Exchange Traded Funds (ETFs): Comprehensive guide to investing in ETFs
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- An exchange-traded fund (ETF) is a basket of securities that’s traded on a stock exchange.
- While many ETFs track indexes, some are actively managed.
- ETFs have some advantages over mutual funds, but they aren’t always as liquid as some mutual funds.
Exchange-traded funds (ETFs) have become one of the most popular investment products offered by many of the best investment apps. ETFs provide a low-cost and convenient way to diversify your portfolio since you can gain access to a large pool of underlying assets within one investment.
However, not all ETFs are the same. Some niche ones, for example, don’t have much trading activity, so it can be hard to find a buyer or seller at a good price. These ETFs might be less liquid than some mutual funds, where the fund manager is generally always a willing buyer or seller.
So, while ETFs have a lot of advantages, you’ll also want to understand what these funds involve, including the costs and risks, before investing in ETFs. Here’s everything you need to know about investing in ETFs.
Definition and purpose of ETFs
An ETF is a basket of securities that is traded on stock market exchanges, much like any other stock. When you purchase a share of the ETF, you become a partial owner of the fund, which might represent ownership in thousands of underlying stocks or other assets such as bonds or commodities. Your investment could increase or decrease in value as the prices of the underlying assets change.
ETFs’ fees are often lower than those of comparable mutual funds, and based on their design, ETFs typically have tax advantages over mutual funds. Plus, ETFs generally are very liquid, as they have a transparent market price that investors can buy or sell at, much like stocks.
“Exchange-traded refers to the fund being able to be bought and sold during the trading day,” says Curtis Bailey, a CFA, chief compliance offer and financial advisor at Quiet Wealth Management. “A fund is an ownership structure that allows an investor to own a portion of an underlying basket of securities.”
How ETFs work
ETFs can be a little confusing when you dig deep into all the details, but for what the average investor experiences, they’re usually easy to understand and trade.
Creation and structure of ETFs
An ETF is created when a financial institution files a plan with the Securities and Exchange Commission (SEC) to act as the fund sponsor/ETF manager, who is responsible for creating and redeeming ETF shares and managing the fund overall.
ETF fund sponsors work with authorized participants (APs) — typically large broker-dealers — who buy the underlying securities that comprise the ETF. The AP then delivers those securities to the fund sponsor who provides the AP with ETF shares that the AP then sells on the stock exchange.
From there, the ETF shares can be bought and sold by any investor much like any other stock. You can even purchase ETFs on margin and place limit orders like you can with stocks, though make sure you understand the risks involved with those approaches.
APs can also reverse the process by delivering ETF shares to the fund sponsor who then retires those shares and delivers the underlying securities to the AP. This creation/redemption process isn’t something that individual investors get involved with, nor is it necessarily something that they need to focus on, but essentially, this interplay between the AP and ETF sponsor helps ETFs trade at a price that accurately reflects the value of the underlying securities.
Also, this creation/redemption process is the mechanism that allows ETFs to avoid triggering capital gains taxes the way that mutual funds do.
Essentially, mutual fund shareholders face capital gains based on the overall trading activity of the fund. In contrast, ETF shareholders only face capital gains based on their individual activity when buying and selling ETF shares. That can be particularly advantageous for those who want to hold ETFs long-term in a taxable account, as you can avoid capital gains during the years when you hold onto your assets.
Trading on exchanges
As the name implies, ETFs trade on exchanges — typically stock exchanges where you would find commonly traded stocks, like the New York Stock Exchange or NASDAQ. This helps make ETFs highly accessible. Most investors can simply open their brokerage app and place a buy or sell order for an ETF, just as they can for most stocks.
Like with stocks, you may have to pay a transaction fee to your brokerage for each ETF trade. That fee, however, is exclusive to the brokerage, rather than being something that the ETF collects. Instead, ETFs have a percentage-based annual fee, like mutual funds, known as an expense ratio.
“The largest ETFs often have really low fees,” says Bailey. “[But] some ETFs have higher expense ratios than actively managed mutual funds.”
The exchange price of an ETF typically reflects the underlying value of the securities the fund holds — for example, an ETF that tracks the S&P 500 will generally go up or down in unison (on a percentage basis, since the actual share price differs depending on the fund) with how those 500 companies in the S&P 500 perform.
