ETF 101: What Are They and How Do They Work?
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Considering the number of investment products out there, it can become confusing for a beginner to choose a product that fits their needs. Whether you are a beginner or looking to expand your portfolio this year, you must know all your options. One such option is an exchange-traded fund. Slightly different from stocks and slightly similar to mutual funds, this investment product could be an ideal choice if you are a passive investor. This guide explains ETFs in detail and helps you understand their pros and cons.
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What is an ETF?
An ETF, or Exchange-Traded Fund, is a type of investment fund that trades on stock exchanges, much like stocks. It holds assets such as stocks, commodities, or bonds and generally operates with an arbitrage mechanism to keep its trading close to its net asset value (NAV).
ETFs offer diversified exposure to a particular asset class or sector, allowing investors to buy and sell shares throughout the trading day at market prices. They provide an efficient way for investors to gain exposure to a wide range of assets without buying each security separately.
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How does an ETF work?
ETFs, or Exchange-Traded Funds, work by pooling money from multiple investors to invest in a diversified portfolio of assets, such as stocks, bonds, or commodities. A financial institution creates an ETF, often called the ETF sponsor or issuer. The sponsor selects a basket of securities that will comprise the ETF's underlying assets where new shares of the EFT are created.
Once created, the ETF shares are listed and traded on stock exchanges, just like individual stocks. Investors can buy and sell ETF shares throughout the trading day at market-determined prices.
Through an arbitrage mechanism, the ETF share price is kept in line with the value of its underlying assets. If the price of the ETF shares deviates from this value, authorized participants have an incentive to buy or sell the ETF shares and the underlying securities in the open market to profit from the price difference.
The NAV of an ETF is the total value of its underlying assets divided by the total number of shares outstanding. ETF sponsors typically calculate and publish the NAV of their ETFs at the end of each trading day. Investors who want to redeem their ETF shares can exchange them for the underlying securities that comprise the ETF's portfolio.
Types of ETFs
Several types of ETFs are available to investors, each offering exposure to different asset classes, investment strategies, and market segments. Here are some common types of ETFs:
- Broad market ETFs. These ETFs track broad market indexes, such as the S&P 500, the Dow Jones Industrial Average, or the Total Stock Market Index.
- Sector ETFs. Sector ETFs focus on specific economic sectors or industries, such as technology, healthcare, financials, energy, consumer discretionary, or utilities.
- Bond ETFs. Bond ETFs invest in fixed-income securities such as government, corporate, municipal, or Treasury bonds.
- International ETFs. International ETFs invest in stocks or bonds issued by companies or governments outside the investor's home country.
- Emerging markets ETFs. Emerging markets ETFs focus on stocks or bonds issued by companies or governments in developing countries with rapidly growing economies.
- Commodity ETFs. Commodity ETFs invest in physical commodities such as gold, silver, oil, natural gas, or agricultural products.
- Real estate ETFs. Real estate ETFs invest in real estate investment trusts (REITs) or companies engaged in the real estate sector, such as property management, development, or construction.
- Thematic ETFs. Thematic ETFs focus on specific investment themes or trends, such as renewable energy, cybersecurity, robotics, artificial intelligence, or sustainable investing.
- Smart beta ETFs. Smart beta ETFs use alternative index weighting methodologies or factor-based strategies to select and weigh securities within the ETF portfolio. These ETFs aim to outperform traditional market-cap-weighted indexes by emphasizing value, momentum, quality, or low volatility factors.
- Inverse and leveraged ETFs. Inverse ETFs seek to profit from declining underlying index or asset class prices by using derivatives or short-selling strategies. Leveraged ETFs aim to amplify the returns of an underlying index or asset class by using financial derivatives or borrowing capital.
Related: Best ETFs of 2024 – Our Top Picks
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Costs associated with ETF investing
Investing in ETFs typically involves several costs that investors should be aware of:
Expense ratio
The expense ratio is an annual fee the ETF issuer charges to cover operating expenses, including management fees, administrative costs, and marketing expenses. It is expressed as a percentage of the ETF's average assets under management (AUM).
Brokerage commissions
Investors may incur brokerage commissions or trading fees when buying or selling ETF shares through a brokerage account. These fees can vary depending on the brokerage platform and trading frequency. Some brokerages offer commission-free trading for select ETFs, which can help reduce investor trading costs.
Bid-ask spread
The bid-ask spread is the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask) for a security. When trading ETF shares on stock exchanges, investors may encounter bid-ask spreads, representing the transaction costs of buying and selling ETF shares.
Taxes
ETF investors may be subject to taxes on investment gains, including capital gains taxes and dividend taxes. Capital gains taxes are incurred when selling ETF shares at a profit, while dividends are incurred when receiving distributions from the ETF's underlying securities.
