Investing 101: What Is an Exchange-Traded Fund (ETF)?

An ETF is a type of fund traded on an exchange, the way a stock is. But instead of representing just one asset (as a stock does), an ETF represents multiple assets, which can themselves be stocks, bonds, commodities, or a mixture of all three. The ETF bundles them together into a single item at a single price, making trading a large number of assets easier and less expensive.

ETFs work in a manner similar to mutual funds. They pool together multiple underlying assets and, in doing so, can offer investors diversification in their investment. ETFs can be structured to follow the price of one particular commodity, or they can contain hundreds or thousands of different stocks, bonds, or commodities within them. Some ETFs track only US-based companies, while others are international.

An ETF has a share price, meaning it can be bought and sold on exchanges, which can happen many times in one day. This can make its price fluctuate throughout the day, in contrast to a mutual fund, which only updates its price once each day after the market closes.

• An easy way to build investment diversification into a portfolio to mitigate risk.
• ETFs likely already exist that offer access to any industry or industries in which you want to invest.
• Because the assets are traded in a bundle, each sale results in only one broker’s commission, rather than the hundreds of commissions that would result if the stocks were traded separately.
• Many ETFs also offer lower expense ratios because they track an index with its own list of stocks (such as the S&P 500). This means they can be passively managed (which costs less), though some ETFs are actively managed.

• Some ETFs are actively managed, which can cause them to have a high expense ratio.
• ETFs focused on one sector would offer little diversification to a portfolio.
• Limited liquidity could hinder other transactions. ETFs with low assets under management (AUM), or low rates of daily trading, might be less liquid.

Two popular types of ETFs are those that track a stock index (and are, therefore, broadly diversified) and those that focus on one particular industry.

• SPDR S&P 500 (SPY), nicknamed “The Spider,” tracks the S&P 500 and is the longest-running and best-known ETF.
• iShares Russell 2000 (IWM) tracks the Russell 2000 small-cap index.
• Invesco QQQ (QQQ), nicknamed “cubes,” tracks the Nasdaq-100 Index, which usually contains technology stocks.
• SPDR Dow Jones Industrial Average (DIA), nicknamed “diamonds,” represents the 30 stocks of the Dow Jones Industrial Average.
• Sector ETFs track individual industries, such as oil (OIH), energy (XLE), financial services (XLF), real estate investment trusts (IYR), and biotechnology (BBH).
• Commodity ETFs represent commodity markets, such as gold (GLD), silver (SLV), crude oil (USO), or natural gas (UNG).
• Country ETFs track primary stock indexes of foreign countries, but they are traded in the United States and denominated in US dollars, including China (MCHI), Brazil (EWZ), Japan (EWJ), and Israel (EIS). There are others that track a variety of foreign markets, such as ones that track emerging market economies (EEM) and developed market economies (EFA).

The rapid growth of the ETF market in recent years has rendered their appraisal somewhat complex. A few factors to consider include: 

• Diversification: Be sure to analyze the weight of each of the various securities as well as their number. An ETF that includes the stocks of many different companies, but concentrates most of its value in two or three of them, does not provide as much diversification as another that perhaps has only a dozen companies more evenly weighted.
• Expense ratio: Passively managed funds generally have lower expenses than actively managed ones, but even so, there is a range. Those small expenses add up, so it is crucial to be aware of the effect of an ETF’s expense ratio.
• Liquidity: Investors might compare two ETFs that are similar in content or strategy, but if one of them has very low AUM, it may indicate liquidity issues.

There are thousands of different ETFs, with between 7,000-8,000 available globally, and, within the United States, a number rapidly approaching 3,000.

The term “index fund” refers to a mutual fund that tracks an index. If an ETF tracks that same index, then it holds all the same stocks held by that mutual fund. The major difference between them is that the mutual fund can only be traded via a broker, and only once each day, at the close of the day. 

In contrast, an index ETF can be bought and sold directly on a stock exchange and at any time of day. This makes them more liquid and more cost-effective than the equivalent mutual fund.

Investors usually pay some administrative and overhead costs, which are called the expense ratio. These can vary widely but are usually a tiny percentage of the investment. Expense ratios for ETFs are on their way down as the ETF market grows and becomes more popular.