However, it’s important to note that tracking errors could lead to a small discrepancy between the ETF’s price and the value of the underlying assets in some cases, such as during periods of unusually high or low demand for an ETF.
ETF tracking error
A tracking error is the difference between the return of an investment/investment portfolio and the return of a chosen benchmark the investment/portfolio is meant to follow.
This also relates to how there can be a difference between the price that people are willing to buy and sell shares of the ETF. The bid-ask spread — which is the difference between the offer/sell (ask) price and the purchase/buy (bid) price of a security — may be more common for less commonly traded ETFs.
“This spread may represent an additional hidden cost as an investor pays more to buy the shares and receives less to sell the shares,” says Bailey.
ETFs vs. mutual funds vs. index funds
ETFs, mutual funds, and index funds share some similarities, but they are not interchangeable terms.
As mentioned, an ETF is a fund that trades on an exchange and represents ownership of a pool of securities. ETFs have real-time pricing based on trading activity/underlying security prices, and they can be bought and sold throughout the trading day when the stock market is open (and sometimes after-hours, depending on the brokerage).
Mutual funds also hold a basket of securities. However, unlike ETFs, mutual funds are not traded on stock exchanges. Instead, a broker typically facilitates buy and sell orders between investors and the fund manager. As part of not being exchange-traded, mutual funds are only priced once per day after the market closes, based on the underlying security prices.
Mutual funds often have higher initial minimum investment requirements and fees than ETFs, though it depends on the specific funds. However, mutual funds can hold advantages over ETFs, like sometimes being easier for buying fractional shares. Mutual funds also arguably provide greater liquidity in the sense that the fund manager acts as a guaranteed trade partner and there’s no bid/ask spread — the fund manager simply offers the price at which it will accept buy or sell orders. There are other important differences between mutual funds and ETFs for investors to consider as well.
An index fund is a general term for a fund that tracks an index. Both ETFs and mutual funds could be index funds. A common simplification is that ETFs tend to track index funds while mutual funds are often actively managed, but you should not assume that’s always the case. Look at the specific details for any fund you’re considering.
“It’s important to understand the fund’s underlying investments, strategy, and costs,” says Bailey.
Benefits of investing in ETFs
ETFs provide several potential benefits, sometimes even above what individual stocks or mutual funds provide. The exact benefits depend on which ETF you’re considering and what the alternatives are, but in general, some of the top pros of ETFs include the following:
Diversification
ETFs offer diversification by providing exposure to a basket of assets. So while you might just be buying one ETF, your investment is generally more diversified than investing in the stock of one individual company.
Liquidity
ETFs tend to be highly liquid in the sense that you can typically buy and sell ETF shares as you wish throughout the trading day, even if the underlying assets aren’t very liquid. Mutual funds are generally liquid too, though it depends on the specific fund and how you look at liquidity. Some investors prefer the intraday liquidity of an ETF, while others prefer how mutual funds have no bid/ask spread, for example, as the fund manager always acts as a clear buyer or seller.
Low costs
ETFs tend to have lower expense ratios and lower investment minimums than mutual funds, though it depends on the type of fund. If you can find a brokerage that has low or no transaction fees, that can also help keep ETF costs down. That said, individual stocks do not have fund management fees like ETFs or mutual funds do.
Tax efficiency
Connected to low costs, ETFs tend to be more tax-efficient than mutual funds. That’s because the structure of ETFs enables the creation and redemption of shares by APs to not trigger capital gains, whereas the activities of other investors in a mutual fund affect the overall fund’s taxes. The best way to think about the difference is that ETFs are only taxed based on when you sell your shares or receive dividends, while mutual funds are also taxed based on the capital gains of the fund overall, even if you hold onto your shares.
Transparency
ETFs may seem complex at times, but they are transparent in the sense that expense ratios are clearly disclosed, as are their holdings on a daily basis, so you can understand what you’re investing in. This is similar to the transparency of mutual funds, while both are more transparent than some other vehicles like hedge funds.
Risks of investing in ETFs
While ETFs offer several benefits, there are also several risks to watch out for, such as:
Market risk
Like with any tradable asset, the value of ETFs can fluctuate based on what’s happening with the overall market. You might invest in a well-managed ETF, but if investors are selling the declining stocks of the companies that the ETF invests in, then the ETF will generally follow suit in losing value.
