What Is an ETF?

Investing

Maybe you’ve recently spoken to a broker or financial adviser about investments, and they suggested exchange-traded funds (ETFs) as a way to diversify your portfolio and boost your earnings.

But, you don’t know how they work or how to go about adding them to your arsenal of investments. Or maybe you’re just starting out and want to learn more before making an investment decision?

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Either way, we’ve got you covered. Read on to learn more.

What are ETFs?

In a nutshell, an exchange-traded fund (ETF) is a basket of assets that can include a medley of the following:

Exchange-traded funds are ideal for individual investors because they allow you to diversify your holdings without purchasing individual shares of each asset. And the profits are generated by the performance of the overall ETF and not individual shares.

Furthermore, ETFs trade like stocks and are easily bought and sold on the stock exchange, making it simple for investors to buy and sell.

How do ETFs work?

Before exchange-traded funds hit the exchange for trading, they must be created by authorized participants or specialized investors. They conduct extensive research and choose the assets that they deem as most suitable for the portfolio.

The pool of assets is then divided into ETF shares and traded on a major stock exchange, like the NYSE or NASDAQ, or through a brokerage firm.

Each exchange-traded fund has a ticker symbol like a stock and intraday price that can be tracked throughout the day. But unlike mutual funds or index funds, prices are constantly fluctuating because ETF shares are issued and redeemed throughout the day.

Mutual funds are priced at the end of the trading day, so all buyers and sellers receive the same price. This is referred to as the NAV (net asset value.)

Individual investors can purchase ETFs, but the way returns are generated differs from what you’d see with stocks or bonds. Profits are not tied to the actual assets in the ETF, but a sum of the profits generated from interest and dividends from the overall ETF. The return is collectively based on your proportion of ownership in the ETF.

Types of ETFs

There’s no shortage of exchange-traded funds as offerings are designed to track various sectors, markets, and indexes both here in the U.S. and abroad. The types of ETFs that are most popular among investors include:

  • Actively managed ETFs: ETFs that are managed by a professional fund manager and traded on a stock exchange. They aim to outperform a specific benchmark or index by actively selecting and trading the securities in the fund’s portfolio.
  • Bond ETFs: ETFs that track a basket of bond securities, such as corporate bonds, government bonds, or municipal bonds.
  • Commodity ETFs: These ETFs track the price of a specific commodity, such as gold, silver, oil, or agricultural products.
  • Currency ETFs: ETFs that track the value of a specific currency, such as the US dollar, Euro, or Japanese yen.
  • Foreign market ETFs: The main objective for these ETFs is to track the performance of a specific foreign market, such as a specific country or region.
  • Inverse ETFs: A type of ETF that aims to produce the opposite return of a specific benchmark or index.
  • Leveraged ETFs: These ETFs use financial instruments, such as futures contracts and options, to amplify the returns of a specific benchmark or index.
  • Market ETFs: The main objective is to track a specific index. These include DIA (tracks the Dow Jones Industrial Average), Spider or SPDR (tracks the S&P 500 Index), and QQQ (tracks the Nasdaq 100).
  • Sector or Industry ETFs: The main objective is to track a sector or industry. Common sector ETFs include XLF (financial companies), OIH (oil companies), FONE (smartphones), and XLE (energy companies).
  • Stock ETFs: ETFs that track a basket of stocks, such as those in a specific index, sector, or country.

Benefits of ETFs

Diversified Asset Pool

With ETFs, you can invest with minimal effort to fit your taste in securities, risk tolerance, and investment goals. This also means you can choose from various market segments. Furthermore, poor-performing assets can offset those that are performing well.

Hands-off Management

Professional fund managers do all the work for you according to your investment objectives. They also continuously monitor the performance of the ETF. But since these investments are generally passive and track an index, your fund manager won’t have to spend a bulk of their time day in and day out managing the ETF to stay ahead of the curve.

Quick note: The exception to this rule applies when you’re dealing with an actively managed ETF that is designed to beat an index.

