, while others are international.
ETFs offer low expense ratios and fewer broker commissions than buying the stocks individually does.
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 trade only once per day after the markets close. Additionally, ETFs tend to be more cost-effective and more liquid when compared to mutual funds.
An ETF is a type of fund that 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.
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.
Types of ETFs
There are various types of ETFs available to investors that can be used for income generation, speculation, price increases, and to hedge or partly offset risk in an investor's portfolio. Here is a brief description of some of the ETFs available on the market today.
Bond ETFs
Bond ETFs 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 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 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. Some of them are also used to hedge against the threat 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. When the 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 like a bank. Be sure to check with your broker to determine if an ETN is a good fit for your portfolio.
In the U.S., most ETFs are set up as open-ended funds and are subject to the Investment Company Act of 1940 except where subsequent rules have modified their regulatory requirements. Open-end funds do not limit the number of investors involved in the product.
ETFs trade through online brokers and traditional broker-dealers. You can view some of the top brokers in the industry for ETFs with Investopedia's list of the best brokers for ETFs. An alternative to standard brokers are robo-advisors like Betterment and Wealthfront who make use of ETFs in their investment products.
Real-World Examples of ETFs
Below are examples of popular ETFs on the market today. Some ETFs track an index of stocks creating a broad portfolio while others target specific industries.
The SPDR S&P 500 (SPY) 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) indexes the Nasdaq 100, which typically contains technology stocks.
The SPDR Dow Jones Industrial Average (DIA) represents the 30 stocks of the Dow Jones Industrial Average.
Sector ETFs track individual industries such as oil (OIH), energy (XLE), financial services (XLF), REITs (IYR), Biotech (BBH).
Commodity ETFs represent commodity markets including crude oil (USO) and natural gas (UNG).
Physically backed ETFs: The SPDR Gold Shares (GLD) and the iShares Silver Trust (SLV) hold physical gold and silver bullion in the fund.
Advantages and Disadvantages of ETFs
ETFs provide lower average costs because it would be expensive for an investor to buy all the stocks held in an ETF portfolio individually. Investors only need to execute one transaction to buy and one transaction to sell, which leads to fewer broker commissions because there are only a few trades being done by investors. Brokers typically charge a commission for each trade. Some brokers even offer no-commission trading on certain low-cost ETFs reducing costs for investors even further.
An ETF's expense ratio is the cost to operate and manage the fund. ETFs typically have low expenses because they track an index. For example, if an ETF tracks the S&P 500 Index, it might contain all 500 stocks from the S&P, making it a passively managed fund that is less time-intensive. However, not all ETFs track an index in a passive manner.
Pros
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
Actively managed ETFs have higher fees
Single-industry-focus ETFs limit diversification
Lack of liquidity hinders transactions
Actively managed ETFs
There are also actively managed ETFs, wherein portfolio managers are more involved in buying and selling shares of companies and changing the holdings within the fund. Typically, a more actively managed fund will have a higher expense ratio than passively managed ETFs. It is important that investors determine how the fund is managed, whether it's actively or passively managed, the resulting expense ratio, and the costs versus the rate of return to make sure it is worth holding.
Indexed-stock ETFs
An indexed-stock ETF provides investors with the diversification of an index fund as well as the ability to sell short, buy on margin, and purchase as little as one share because there are no minimum deposit requirements. However, not all ETFs are equally diversified. Some may contain a heavy concentration in one industry, or a small group of stocks, or assets that are highly correlated to each other.
Dividends and ETFs
Though ETFs provide investors with the ability to gain as stock prices rise and fall, they also benefit from companies that pay dividends. Dividends are a portion of earnings allocated or paid by companies to investors for holding their stock. ETF shareholders are entitled to a proportion of the profits, such as earned interest or dividends paid, and may get a residual value in the event that the fund is liquidated.
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