What Is an Exchange-Traded Fund (ETF)?
An exchange-traded fund (ETF) is a pooled investment security that can be bought and sold like an individual stock. ETFs can be structured to track anything from the price of a commodity to a large and diverse collection of securities.
ETFs can even be designed to track specific investment strategies. Various types of ETFs are available to investors for income generation, speculation, and price increases, and to hedge or partly offset risk in an investor’s portfolio. The first ETF was the SPDR S&P 500 ETF (SPY), which tracks the .
Key Takeaways
- An exchange-traded fund (ETF) is a basket of securities that trades on an exchange just like a stock does.
- ETF share prices fluctuate all day as the ETF is bought and sold; this is different from mutual funds, which only trade once a day after the market closes.
- ETFs offer low expense ratios and fewer broker commissions than buying the stocks individually.
Everything You Need to Know About Exchange Traded Funds (ETFs)
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How ETFs Work
An ETF must be registered with the Securities and Exchange Commission. In the United States, most ETFs are set up as open-ended funds and are subject to the Investment Company Act of 1940, except where subsequent rules have modified their regulatory requirements. Open-end funds do not limit the number of investors involved in the product.
Vanguard's Consumer Staples ETF (VDC) tracks the MSCI US Investable Market Consumer Staples 25/50 Index and has a minimum investment of $1.00. The fund holds shares of all 104 companies on the index, some familiar to most because they produce or sell consumer items. A few of the companies held by VDC are Proctor & Gamble, Costco, Coca-Cola, Walmart, and PepsiCo. Investors who buy $1.00 in VDC own $1.00 shares representing 104 companies.
There is no transfer of ownership because investors buy a share of the fund, which owns the shares of the underlying companies. Unlike mutual funds, ETF share prices are determined throughout the day. A mutual fund trades only once a day after market close.
Volatile stock performance is curtailed in an ETF because they do not involve direct ownership of securities. Industry ETFs are also used to rotate in and out of sectors during economic cycles.
Cash Invested in ETFs by Year
Types of ETFs
- Passive ETF: Passive ETFs aim to replicate the performance of a broader index—either a diversified index such as the S&P 500 or a more specific targeted sector or trend.
- Actively managed ETF: Do not target an index of securities, but rather have portfolio managers making decisions about which securities to include in the portfolio. Actively managed ETFs have benefits over passive ETFs but can be more expensive to investors.
- Bond ETF: Used to provide regular income to investors and distribution depends on the performance of underlying bonds which may include government, corporate, and state and local bonds, usually called municipal bonds. Unlike their underlying instruments, bond ETFs do not have a maturity date.
- Stock ETF: A basket of stocks that track a single industry or sector like automotive or foreign stocks. The aim is to provide diversified exposure to a single industry, one that includes high performers and new entrants with growth potential. Unlike stock mutual funds, stock ETFs have lower fees and do not involve actual ownership of securities.
- Industry or sector ETF: Funds that focus on a specific sector or industry. An energy sector ETF will include companies operating in that sector. Blackrock's iShares U.S. Technology ETF (IYW) mirrors the performance of the Russell 1000 Technology RIC 22.5/45 Capped Index and holds 1374 stocks of technology sector companies.
- Commodity ETF: Invest in commodities like crude oil or gold. Commodity ETFs can diversify a portfolio, making it easier to hedge market downturns. Holding shares in a commodity ETF is cheaper than physical possession of the commodity.
- Currency ETF: Track the performance of currency pairs consisting of domestic and foreign currencies. Currency ETFs can be used to speculate on the prices of currencies based on political and economic developments in a country. They are also used to diversify a portfolio or as a hedge against volatility in forex markets by importers and exporters.
- Bitcoin ETF: The spot Bitcoin ETF was approved by the SEC in 2024. These ETFs expose investors to bitcoin's price moves in their regular brokerage accounts by purchasing and holding bitcoins as the underlying asset and allowing them to buy shares of the fund. Bitcoin futures ETFs, approved in 2021, use futures contracts traded on the Chicago Mercantile Exchange and mimic the price movements of bitcoin futures contracts.
- Inverse ETF: Earn gains from stock declines by shorting stocks. Shorting is borrowing a stock, selling it while expecting a decline in value, and repurchasing it at a lower price. An inverse ETF uses derivatives to short a stock. Inverse ETFs are exchange-traded notes (ETNs) and not true ETFs. An ETN is a bond that trades like a stock and is backed by an issuer such as a bank.