Flexible Purchase and Selling Window

Unlike mutual funds, ETFs are available for purchase at any time of the day. There’s also flexibility with orders as you can choose from margin, limit, or stop-loss orders. Even better, there are no minimum holding periods, like you’ll see with some mutual funds, so you’re free to sell at any point after you purchase ETF shares.

This added flexibility is also beneficial to investors because it minimizes the level of risk they’ll have to absorb if the market takes an unexpected turn for the worse. ETFs are much easier to unload in a shorter window than mutual funds that sometimes have a 30-day holding period before they can be sold.

Tax Efficient

With taxable mutual funds, you must pay taxes on distributions regardless of whether you keep the cash or use it to invest in more mutual fund shares. However, you will only pay capital gains on ETFs when your investment is sold.

Transparency

As mentioned earlier, the performance of a particular ETF can be tracked throughout the day using the ticker. And the end of each day, the ETF’s holdings are shared with the public. But mutual funds only disclose this information on a monthly or quarterly basis.

Lower Administrative Costs

Unless the ETF is actively managed, your administrative costs will be substantially lower than what you’d find with a portfolio that must have oversight at all times, like a mutual fund. On average, the expense ratio for most ETFs is lower than .20 per year, compared to the 1 percent or more per year in administrative costs that accompany actively managed mutual funds, according to Nasdaq.

But keep in mind that expense ratios aren’t the same across the board. So, it’s best to speak with the ETF issuer to get a better idea of what you’d expect to pay in administrative costs should you decide to invest in their ETFs.

Drawbacks of ETFs

Before you invest in ETFs, there are some drawbacks you should be mindful of.

Price Fluctuations

Prices often change, so you could be at a disadvantage if you like to buy in small increments. And it’s not always possible to buy low and sell high if the ETF is a slow mover.

Fees from Commissions

Looking to buy ETFs through an online broker? If you select an ETF that’s outside the scope of what they offer, you could incur substantial fees from brokerage commissions.

Sudden Death

If the ETF underperforms and is forced to shut down abruptly, you have no control over the hit you may take, either through a loss on your investment or tax obligation.

Settlement Window

When you sell ETFs, there’s a two-day settlement window that must pass before you can access your cash. This could be to your disadvantage if you need the funds right away to invest in another asset.

How to Invest in ETFs

To invest in exchange-traded funds (ETFs), you’ll need to follow these steps:

  1. Choose a brokerage: First, select a brokerage firm where you will place your trades. Reputable options include well-known online brokers such as Charles Schwab, E*TRADE, Robinhood, and Fidelity. Be sure to compare fees, trading platforms, and other features before making your decision.
  2. Open an account: Once you’ve chosen a brokerage, you’ll need to open a brokerage account and complete any required paperwork. This may include providing personal and financial information, as well as completing any necessary identity verification steps.
  3. Fund your account: To buy ETFs, you’ll have to deposit money into your brokerage account. This can typically be done by linking a bank account or using a credit or debit card.
  4. Select your ETFs: Once your account is funded, you’ll be able to browse and select the ETFs you’d like to purchase. Most brokerage firms offer a wide range of ETFs to choose from, including those that track specific indexes, sectors, or countries.
  5. Place your trade: Once you’ve selected the ETFs you’d like to purchase, you can place your trade by specifying the quantity and price. Your brokerage firm will handle the rest of the process, including executing the trade and holding the ETF shares in your account.

Keep in mind that investing in ETFs carries risks, and it’s important to do your own research and consider your own financial goals and risk tolerance before making any investment decisions. It’s also a good idea to consult a financial professional for personalized advice.

Bottom Line

It’s easy to buy or sell ETFs and make them part of your investment strategy. By gaining a thorough understanding of how they work and working with a broker to analyze how they will impact your investment portfolio, you’ll have the best chance of maximizing your returns.

Allison Martin
Meet the author

Allison Martin is a syndicated financial writer, author, and Certified Financial Education Instructor (CFEI). She has written about personal finance for almost ten years and holds a master's degree in Accounting from the University of South Florida.