ETF vs. stocks
ETFs and individual stocks are both investment options, but they have some key differences:
Diversification
ETFs typically offer built-in diversification because they hold a basket of assets such as stocks, bonds, or commodities. This diversification can help spread risk across multiple securities. On the other hand, when you invest in individual stocks, your investment is concentrated on the performance of that specific company, which can be riskier.
Management
ETFs are passively managed or actively managed. Passively managed ETFs aim to replicate the performance of a particular index. In contrast, actively managed ETFs are managed by investment professionals who actively trade securities in an attempt to outperform the market. Individual stocks require more active management decisions, such as researching individual companies, analyzing financial statements, and monitoring market trends.
Cost
ETFs generally have lower expense ratios compared to actively managed mutual funds, making them a cost-effective investment option. Buying and selling individual stocks may involve brokerage fees and commissions, which can add up over time.
Liquidity
ETFs trade on stock exchanges, which means they can be bought and sold throughout the trading day at market prices. This provides liquidity and flexibility for investors. Individual stocks also trade on exchanges, but the liquidity can vary depending on the investment company's size, trading volume, and market conditions.
Ownership
When you invest in an ETF, you own shares of the fund, which represents a proportional ownership of the fund's underlying assets. When you buy individual stocks, you directly own shares of a specific company.
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ETFs vs mutual funds
ETFs (Exchange-Traded Funds) and mutual funds are both investment vehicles that pool money from multiple investors to invest in a diversified portfolio of assets, such as stocks, bonds, or commodities. However, there are several key differences between them:
Trading
ETFs trade on stock exchanges throughout the trading day at market-determined prices, just like individual stocks. This means investors can buy and sell ETF shares whenever the market opens. On the other hand, mutual funds are bought and sold at the end of the trading day at their net asset value (NAV), calculated based on the closing prices of the securities in the fund's portfolio.
Costs
ETFs typically have lower expense ratios compared to mutual funds. Expense ratios represent the fund's annual operating expenses as a percentage of its assets under management.
Flexibility
ETFs offer intraday trading flexibility, allowing investors to buy and sell shares throughout the trading day at market prices. Mutual funds are only traded once daily after the market closes, and transactions are processed at the end of the NAV.
Transparency
ETFs typically disclose their holdings daily, providing investors with transparency into the fund's portfolio. Mutual funds generally disclose their holdings less frequently, typically quarterly.
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Who should invest in an ETF?
ETFs can be suitable for a wide range of investors, but they may be particularly attractive for the following types of investors:
- Beginner investors. ETFs are often recommended for beginner investors due to their simplicity and accessibility. With ETFs, investors can gain diversified exposure to various asset classes or sectors without picking individual stocks or bonds.
- Long-term investors. Investors with a long-term investment horizon may benefit from investing in ETFs, especially those that track broad market indexes or core asset classes such as stocks and bonds. By holding a diversified portfolio of ETFs, long-term investors can potentially achieve consistent returns over time while mitigating risk through diversification.
- Passive investors. ETFs are a popular choice for passive investors who prefer a buy-and-hold approach. Passive investors can use ETFs to build a diversified portfolio that closely mirrors the performance of a specific index or asset class.
- Cost-conscious investors. ETFs generally have lower expense ratios than actively managed mutual funds, making them cost-effective investments.
- Tax-conscious investors. ETFs are known for their tax efficiency, making them suitable for investors concerned about minimizing tax liabilities. ETFs' unique structure allows for tax-efficient trading and potential capital gains deferral, making them a preferred choice for taxable investment accounts.
- Liquidity needs. Investors who value liquidity and flexibility in their investments may prefer ETFs because they can trade shares on stock exchanges throughout the trading day.
- Investors seeking specific exposure. ETFs offer exposure to various asset classes, sectors, industries, and regions. Investors with specific investment preferences or thematic interests can find ETFs that align with their investment goals, whether it's investing in a specific sector (e.g., technology, healthcare) or thematic investing (e.g., renewable energy, cybersecurity).
Who shouldn't invest in an ETF?
- High-frequency traders. Investors who engage in high-frequency trading or short-term speculation may find ETFs less suitable due to potential trading costs, such as brokerage commissions and bid-ask spreads.
- Active traders. Investors who actively trade securities and seek to capitalize on short-term price movements may find ETFs less suitable, especially if they prefer individual stocks or options trading. While ETFs offer intraday liquidity and flexibility, frequent trading can lead to higher transaction costs and potential tax consequences.
- Investors seeking active management. ETFs are typically passively managed to track an index or asset class, which may not appeal to investors seeking active management and outperformance relative to the market. Investors who prefer active management or customized investment strategies may find actively managed mutual funds or individual securities more suitable.
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How to choose an ETF?
Choosing an ETF involves considering several factors to ensure it aligns with your investment goals, risk tolerance, and preferences. Here are some steps to help you choose an ETF:
- Identify your investment goals. Determine your investment objectives, whether it's long-term wealth accumulation, income generation, capital preservation, or a specific financial goal such as retirement or education funding.