- Leveraged ETF: A leveraged ETF seeks to return some multiples (e.g., 2× or 3×) on the return of the underlying investments. If the S&P 500 rises 1%, a 2× leveraged S&P 500 ETF will return 2% (and if the index falls by 1%, the ETF would lose 2%). These products use debt and derivatives, such as options or futures contracts, to leverage their returns.
As of January 2024, nine ETFs focus on companies engaged in gold mining, excluding inverse, leveraged, and funds with low assets under management (AUM).
Buying ETFs
ETFs trade through online brokers and traditional broker-dealers. Many sources provide pre-screened brokers in the ETF industry. Individuals can also purchase ETFs in their retirement accounts. An alternative to standard brokers is a robo-advisor like Betterment and Wealthfront.
An ETF’s expense ratio is the cost to operate and manage the fund. ETFs typically have low expenses because they track an index.
ETFs are available on most online investing platforms, retirement account provider sites, and investing apps like Robinhood. Most of these platforms offer commission-free trading, meaning that investors don’t have to pay fees to the platform providers to buy or sell ETFs.
After creating and funding a brokerage account, investors can search for ETFs and make their chosen buys and sells. One of the best ways to narrow ETF options is to utilize an ETF screening tool with criteria such as trading volume, expense ratio, past performance, holdings, and commission costs.
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Popular ETFs
Below are examples of popular ETFs on the market. Some ETFs track an index of stocks, thus creating a broad portfolio, while others target specific industries.
- SPDR S&P 500 (SPY): The oldest surviving and most widely known ETF that tracks the S&P 500 Index.
- iShares Russell 2000 (IWM): An ETF that tracks the Russell 2000 small-cap index.
- Invesco QQQ (QQQ) (“cubes”): An ETF that tracks the Nasdaq 100 Index, which typically contains technology stocks.
- SPDR Dow Jones Industrial Average (DIA) (“diamonds”): An ETF that represents the 30 stocks of the Dow Jones Industrial Average.
- Sector ETFs: ETFs that track individual industries and sectors such as oil (OIH), energy (XLE), financial services (XLF), real estate investment trusts (IYR), and biotechnology (BBH).
- Commodity ETFs: These ETFs represent commodity markets, including gold (GLD), silver (SLV), crude oil (USO),and natural gas (UNG).
- Country ETFs: Funds that 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).
Pros and Cons of ETFs
Pros
Access to many stocks across various industries
Low expense ratios and fewer broker commissions
Risk management through diversification
ETFs exist that focus on targeted industries
Cons
Actively managed ETFs have higher fees
Single-industry-focused ETFs limit diversification
Lack of liquidity hinders transactions
ETFs vs. Mutual Funds vs. Stocks
Most stocks, ETFs, and mutual funds can be bought and sold without a commission. Funds and ETFs differ from stocks because of the management fees that most of them carry, though they have been trending lower for many years. In general, ETFs tend to have lower average fees than mutual funds.
| Exchange-Traded Funds | Mutual Funds | Stocks |
|---|---|---|
| Exchange-traded funds (ETFs) are a type of index funds that track a basket of securities. | Mutual funds are pooled investments into bonds, securities, and other instruments. | Stocks are securities that provide returns based on performance. |
| ETF prices can trade at a premium or at a loss to the net asset value (NAV) of the fund. | Mutual fund prices trade at the net asset value of the overall fund. | Stock returns are based on their actual performance in the markets. |
| ETFs are traded in the markets during regular hours, just like stocks are. | Mutual funds can be redeemed only at the end of a trading day. | Stocks are traded during regular market hours. |
| Some ETFs can be purchased commission-free and are cheaper than mutual funds because they do not charge marketing fees. | Some mutual funds do not charge load fees, but most are more expensive than ETFs because they charge administrative and marketing fees. | Stocks can be purchased commission-free on some platforms and generally do not have charges associated with them after purchase. |
| ETFs do not involve actual ownership of securities. | Mutual funds own the securities in their basket. | Stocks involve physical ownership of the security. |
| ETFs diversify risk by creating a portfolio that can span multiple asset classes, sectors, industries, and security instruments. | Mutual funds diversify risk by creating a portfolio that can span multiple asset classes, sectors, industries, and security instruments. | Risk is concentrated in a stock’s performance. |
| ETF trading generally occurs in-kind, meaning they are not redeemed for cash. | Mutual fund shares can be redeemed for money at the fund’s net asset value for that day. | Stocks are bought and sold using cash. |
| Because ETF share exchanges are usually treated as in-kind distributions, ETFs are the most tax-efficient among all three types of financial instruments. | Mutual funds offer tax benefits when they return capital or include certain types of tax-exempt bonds in their portfolio. | Stocks are taxed at either ordinary income tax rates or capital gains rates. |
Active vs. Passive Equity Funds
Dividends and Taxes
Though ETFs allow investors to gain as stock prices rise and fall, they also benefit from companies that pay dividends. Dividends are a portion of earnings allocated or paid by companies to investors for holding their stock. ETF shareholders are entitled to a proportion of the profits, such as earned interest or dividends paid, and may get a residual value if the fund is liquidated.
