An exchange-traded fund (ETF) is a popular investment vehicle that allows you to invest in a diversified portfolio of assets. ETFs trade on stock exchanges like individual stocks but consist of a "bundle" of securities. They provide investors with diversification and, in some cases, tax advantages, making them a versatile option for both beginners and experienced investors.
ETFs are major components of the stock market today. But are they the right investment for you? Keep reading to learn more about ETFs: how they work, the different types, and how to choose the right one for your portfolio.
What Is an Exchange-Traded Fund?
ETFs are collections of assets—such as stocks, bonds, currencies, or commodities—that trade together as a single unit on stock exchanges. This flexibility makes ETFs a popular choice for building a well-rounded investment portfolio.
Each ETF has a theme or strategy, such as tracking an index, targeting a specific sector, or investing in income-generating assets. For instance, an ETF might replicate the S&P 500 index or focus on dividend-paying stocks.
How Do ETFs Work?
ETFs pool investors' money to create a portfolio of underlying securities. These funds are designed to match the performance of a specific benchmark or asset class. ETFs trade throughout the day on exchanges, and their prices fluctuate based on the value of their underlying holdings.
Passively managed ETFs aim to replicate the performance of indexes like the S&P 500 by tracking their composition, while actively managed ETFs rely on professional managers to select securities with the goal of outperforming the market.
Types of ETFs
ETFs come in various forms to meet different investor goals. Here are some of the most common types:
Index ETFs
Index ETFs track major market indexes, such as the S&P 500, by holding the same assets as the index. They are cost-effective, diversified, and ideal for long-term investors.
Market Cap ETFs
These focus on companies grouped by market capitalization. For example, small-cap ETFs invest in smaller, high-growth companies, while large-cap ETFs focus on industry leaders.
Bond ETFs
Bond ETFs invest in fixed-income securities like corporate or municipal bonds. They offer lower risk and steady returns, making them a conservative choice for income-focused investors.
Commodity ETFs
Commodity ETFs provide exposure to physical assets like gold, oil, or agricultural products. They are often used to hedge against inflation or diversify portfolios.
Because they typically use derivatives like futures contracts to gain exposure to the underlying commodities, these ETFs can provide investors with indirect ownership of the physical commodities without requiring direct storage or delivery.
Sector ETFs
Sector ETFs invest in companies within a specific industry, such as technology, healthcare, or consumer goods. They allow investors to target high-growth sectors without selecting individual stocks.
For example, a consumer discretionary ETF might invest in stocks like The Walt Disney Company NYSE: DIS, Starbucks Corporation NASDAQ: SBUX and Royal Caribbean Cruises Ltd. NYSE: RCL, all in the same fund.
Real Estate ETFs
These funds invest in real estate investment trusts (REITs) and related companies, providing exposure to real estate markets without owning physical property. Many real estate ETFs also qualify as income ETFs thanks to the REIT requirement to pay at least 90% of profits in dividends.
Currency ETFs
Interested in the forex market but don't want to take the risk of active trading? Consider currency ETFs, which track foreign exchange rates, allowing investors to profit from currency fluctuations or hedge against currency risks.
High-Income ETFs
High-income ETFs invest in assets that generate consistent dividends, such as dividend-paying stocks, REITs, or high-yield bonds.
International ETFs
International ETFs invest in securities outside the United States, providing exposure to competing markets. International ETFs usually track specific international indexes like the MSCI EAFE Investable Market Index, making them similar to other index funds on this list. An international ETF might provide exposure to developing countries or established international competitors.
ETFs vs. Index Funds
While the characteristics of ETFs and index funds often overlap, there are key differences:
-
- Intraday Trading: ETFs trade throughout the day, while index funds are priced once daily.
- Fees: ETFs typically have lower expense ratios than mutual funds.
- Transparency: ETFs disclose their holdings daily, while index funds may do so less frequently.
ETFs vs. Mutual Funds
ETFs and mutual funds are both pooled investment vehicles, but they differ in structure:
- Trading: ETFs trade like stocks, while mutual funds are bought or sold at the end-of-day NAV price.
- Accessibility: ETFs often have lower minimum investment requirements, making them more accessible.