ETFs are a valuable type of trading tool. One of the main benefits of ETFs is their ability to add investment diversification to an investor’s portfolio easily. Instead of investing in a single organization, the ETF spreads that risk over the industry or a group of companies. As a result, if one company struggles, the ETF's value doesn't plummet to a dangerous level.

Like other stocks, ETFs are likely to see their price change various times during the trading day. This price change happens as ETF shares are purchased and sold on the market. They are traded on an exchange, which makes them different from mutual funds. When comparing ETFs to other investment options, they tend to be more liquid and cost-effective, especially when compared to mutual funds.

Many investors, including some of the most wealthy, are using ETFs to build their portfolios. They tend to be beneficial for many types of investors, and in many cases, they are more affordable overall. 

Learn More: The SPDR S&P 500 ETF tracks the S&P 500 Index and is one of the most common and well-known ETFs. 

ETFs are designed much like mutual funds, though they offer different benefits. Investors typically don't have to worry about the actual process of creating an ETF to invest in them.

Nevertheless, the ETF creation process begins when an ETF manager files a plan with the US Securities and Exchange Commission to create a specific ETF. Next, they form an agreement with authorized participants, such as the market maker or large investor. The authorized participants then acquire stock shares and place those shares into a trust. This forms the creation of ETF units. These units may range from 10,000 to 600,000 shares, depending on its stocks. 

The trust then makes the shares for the ETF. This creates legal claims on the shares in the trust for the authorized participant. Once that participant receives the shares, they can then be sold to the public on the market.

Several types of ETFs exist, allowing buyers and sellers to use them for various goals. For example, they may be used to generate income. Other times, they may be used to reduce risks associated with investing in specific companies. They may also be invested in for speculation or expected price increases.

A stock ETF is a common type. It's made up of stocks that track a single industry or sometimes a sector. For example, some may track foreign stocks, while others track a specific commodity. When investing in stock ETFs, there is more opportunity for diversification. Stock ETFs are typically more affordable with lower fees than stock mutual funds, and they typically allow investors to put money into a fund that diversifies risk across high performers but also new entrants into that sector. 

Investors use bond ETFs to create a regular income. The income amount depends on the performance of the bonds within the ETF. These may include any type of bond, such as a corporate bond or a municipal bond. However, bond ETFs do not have a specific maturity date, which is different from purchasing a bond directly. Most often, ETFs like this trade at a premium or sometimes at a discount from the actual bond value.

Industry ETFs, sometimes called sector ETFs, are specific to an industry. This may include the automotive industry, energy industry, or another. Industry ETFs are typically made up of the biggest companies in the sector. The benefit of investing in an industry ETF is that it allows investors to put money into a group of companies within that industry instead of one. That means that it tracks the overall performance of the industry as a whole rather than a specific company. 

Often, industry ETFs are beneficial when an industry sees a significant amount of investment into it. In addition, some investors use them to move from one sector to another based on economic conditions.

A commodity ETF is one in which the underlying investments are a specific commodity. That may include gold or oil, for example. Using an ETF for commodity investment may offer investors several benefits, including the ability to make it easier to hedge downturns within that sector. Additionally, it is typically less expensive for an investor to hold shares in a commodity ETF than to do so in the physical possession of that commodity. 

An inverse ETF has a specific goal of gaining from declines in stock value by shorting stocks. The process of shorting stocks involves expecting a decline in the value of the stock, so the investor sells the stock and then purchases it back up again when the price drops. These can be beneficial for investors speculating a downturn in the economy or for a particular sector.

A currency ETF is just what it sounds like. These investments track the performance of currency pairs, which typically include domestic and foreign currencies. They are often used to speculate on currency prices based on political and economic conditions or changes within a location. They may also be a helpful way of hedging against forex markets. 

Most often, buying ETFs happens through a brokerage using a trading function. This includes online and traditional broker-dealers. Some robo-advisors trade ETFs, though not all do. 

As with buying ETFs, selling ETFs is done through online brokerages or traditional brokerage organizations. Selling them is easy to do – one of the core benefits of these investment options is that they are liquid enough for a fast transaction.

It is also important for investors to consider ETF taxes. When compared to mutual funds, ETFs can be more efficient from a tax perspective, as the selling and buying of the ETFs typically occur through an exchange, unlike that of mutual funds. That means that the ETF sponsor has no need to redeem the shares or issue new shares every time investors decide to sell or purchase them. 

That being said, each investor’s needs vary, and the best choice for you will depend on your individual financial goals.