ETF is an abbreviation for the word Exchange-Traded Fund. ETFs are a type of investment fund that combines the best features of two popular assets: They combine the diversification benefits of mutual funds with the ease with which stocks can be traded.
What Is EFT(Exchange-Traded Fund)
An exchange-traded fund (ETF) is a pooled investment security that functions similarly to a mutual fund. ETFs typically track a specific index, sector, commodity, or other assets, but unlike mutual funds, ETFs can be bought and sold on a stock exchange in the same way that regular stocks can.
An ETF can be designed to track anything from a single commodity’s price to a large and diverse collection of securities. ETFs can even be designed to follow specific investment strategies.
How ETF Works
An ETF is an exchange-traded fund because it is traded on a stock exchange, just like stocks. The value of an ETF’s shares fluctuates throughout the trading day as they are bought and sold on the market. In contrast, mutual funds are not traded on an exchange and trade only once per day after the markets close.
Furthermore, when compared to mutual funds, ETFs are less expensive and more liquid. An ETF is a type of fund that holds multiple underlying assets as opposed to just one, as a stock does. Because an ETF contains multiple assets, it can be a popular choice for diversification.
ETFs can thus hold a wide range of investments, such as stocks, commodities, bonds, or a mixture of investment types.
An ETF can hold hundreds or thousands of stocks across multiple industries, or it can be limited to a single industry or sector. Some funds only offer products in the United States, whereas others have a global outlook. Banking-focused ETFs, for example, would hold stocks from various banks across the industry.
An ETF is marketably secure, which means that its share price is easily bought and sold on exchanges throughout the day, and it can be sold short.
Most ETFs in the United States are structured as open-ended funds and are governed by the Investment Company Act of 1940 unless subsequent rules modify their regulatory requirements. The number of investors who can participate in an open-end fund is not limited.
ETF Examples
For all their simplicity, exchange-traded funds have nuances that are important to understand. Armed with the basics, you can decide whether an ETF makes sense for your portfolio, and embark on the exciting journey of finding one — or several.
There are lots of great ETFs out there, but here are a few picks from our list of the top-rated 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.
Sector ETFs track individual industries and sectors such as oil (OIH), energy (XLE), financial services (XLF), real estate investment trusts (IYR), and biotechnology (BBH).
Commodity ETFs represent commodity markets, including gold (GLD), silver (SLV), crude oil (USO), and natural gas (UNG).
Country ETFs track the primary stock indexes in foreign countries, but they are traded in the United States and denominated in U.S. dollars.
Examples include China (MCHI), Brazil (EWZ), Japan (EWJ), and Israel (EIS). Others track a wide breadth of foreign markets, such as ones that track emerging market economies (EEM) and developed market economies (EFA).
Types Of ETFs
Investors can choose from a variety of ETFs that can be used for income generation, speculation, and price increases, as well as to hedge or partially offset risk in an investor’s portfolio. Here is a brief description of some of the ETFs that are currently available on the market.
Passive and Active ETFs
ETFs are classified as either passive or actively managed. Passive ETFs seek to replicate the performance of a broader index, such as the S&P 500, or a more specific targeted sector or trend.
Gold mining stocks are an example of the latter category: as of February 18, 2022, there are approximately eight ETFs that focus on gold mining companies, excluding inverse, leveraged, and funds with low assets under management (AUM).
Actively managed ETFs do not typically track an index of securities, but rather rely on portfolio managers to decide which securities to include in the portfolio. These funds have advantages over passive ETFs, but they are more expensive for investors.
Bond ETFs
Bond ETFs are used to provide investors with consistent income. Their income distribution is influenced by the performance of the underlying bonds.
Government bonds, corporate bonds, and state and local bonds, known as municipal bonds, may all be included. Bond ETFs, unlike their underlying instruments, do not have a maturity date. They typically trade at a premium or discount to the underlying bond price.
Stock ETFs
Stock (equity) ETFs are a collection of stocks that track a single industry or sector. A stock ETF, for example, could track automotive or foreign stocks.
The goal is to provide diversified exposure to a single industry that includes both high performers and new entrants with growth potential. Stock ETFs, unlike stock mutual funds, have lower fees and do not require actual ownership of securities.
Industry/Sector ETFs
sector or industry ETFs are funds that specialize in a particular sector or industry. An energy sector ETF, for example, will include companies in that sector. The idea behind industry ETFs is to gain exposure to the upside of a specific industry by tracking the performance of companies in that industry.
One example is the technology sector, which has seen an increase in funding in recent years. At the same time, because ETFs do not involve direct ownership of securities, the downside of volatile stock performance is also limited. During economic cycles, industry ETFs are also used to rotate in and out of sectors.
Commodity ETFs
Commodity ETFs, as the name suggests, invest in commodities such as crude oil or gold. Commodity ETFs offer several advantages. To begin with, they diversify a portfolio, making it easier to hedge against downturns.
Commodity ETFs, for example, can act as a buffer during a stock market downturn. Second, owning shares in a commodity ETF is less expensive than owning the commodity itself. This is because the former does not require insurance or storage.
Currency ETFs
Currency exchange-traded funds (ETFs) are pooled investment vehicles that track the performance of currency pairs, which include both domestic and foreign currencies. Currency ETFs serve several functions. They can be used to speculate on currency prices based on a country’s political and economic developments.
Importers and exporters use them to diversify their portfolios or as a hedge against volatility in forex markets. Some are also used to protect against the threat of inflation. Bitcoin is even available as an ETF.
Inverse ETFs
Shorting stocks allows inverse ETFs to profit from stock declines. Shorting a stock means selling it with the expectation of repurchasing it at a lower price. In order to short a stock, an inverse ETF employs derivatives.