- Expense Ratios: ETFs usually have lower fees than actively managed mutual funds.
| |
ETFs
|
Mutual funds
|
Index funds
|
|
Minimum investment requirements
|
Price of one share
|
Set by mutual company
|
Variable depending on structure
|
|
Structure
|
May be actively or passively managed depending on what the index tracks
|
May be actively managed by institutional managers
|
Tracks an underlying index; usually passively managed
|
|
Fees
|
Average expense ratio of 0.16%
|
Average expense ratio of 0.39%
|
Average expense ratio of 0.2% for passively managed funds
|
|
Accessibility
|
Traded during regular business hours like shares of stock
|
Purchased at the end of the trading day by the mutual fund company
|
Variable depending on structure
|
|
Transparency
|
Legally required to reveal holdings to potential investors on a daily basis
|
Not required to reveal holdings
|
Usually elect to reveal holdings when not required by law
|
Popular ETFs and Indexes
Here are a few examples of the most popular ETFs and the indexes that they track.
Let’s take a closer look at the ETFs listed above and how they benefit investors.
SPDR S&P 500 ETF Trust
The SPDR S&P 500 ETF Trust NYSE: SPY is one of the world's largest and most popular ETFs. Its mission is to provide investors with exposure to the performance of the S&P 500 Index, a widely recognized benchmark of the U.S. stock market. SPY aims to replicate the index's performance by holding a diversified portfolio of stocks that closely mirrors the index composition.
Vanguard Mega Cap ETF
The Vanguard Mega Cap ETF NYSE: MGC invests in mega-cap, blue-chip stocks that dominate their industries. It tracks the CRSP U.S. Mega Cap Index, which represents the largest companies in the U.S. equity market when sorted by total market capitalization. Some of the fund's largest holdings include Apple Inc. NASDAQ: AAPL and Microsoft Corporation NASDAQ: MSFT.
Fidelity Total Bond ETF
The Fidelity Total Bond ETF NYSE: FBND can be a great option if you want exposure to the broad U.S. bond market. The FBND tracks the Bloomberg Barclays U.S. Universal Bond Index, which includes a diverse range of fixed-income securities such as government bonds, corporate bonds and mortgage-backed securities. It's an option if you're looking for the stability of bond protections.
SPDR Gold Shares
Gold investors frequently choose the SPDR Gold Shares ETF NYSE: GLD when they want to add exposure to the gold commodity market to their portfolios. Each share of the ETF represents a fractional ownership interest in the trust, which holds physical gold bars in secure vaults. Unlike most ETFs, GLD does not track a particular index and instead showcases value based on the changing value of gold bullion on the international market.
Consumer Discretionary Select Sector SPDR Fund
The Consumer Discretionary Select Sector SPDR Fund NYSE: XLY is an ETF that provides investors with a convenient way to invest in a series of leisure and luxury companies. It tracks the Consumer Discretionary Select Sector Index, representing companies selling non-essential goods throughout the United States. Some of the fund's top holdings are in Amazon.com NASDAQ: AMZN, Tesla Inc. NASDAQ: TSLA and The Home Depot Inc. NYSE: H.D..
Vanguard Real Estate ETF
A real estate ETF may provide diversified access to a particular property market segment without the massive upfront investment required to own property directly. The Vanguard Real Estate ETF NYSE: VNQ invests in both Vanguard-owned and third-party real estate opportunities according to the MSCI US RIT Index.
Invesco DB U.S. Dollar Index Bullish Fund
The Invesco DB U.S. Dollar Index Bullish Fund NYSE: UUP is designed to track the performance of the U.S. dollar relative to a basket of major currencies. UUP seeks to replicate the price and yield performance of the Deutsche Bank Long USD Currency Portfolio Index, which consists of futures contracts on six currencies: the euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc. Investing in UUP can expose you to the U.S. dollar's movements against these currencies.
Amplify High Income ETF
If you're looking to invest in ETFs to create a consistent stream of dividend income, a high-income option like the Amplify High Income ETF NYSE: YYY might be an appealing choice. YYY utilizes a multi-asset income strategy, investing in a diversified portfolio of high-yield bonds, dividend stocks and covered call options. The fund seeks to generate attractive income for investors by targeting securities with high yields, combining fixed-income and equity investments to enhance income generation while managing risk.