- Understand your risk tolerance. Assess your risk tolerance, which is your willingness and ability to withstand fluctuations in investment value. Consider factors such as your investment time horizon, financial situation, and comfort level with market volatility.
- Define your asset allocation. Determine the appropriate asset allocation for your investment portfolio based on your investment goals and risk tolerance. Decide how much exposure you want to allocate to different asset classes, such as stocks, bonds, and other alternative investments.
- Research ETF categories. Research different categories of ETFs to find ones that match your desired asset allocation. Common ETF categories include broad market indexes, sector-specific ETFs, bond ETFs, international ETFs, thematic ETFs, and smart beta ETFs. Evaluate key characteristics of ETFs, such as expense ratio, tracking error, liquidity, trading volume, assets under management (AUM), and historical performance. Look for ETFs with low expense ratios and sufficient liquidity to ensure ease of trading.
- Examine holdings and strategy. Review the ETF's holdings, investment strategy, and index methodology to ensure they align with your investment objectives. Consider factors such as geographic diversification, sector exposure, market capitalization, and underlying fundamentals.
- Compare ETFs. Compare multiple ETFs within the same category to identify the best fit for your investment needs. Evaluate factors such as performance, risk-adjusted returns, tracking error, and portfolio composition to make an informed decision.
- Consider tax efficiency. Assess the tax efficiency of ETFs, especially if investing in taxable accounts. Look for ETFs with low portfolio turnover and tax-efficient trading strategies to minimize capital gains distributions and tax liabilities.
- Review provider reputation. Consider the reputation and track record of the ETF provider or issuer. Choose ETFs from reputable providers with a history of strong performance, robust fund management, and adherence to industry best practices.
Pros and cons
Pros
- Diversification. ETFs typically hold a basket of securities, providing investors with instant diversification across various asset classes, industries, or regions. This diversification helps spread risk and reduce the impact of volatility on the portfolio.
- Low costs. ETFs often have lower expense ratios compared to actively managed mutual funds, making them a cost-effective investment option. Additionally, because ETFs are passively managed, they tend to have lower management fees.
- Liquidity. ETFs trade on stock exchanges like individual stocks, allowing investors to buy and sell shares throughout the trading day at market-determined prices. This provides liquidity and flexibility, especially for short-term traders.
- Transparency. Most ETFs disclose their holdings on a daily basis, providing investors with transparency into the fund's portfolio. This transparency allows investors to know exactly what assets they are invested in at any given time.
- Tax efficiency. ETFs are generally more tax-efficient than mutual funds due to their unique structure. ETFs have the ability to redeem shares "in-kind," which can help minimize capital gains distributions to investors. Additionally, because ETFs are traded on exchanges, investors have more control over the timing of capital gains realization.
Cons
- Brokerage commissions. While ETF expense ratios are typically low, investors may incur brokerage commissions or trading fees each time they buy or sell ETF shares. These fees can add up, especially for frequent traders or investors with small portfolios.
- Potential tracking error. While most ETFs aim to closely track the performance of their underlying index or asset class, there can be slight tracking errors over time. Factors such as expenses, trading costs, and market conditions can contribute to these tracking errors.
- Market price fluctuations. The market price of an ETF may deviate from its net asset value (NAV) due to supply and demand dynamics in the market. This can lead to premiums or discounts to NAV, especially for less liquid ETFs or during times of market volatility.
- Limited control. ETF investors have limited control over the management of the fund's portfolio, as ETFs are typically passively managed to track an index or asset class. This may not be suitable for investors seeking more active management or customization of their investments.
FAQs
How do I choose an ETF?
When choosing an ETF, consider factors such as your investment goals, risk tolerance, time horizon, and preferences. Evaluate the ETF's category, expense ratio, liquidity, tracking error, holdings, strategy, performance, and provider reputation to make an informed decision.
What are the risks of investing in ETFs?
While ETFs offer numerous benefits, they also come with risks, including market risk, liquidity risk, tracking error risk, concentration risk, and regulatory risk. Additionally, leveraged and inverse ETFs carry additional risks due to their use of derivatives and leverage.
How can I invest in ETFs?
Investors can invest in ETFs through brokerage accounts, online trading platforms, robo-advisors, financial advisors, or employer-sponsored retirement plans. Simply choose the ETF(s) you want to invest in, place a buy order through your chosen investment platform, and monitor your investment over time.
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The bottom line
Investing in ETFs can offer numerous benefits, including diversification, low costs, liquidity, transparency, and tax efficiency. However, investors should know the associated costs, such as expense ratios, brokerage commissions, bid-ask spreads, taxes, and tracking errors. By carefully considering these factors and conducting thorough research, investors can make informed decisions about incorporating ETFs into their investment portfolios. ETFs can be valuable investment vehicles for a wide range of investors. Still, it's essential to align them with your investment goals, risk tolerance, and preferences to achieve long-term financial success.
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