An ETF is more tax-efficient than a mutual fund because most buying and selling occur through an exchange, and the ETF sponsor does not need to redeem shares each time an investor wishes to sell or issue new shares each time an investor wishes to buy.
Redeeming shares of a fund can trigger a tax liability, so listing the shares on an exchange can keep tax costs lower. In the case of a mutual fund, each time an investor sells their shares, they sell it back to the fund and incur a tax liability that must be paid by the shareholders of the fund.
Creation and Redemption
The supply of ETF shares is regulated through creation and redemption, which involves large specialized investors calledauthorized participants (APs). When an ETF wants to issue additional shares, the AP buys shares of the stocks from the index—such as the S&P 500 tracked by the fund—and sells or exchanges them to the ETF for new ETF shares at an equal value. In turn, the AP sells the ETF shares in the market for a profit.
When an AP sells stocks to the ETF sponsor in return for shares in the ETF, the block of shares used in the transaction is called acreation unit. If an ETF closes with a share price of $101 and the value of the stocks that the ETF owns is only worth $100 on a per-share basis, then the fund’s price of $101 was traded at a premium to the fund’s net asset value (NAV). The NAV is an accounting mechanism that determines the overall value of the assets or stocks in an ETF.
Conversely, an AP also buys shares of the ETF on the open market. The AP then sells these shares back to the ETF sponsor in exchange for individual stock shares that the AP can sell on the open market. As a result, the number of ETF shares is reduced through the process called redemption. The amount of redemption and creation activity is a function of demand in the market and whether the ETF is trading at a discount or premium to the value of the fund’s assets.
ETFs in the United Kingdom
The U.K. ETF market is one of the largest and most diverse in Europe, with ETFs listed on the London Stock Exchange (LSE) that offer exposure to various asset classes and markets, including equities, fixed income, commodities, currencies, real estate, and alternative investments.
Buying ETFs in the U.K. allows inclusion in Individual Savings Accounts (ISAs), which are tax-efficient savings vehicles that allow investors to invest up to £20,000 per year without paying any income or capital gains tax on their returns. Another benefit is that ETFs attract no stamp duty, which is a tax levied on ordinary share transactions in the U.K.
U.K. investors can buy shares in U.S.-listed companies from the U.K., but due to local and European regulations,you're not allowed to purchase U.S.-listed exchange-traded funds (ETFs) in the U.K. There are U.K.-based ETFs that track U.S. markets, as long as it has the 'UCITS' moniker in the name. This means the fund is fully regulated in the U.K. and allowed to track U.S. investments.For broad-based exposure to U.K. equities, there are several UCITS ETFs that track the FTSE 100 index, which consists of the 100 largest publicly listed companies in the country. The HSBC FTSE UCITS ETF is listed on the London Stock Exchange and trades under the ticker symbol HUKX. The ETF has an ongoing charge of 0.07% and a dividend yield of 3.62% as of January 2024.
What Was the First Exchange-Traded Fund (ETF)?
The distinction of being the first exchange-traded fund (ETF) is often given 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 an ETF Different From an 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, the difference between an index fund and an ETF is that an ETF tends to be more cost-effective and liquid than an index mutual fund. You can also buy an ETF from a broker who will execute the trade throughout the trading day, while a mutual fund trades via a broker only at the close of each trading day.
Do ETFs Provide Diversity?
Nearly all ETFs provide diversification benefits relative to an individual stock purchase. Still, some ETFs are highly concentrated—either in the number of different securities they hold or in the weighting of those securities. For example, a fund that concentrates half of its assets in two or three positions may offer less diversification than a fund with fewer total portfolio constituents but broader asset distribution.
The Bottom Line
Exchange-traded funds represent a cost-effective way to gain exposure to a broad basket of securities with a limited budget. Investors can build a portfolio that holds one, many, or only ETFs. Instead of buying individual stocks, investors buy shares of a fund that targets a representative cross-section of the wider market. However, there are some additional expenses to keep in mind when investing in an ETF.
Article Sources
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