Vanguard Total International Stock ETF
The Vanguard Total International Stock ETF NASDAQ: VXUS provides investors with broad exposure to international equity markets. Its underlying stock index, the FTSE Global All Cap ex U.S. Index, is a market-cap-weighted index of global stocks, covering about 99% of the world's global market capitalization outside the United States. It includes assets from emerging and established international markets, providing wider exposure for investors.
How to Choose an ETF
Selecting ETFs as an investor involves managing your expectations and reducing overall portfolio risk. Here's a step-by-step guide to help with the selection process.
1. Define Your Investment Objectives: Determine whether you’re seeking growth, income, or diversification.
2. Determine Your Risk Tolerance: Assess your comfort with potential market volatility. ETFs can vary in risk exposure depending on the underlying assets that make up the fund.
3. Conduct Thorough Research: Examine the fund's investment strategy, holdings, historical performance, expense ratio, and the index or benchmark it tracks if it operates as an index fund. Review the fund's prospectus and other available materials to gain insights into its objectives and risks to ensure they align with your goals before investing.
4. Diversify Your Holdings: As the old saying goes, you should never put your eggs into one basket. This is especially true when investing in ETFs, which may show similar volatility to stocks depending on their underlying assets.
Pros and Cons of Investing in ETFs
Investors can decide if ETFs align with their financial goals and risk tolerance by weighing these positives and negatives.
Pros
Some benefits of ETFs include:
- Diversification: ETFs provide access to a broad range of assets within a single investment, reducing portfolio risk.
- Cost-Effective: They generally have lower expense ratios compared to mutual funds, especially passive ETFs.
- Tax Efficiency: The creation and redemption process minimizes capital gains distributions, leading to lower tax burdens.
- Liquidity: ETFs trade like stocks, allowing intraday buying and selling at market prices.
- Transparency: ETFs disclose their holdings daily, giving investors a clear view of the underlying assets.
- Flexibility: They support various trading strategies, such as short selling, margin buying, and using limit orders.
Cons
Some drawbacks of ETFs include:
- Expense Ratios: Although lower than mutual funds, ETFs still charge fees that can erode returns over time.
- Lack of Control: Investors have no say in the selection or management of the fund’s holdings.
- Market Risk: ETFs are still subject to market volatility, particularly those tracking high-risk sectors or assets.
- Liquidity Concerns for Niche ETFs: Some specialized or less popular ETFs may have lower trading volumes, leading to wider bid-ask spreads.
- Complexity for Beginners: The variety of ETFs can be overwhelming, making it difficult for new investors to choose suitable funds.
Becoming an ETF Investor
While ETFs provide a more stable option than investing in individual shares of stock, it's important to remember that the same market factors influence these assets. However, unlike stocks, investors must also be wary of the expense ratios of holding ETFs, which are payments made to the company that manages the fund. If you're looking for affordable ETFs to hold in the long term, look for those that track a major index, which are more likely to have low expense ratios due to higher market competition. Understanding how ETFs work and choosing the right ones for your goals can help you build a portfolio that grows steadily over time.
FAQs
Interested in learning more about the most active ETFs today? The following are some of the most common last-minute questions about ETFs.
What is an ETF and how does it work?
An ETF is an investment vehicle that pools money from multiple investors to buy a diversified portfolio of stocks, bonds and other assets. ETFs offer investors an easy way to gain exposure to a specific market or asset class without buying individual stocks. Their value fluctuates throughout the trading day based on their underlying assets, like stocks.
Are ETFs good investments?
ETFs can be great investment choices for investors looking for diversification, liquidity and more affordable fund holdings. There may be better choices for investors looking for direct control over all holdings in their portfolio or who want to actively manage their own portfolios to avoid fees.
How do ETFs make you money?
ETFs earn money by dividing investor funds between multiple stocks, bonds and other assets likely to increase in value over time. Investors see their shares of the fund increase after investing in ETFs, returning value to their portfolios. Many ETFs also return value by offering dividend payments.
