Understanding Exchange-Traded Funds (ETFs)
An exchange-traded fund, or ETF, functions as an investment vehicle that contains a collection of assets. These funds are traded on stock exchanges similarly to individual company shares. ETFs are structured to mirror various benchmarks, ranging from commodity prices to vast selections of stocks, and even specific investment strategies. Investors can leverage ETFs for diverse purposes, such as generating income, engaging in speculation, or mitigating potential risks within their investment portfolio. The SPDR S&P 500 ETF (SPY), which tracks the performance of the S&P 500 Index, was the pioneer ETF introduced in the U.S.
Key Points to Remember
- An ETF is a collection of investments that trades on an exchange like a standard stock.
- Unlike mutual fund prices, which are fixed once daily after market closure, ETF values fluctuate throughout the trading day.
- ETFs typically offer lower expense ratios and reduced brokerage fees compared to investing in individual stocks.
Investopedia / Zoe Hansen
The Mechanics Behind ETFs
All ETFs must be registered with the Securities and Exchange Commission (SEC). In the United States, the majority of ETFs are structured as open-ended funds, governed by the Investment Company Act of 1940, with certain regulatory adjustments. Open-ended funds have no restrictions on the number of investors participating.
Vanguard’s Consumer Staples ETF (VDC) mirrors the MSCI US Investable Market Consumer Staples 25/50 Index and requires a minimum investment of just $1.00. This ETF encompasses shares from all 104 companies included in the index, many of which are recognizable due to their production or sale of everyday consumer goods. Some prominent holdings within VDC include Proctor & Gamble, Costco, Coca-Cola, Walmart, and PepsiCo.
When investing in an ETF, ownership of the underlying companies’ shares is not directly transferred to the individual investor. Instead, investors are purchasing a share of the fund itself, which then holds the shares of those companies. Unlike mutual funds, ETF prices are continuously updated throughout the trading day. Mutual funds, in contrast, only establish a single price at the close of each trading day.
Key Consideration
ETFs mitigate volatility through diversified holdings. Sector-specific ETFs are also employed to strategically shift investments across different sectors during various phases of economic cycles.
Cash Invested in ETFs by Year
Variety of ETF Options
- Passive ETFs: These Passive ETFs are designed to mirror the performance of an established index, which could be broad-based like the S&P 500, or targeted to a specific industry or trend.
- Actively Managed ETFs: Instead of mirroring an index, these ETFs rely on portfolio managers to actively choose which securities to include. Actively managed ETFs may offer benefits beyond passive ETFs, but they typically involve higher management fees.
- Bond ETFs: These ETFs aim to generate consistent income for investors, with distributions tied to the performance of the underlying bonds, which can include government, corporate, and municipal bonds. Bond ETFs, unlike the individual bonds they hold, do not have a set maturity date.
- Industry or Sector ETFs: These ETFs concentrate on stocks within a particular industry or sector, such as technology or energy. The goal is to provide diversified exposure to the chosen sector, including both established leaders and emerging companies with growth potential. For example, BlackRock’s iShares U.S. Technology ETF (IYW) follows the Russell 1000 Technology RIC 22.5/45 Capped Index.
- Commodity ETFs: These ETFs invest in tangible commodities like crude oil or precious metals. Commodity ETFs can serve as a tool for portfolio diversification. Investing in commodity ETFs can be more cost-effective than directly holding physical commodities.
- Currency ETFs: These ETFs track the movements of currency pairs. They can be used to speculate on currency exchange rates based on economic and political developments. Some investors use them for diversification, while importers and exporters might employ them to hedge against volatility in currency markets.
- Bitcoin ETFs: The spot Bitcoin ETF received SEC approval in 2024. These ETFs allow investors to gain exposure to Bitcoin’s price fluctuations through their standard brokerage accounts by purchasing and holding Bitcoin as the underlying asset. Bitcoin futures ETFs, which were approved earlier in 2021, track the price changes of Bitcoin futures contracts traded on the Chicago Mercantile Exchange.
- Ethereum ETFs: Spot ether ETFs offer a means of investing in ether, the Ethereum blockchain’s native cryptocurrency, without necessitating direct ownership of the cryptocurrency. In May of 2024, the SEC granted permission to Nasdaq, the Chicago Board Options Exchange, and the NYSE to list ETFs that hold ether. Then in July 2024, the SEC formally sanctioned nine spot ether ETFs to commence trading on U.S. exchanges.
- Inverse ETFs: These ETFs are designed to profit from declines in the stock market, allowing investors to bet against stocks without engaging in short selling. These ETFs utilize derivatives to simulate shorting a stock. It’s important to note that inverse ETFs are technically exchange-traded notes (ETNs), which are debt instruments backed by an issuer like a bank, rather than true ETFs.