They are essentially bets on the market falling. When the market falls, an inverse ETF increases in proportion. Many inverse ETFs are exchange-traded notes (ETNs) rather than true ETFs, which investors should be aware of.
An ETN is a bond that trades like a stock and is backed by a bank or other issuer. Check with your broker to see if an ETN is appropriate for your portfolio.
Leveraged ETFs
A leveraged ETF seeks to outperform the underlying investments by a factor of two or three. For example, if the S&P 500 rises 1%, a 2 leveraged S&P 500 ETF will rise 2%. (and if the index falls by 1 percent, the ETF would lose 2 percent ).
These products leverage their returns by utilizing derivatives such as options or futures contracts. In addition, leveraged inverse ETFs seek an inverse multiplied return.
ETF Advantages
Investors have flocked to exchange-traded funds because of their simplicity, relative cheapness, and access to a diversified product. Here are the advantages:
Diversification
While it is common to think of diversification in terms of broad market verticals — stocks, bonds, or a specific commodity, for example — ETFs allow investors to diversify across horizontals, such as industries. It would take a lot of money and effort to buy all of the components of a specific basket, but an ETF delivers those benefits to your portfolio with the click of a button.
Diversification can help protect your portfolio from market volatility. If you only invested in one industry and that industry had a bad year, your portfolio would most likely have performed poorly as well.
By diversifying your investments across industries, company sizes, geographies, and other factors, you can better balance your portfolio. You don’t have to be concerned about creating it within your portfolio because ETFs are already well-diversified.
Transparency
Anyone with internet access can look up the price movement of a specific ETF on an exchange. Furthermore, a fund’s holdings are disclosed to the public every day, whereas mutual funds do so monthly or quarterly.
This transparency enables you to keep a close eye on your investments. Assume you don’t want to invest in oil. You’d be able to spot those changes in your ETF more easily than you would in a mutual fund.
Tax benefits
Over mutual funds, ETFs have two significant tax advantages.
If you invest in a mutual fund, you may be required to pay capital gains taxes (profits from the sale of an asset, such as stock) for the duration of your investment. This is because mutual funds, particularly actively managed funds, frequently trade assets more frequently than ETFs. Most ETFs, on the other hand, only incur capital gains taxes when they are sold. This means you’ll pay less tax overall on your ETF investment.
Because mutual fund managers actively buy and sell investments while incurring capital gains taxes, the investor may be subject to both long-term and short-term capital gains taxes. When you invest in an ETF, you can choose when to sell, which makes it easier to avoid the higher short-term capital gains tax rates.
ETF Disadvantages
Exchange-traded funds may work well for some investors, but they aren’t perfect. Here are the cons:
Trading costs
ETF costs may not end with the expense ratio. Because ETFs are exchange-traded, they may be subject to commission fees from online brokers. Many brokers have decided to drop their ETF commissions to zero, but not all have.
Potential liquidity issues
As with any security, you’ll be at the whim of the current market prices when it comes time to sell, but ETFs that aren’t traded as frequently can be harder to unload.
Risk the ETF will close
The primary reason this happens is that a fund hasn’t brought in enough assets to cover administrative costs. The biggest inconvenience of a shuttered ETF is that investors must sell sooner than they may have intended — and possibly at a loss. There’s also the annoyance of having to reinvest that money and the potential for an unexpected tax burden.
FAQS
What Is An ETF Account?
In most cases, it is not necessary to create a special account to invest in ETFs. One of the primary draws of ETFs is that they can be traded throughout the day and with the flexibility of stocks. For this reason, it is typically possible to invest in ETFs with a basic brokerage account.
How Many ETFs Are There?
The number of ETFs, along with the number of assets that they control, has grown dramatically over the past two decades. In 2020, there were an estimated 7,602 individual ETFs listed globally, up from 7,083 in 2019—and only 276 in 2003.2
What Was The First Exchange-Traded Fund (ETF)?
The first exchange-traded fund (ETF) is often credited to the SPDR S&P 500 ETF (SPY) launched by State Street Global Advisors on Jan. 22, 1993. There were, however, some precursors to the SPY, notably securities called Index Participation Units listed on the Toronto Stock Exchange (TSX) that tracked the Toronto 35 Index that appeared in 1990.
How Is ETF Different From Index Fund?
An index fund usually refers to a mutual fund that tracks an index. An index ETF is constructed in much the same way and will hold the stocks of an index, tracking it. However, an ETF tends to be more cost-effective and liquid than an index mutual fund. You can also buy an ETF directly on a stock exchange throughout the day, while a mutual fund trades via a broker only at the close of each trading day.
How to invest in ETFs?
Because shares of ETFs trade like stocks, the most common way for individual investors to buy and sell ETFs is through a broker. Brokerage accounts allow investors to make ETF trades manually or through a passive approach such as a Robo-advisor.
Investors choosing to have a more hands-on approach will need to search through the growing ETF market for funds to buy, keeping in mind that some ETFs are designed for long-term investment and others are designed to be bought and sold over a short period of time.
What Does An ETF Cost?
ETFs have administrative and overhead costs which are generally covered by investors. These costs are known as the “expense ratio,” and typically represent a small percentage of investment.
The growth of the ETF industry has generally driven expense ratios lower, making ETFs among the most affordable investment vehicles. Still, there can be a wide range of expense ratios depending upon the type of ETF and its investment strategy.
Conclusion
ETFs are a type of investment fund and exchange-traded product that track the performance of an index or “basket” of securities (such as shares, bonds, commodities, etc.). ETFs are listed on a stock exchange and trade similarly to stocks; they allow investors to diversify their investments at a lower cost and gain exposure to various asset classes and strategies such as;
