Exchange-Traded Funds (ETFs)
Exchange-traded funds (ETFs) have become increasingly popular in recent years. The return on your investment is tied to the performance of a market index. ETFs provide investors with a diversified portfolio and other benefits of mutual funds but often at a lower minimum investment.
What Is an ETF?
An ETF — or exchange-traded fund — is an investment vehicle that lets investors gain diversified exposure to stocks, bonds and other assets.
The performance of an ETF’s investments is tied to a market index — such as the S&P 500 — or a sector of the economy, a basket of commodities or another reference.
The earliest ETFs were designed to track specific U.S. stock indexes. This type of ETF is still common, but newer ETFs may track fixed-income investments or foreign securities, according to the U.S. Securities and Exchange Commission.
Before investing in an exchange-traded fund, you should read the fund’s summary prospects as well as its full prospectus. The document will detail the ETF’s principal investment strategies, investment objectives, costs, risks and historical performance.
How Are ETFs Different from Stocks and Mutual Funds?
While there are some similarities between ETFs and mutual funds, they are two completely different investment funds. Both exchange-traded funds and mutual funds typically include publicly traded securities, like stocks, in their investment portfolios.
- Mutual Funds
- Mutual funds can only be traded — meaning bought or sold — at the end of the trading day. The trading price is based on the net asset value (NAV) of the fund, which is a measure if all holdings less liabilities.
- Exchange-traded funds utilize many of the features of mutual funds, but they trade like stocks on national securities exchanges throughout the day.
- A stock, or equity, is a type of security. A single stock represents your proportionate share of assets and future earnings associated with a company. You can buy and sell shares via national stock exchanges throughout the day. Transaction prices are determined by the interaction of market supply and demand.
When choosing from ETFs, mutual funds and stocks for your personal finance investment options, you should consider the minimum investment buy-in, the trading times and the fees associated with executing transactions and holding the asset. These factors vary among each investment option.
Both ETFs and mutual funds offer investors diversified access to an asset class or group of asset classes. However, each has different rules, costs and risks, so it’s important to choose based on your investment style and priorities.
What Are the Types of ETFs Available to Purchase?
There are two main management types of exchange-traded funds: actively managed ETFs and passively managed ETFs.
- Passively Managed ETFs
- Passively managed — or index-based — ETFs are designed to track a specific securities index, such as the S&P 500. Passively managed ETFs do this by investing primarily in the stocks making up that index. This way, the performance of the fund tends to mirror the index’s performance. However, the ETF may still invest some of its resources in other securities.
- Actively Managed ETFs
- Actively managed ETFs don’t follow an index. They may instead follow an existing mutual fund, an investment manager’s preferred investment choices or some other strategy that seeks to deliver higher returns. The fund may buy or sell investments daily without conforming to any index.
There are several different kinds of exchange-traded funds that fall into these two managerial categories. They are designed for different investment strategies, styles and risks.
- Market ETFs
- Market EFTs are traditional exchange-traded funds designed to track a specific index such as the NASDAQ or S&P 500.
- Bond ETFs
- Bond ETFs are designed to track bond performance and are typically diversified to include a wide range of bonds such as U.S. Treasury, municipal, international, corporate and others.
- Commodity ETFs
- Commodity ETFs track the price of commodities — such as oil, gold or a specific agricultural commodity.
- Currency ETFs
- Currency ETFs track the performance of currencies — for example, the U.S. dollar against a specific foreign currency or against a basket of currencies.
- Foreign ETFs
- Foreign ETFs are designed to track foreign market indexes such as Japan’s Nikkei or the UK’s FTSE 100.
- Inverse ETFs
- Inverse ETFs are designed so that they turn a profit whenever the market or index they track declines.
- Sector or Industry ETFs
- There are 11 sectors in the U.S. stock market and sector — each made up of similar industries. Sector or industry ETFs are designed to track the performance of a particular sector.
- Style ETFs
- Style ETFs focus on market capitalization — such as large-cap or small-cap stocks.
Advantages and Disadvantages of ETFs
All investment options come with pros and cons. You should consider the advantages and disadvantages of ETFs before investing in one. You should also compare ETFs to other investment options you are considering.
- Diversification of investments reduces risk.
- Low commission and fee costs.
- You can target a specific industry or sector with certain ETFs.
- ETFs trade like stocks — you can trade them at any time of the day for the price at that time.
- Some types of ETFs present higher risk than others.
- Fees can be higher with actively managed ETFs.
- ETFs that track a specific industry or sector may limit your diversification.
- Long term investors are not likely to benefit from intraday trading — trading at any time of day.
Who Is an ETF Suitable For?
The qualities of ETFs make them a practical investment for beginners and hands-off investors. Those with little investment money may also find exchange-traded funds their best investment option.
ETFs let you build a diversified portfolio with some of the lowest fees and investment requirements. In addition, ETFs are liquid — allowing investors to quickly pull out of a losing investment.
How Do You Buy and Sell an ETF?
Trading an exchange-traded fund — meaning buying and selling an ETF — can be done through a variety of brokers —traditional or digital.
- Traditional Brokers
- Traditional ETF brokers and dealers include some of the largest financial institutions and businesses. They typically offer mutual funds and other investment vehicles. They can also include independent financial professionals who can compare funds from different companies to find the best option for your needs and goals.
- Online Brokers
- Many traditional ETFs can be purchased online, allowing you to open a brokerage account and begin investing from home.
- Robo-advisors may be a good choice for a beginning investor or others who want a hands-off approach to investing. These are firms that manage your investments for you and charge you a typically low fee. However, the fees may limit your return potential.
To begin investing in an exchange-traded fund, you’ll need to follow a few simple steps.
First, do your research. There are a lot of ETFs to choose from. You’ll want to find the one that works best with your financial situation and goals. You’ll also want to consider your investment objectives and style, including your level of comfort with risk, your desire for income and growth, whether you want an active or passive investment and other matters that are important to you.
When you settle on a fund, you’ll want to find a broker that offers it. You can go in person to a traditional broker or dealer, or you can find an online broker or robo-broker.
Be sure to consider fees and other costs.
Once you’ve shopped around, you’ll need to open a brokerage account with your broker. This will be where your investment will be kept — and where you can monitor, access and invest in it.
Once you have all these steps completed, you can buy the ETF. Be sure to confirm all costs and fees — and if you’re buying online, be sure the purchase goes through.
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- U.S. Office of Government Ethics. (2017, January 26). Exchange-Traded Fund. Retrieved from https://www.oge.gov/Web/278eGuide.nsf/Content/Definitions~Exchange-Traded+Fund
- U.S. Securities and Exchange Commission. (2012, August). Investor Bulletin: Exchange-Traded Funds (ETFs). Retrieved from https://www.sec.gov/investor/alerts/etfs.pdf
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