- Leveraged ETFs: A leveraged ETF aims to amplify the returns of the underlying investments (e.g., 2x or 3x). If the S&P 500 increases by 1%, a 2x leveraged S&P 500 ETF will aim for a 2% return (and a 2% loss if the index declines by 1%). These ETFs employ debt and derivatives to achieve these amplified returns.
Did You Know?
There are approximately 10 ETFs focused on companies within the gold mining sector, excluding those with inverse or leveraged strategies, as well as those with limited assets under management (AUM).
Advantages and Disadvantages of ETFs
Advantages
- Access to a diverse range of stocks across multiple industries.
- Generally low expense ratios and brokerage commissions.
- Risk mitigation through diversification.
- Opportunity to focus on specific industries or commodities.
Disadvantages
- Actively managed ETFs often come with higher fees.
- ETFs focused on a single industry can limit diversification.
- Lack of sufficient trading activity can hinder transactions.
Getting Started with ETF Investing
ETFs are bought and sold through online brokerage platforms and traditional broker-dealers. Several resources provide recommendations for brokers specializing in ETFs. ETFs can also be incorporated into retirement accounts. As an alternative to traditional brokers, individuals can utilize robo-advisors such as Betterment or Wealthfront. An ETF’s expense ratio signifies the costs associated with managing and operating the fund. Typically, ETFs maintain low expense ratios, especially when they track an index.
ETFs are readily available through the majority of online investment platforms, retirement account providers, and mobile investment applications like Robinhood. Many of these platforms now offer commission-free trading, eliminating trading fees for buying or selling ETFs.
After creating and funding a brokerage account, investors can explore the range of available ETFs and make desired trades. One effective strategy is to employ an ETF screening tool, utilizing criteria like trading volume, expense ratio, historical performance, fund holdings, and any commission charges.
Widely Traded ETFs
Below are some well-known ETFs. Certain ETFs are designed to track an index of stocks, offering diversified portfolios, whereas others concentrate on specific sectors or industries.
- SPDR S&P 500 (SPY): This is the original and most widely recognized ETF, designed to mirror the S&P 500 index.
- iShares Russell 2000 (IWM): This ETF tracks the performance of the Russell 2000 small-cap index.
- Invesco QQQ (QQQ): Commonly known as “cubes,” this ETF follows the Nasdaq 100 Index, heavily weighted toward technology stocks.
- SPDR Dow Jones Industrial Average (DIA): Often referred to as “diamonds,” this ETF tracks the 30 stocks that comprise the Dow Jones Industrial Average (DJIA).
- Sector ETFs: These ETFs are tailored to track individual industries and sectors. Examples include oil (OIH), energy (XLE), financial services (XLF), real estate investment trusts (IYR), and biotechnology (BBH).
- Commodity ETFs: These ETFs offer exposure to various commodities, including gold (GLD), silver (SLV), crude oil (USO), and natural gas (UNG).
- Country ETFs: These funds track primary stock indexes in foreign nations but are traded in U.S. dollars. Examples include China (MCHI), Brazil (EWZ), Japan (EWJ), and Israel (EIS). Other ETFs track broader foreign markets encompassing multiple countries, such as emerging market economies (EEM) and developed market economies (EFA).
ETFs, Mutual Funds, and Individual Stocks: A Comparison
Many stocks, ETFs, and mutual funds can be traded without incurring a commission. However, unlike stocks, both mutual funds and ETFs may have management fees, although these fees have been generally decreasing in recent years. ETFs are generally less expensive compared to mutual funds in terms of fees.
| Exchange-Traded Funds | Mutual Funds | Stocks | |
|---|---|---|---|
| Definition | Funds tracking a collection of securities or commodities. | Pooled investments in a range of assets, including bonds, securities, and other instruments. | Ownership shares in publicly traded companies. |
| Pricing | Can be traded at prices that differ from the net asset value (NAV). | Traded at the calculated net asset value of the entire fund. | Price determined by market performance. |
| Trading Hours | Traded continuously during regular market hours. | Bought and sold only at the end of each trading day. | Traded continuously during regular market hours. |
| Fees and Costs | Potentially commission-free purchases and generally less expensive than mutual funds. | Some may not charge load fees, but generally more expensive due to management fees. | Potentially commission-free on certain platforms with no ongoing fees. |
| Security Ownership | Retail investors do not have direct ownership of the underlying securities. | The fund owns the securities comprising its portfolio. | Direct ownership of the security. |
| Risk Management | Offers diversification across various asset classes, sectors, and industries. | Provides diversification across a variety of security instruments, sectors, and asset classes. | Risk primarily tied to the performance of a single stock. Diversification requires purchasing multiple stocks. |
Active vs. Passive Equity Funds
ETF Dividends and Tax Implications
ETF investors may be eligible to receive dividends from companies within the fund. Dividends represent a share of a company’s earnings distributed to its investors. ETF shareholders are entitled to a portion of the earned interest or dividends and may also receive residual value if the fund undergoes Share.