Also, some more exotic ETFs use leverage or short stocks (or gain short exposure through assets like derivatives), which can amplify losses more than if you invested directly in the underlying stocks.
Tracking error
Because ETFs are tradable securities, the price might not always reflect the underlying assets or benchmark it tracks. It’s possible, for example, that high demand for an ETF temporarily drives up the price above what the underlying securities are worth, which could cause the overall returns to slightly lag the benchmark.
Liquidity risk
While the liquidity of ETFs is generally seen as a positive, there are also some risks to consider. For one, less popular ETFs might not have much trading activity, so the bid/ask spreads could be wide, causing investors to essentially incur higher trading costs that affect net returns. Also, some argue that the intraday liquidity of ETFs makes them susceptible to overtrading, whereas you might feel more capable of taking a set-it-and-forget-it approach with mutual funds.
Types of ETFs
One way of categorizing ETFs is by management style. In that sense, there are two main types of ETFs: index-based ETFs and actively managed ETFs. Index-based ETFs are passively managed investments and track an index — a grouping of individual assets that share a common feature. For example, the S&P 500 is an index of the stocks of the 500 largest public companies in the US. Most ETFs are passively managed.
Then there are actively managed ETFs, which aren’t based on an index. Instead, they often have a benchmark index and a fund manager or team tries to outperform the benchmark by trading assets a little differently than what the index does.
For example, an actively managed ETF might include only certain companies within the S&P 500, or the fund manager might frequently buy and sell the stocks of S&P 500 companies to try to capture an edge, rather than just holding these assets. Generally, you’ll pay higher fees for an actively managed ETF.
Whether an ETF is passive or active, there can also be some different types of ETFs such as the following:
Stock ETFs
Stock or equity ETFs often track a specific index of stocks. The index may be based on the companies’ size, region, industry, or other commonalities. That said, a stock/equity ETF could be actively managed based on the stocks the fund manager thinks will perform well.
Bond ETFs
Bond or fixed-income ETFs track a portfolio of bonds, such as corporate and government debt.
Commodity ETFs
Commodity ETFs track the price of raw materials, such as gold or oil.
International ETFs
International ETFs track companies from a specific country or region. These are often types of equity ETFs, but a bond ETF could also represent a basket of international fixed-income securities.
Specialty ETFs
There are many types of niche or specialty ETFs, such as those that track certain industries or follow investment themes like allocating to ESG investing in socially conscious companies. There are now even ETFs that track cryptocurrency.
Examples of real ETFs
With the different types of ETFs in mind, here are a few examples of real ETFs:
How to invest in ETFs
Investing in ETFs is typically easy. You can buy and sell ETFs through a brokerage account by simply placing a buy or sell order, just as you would for other stocks.
The exact ETFs available can differ by brokerage, but most online brokerage accounts/investing platforms offer ETFs in some capacity. But not all investing apps and brokerages do, so make sure to do your research before signing up.
Beginners may have the best luck accessing ETFs with one of the best online brokerages for beginners, the best robo-advisors, or the best investment apps for beginners. These platforms might recommend certain ETFs to you, based on factors like your risk tolerance and investment style. But a more hands-on investor can use online screeners and your brokerage’s trading function to find ETFs that fit your investment goals.
“Every investor should consider ETFs,” says Bailey. “They are typically more tax-efficient and lower cost than mutual funds and offer diversification that would be hard to mimic through individual positions.”
However, there are also complex and high-risk ETFs available. Before making an investment decision, consider how the particular ETF could impact your portfolio and how it compares to other types of funds.
FAQs about ETFs
The main difference between ETFs and mutual funds is that an ETF trades on a stock exchange, while a mutual fund only trades via a broker. As such, there are differences such as ETFs having intraday liquidity. ETFs also often have tax advantages and lower costs.
For many investors, ETFs are suitable for long-term, low-cost investing, but it depends on the specific ETF and investor. A common long-term approach with ETFs is to buy and hold a low-cost ETF that tracks a diversified index like the S&P 500.
Choosing the right ETF for your portfolio is a matter of weighing your investment goals, risk tolerance, liquidity needs, and similar factors like you would weigh for other investments. For example, a long-term investor might choose a diversified, low-cost ETF, while a more speculative, high-risk investor might choose a specialty, leveraged ETF to try to make quick gains, at the risk of higher losses.