Spend any time researching investing and you’re bound to encounter words like diversification, sectors, and index funds. ETFs, or exchange traded funds, have to do with all of these. Let’s break down your question of “What is an ETF?” to help you understand how to use them, how these funds differ from other types of investments, and common ETFs you’ll encounter in the market.
- An ETF, or exchange traded fund, is an index fund that holds a basket of securities.
- Unlike mutual funds, you can trade ETFs throughout the day — but unlike stocks, you can invest in diversified securities all at once.
- Fund providers set up ETFs so investors hold stock in the basket, not the underlying assets.
- ETFs can be designed based on market sector, geographical region, type of security, and more.
- Three of the most common ETFs are the SPDR Dow Jones Industrial Average ETF, SPDR S&P 500 ETF, and Invesco QQQ ETF. There are a lot more options based on a variety of factors, and you can find ones that suit your preferences.
What is an ETF?
Let’s start with the basic definition:
An exchange traded fund is a type of index fund. It’s a collection of securities (keep in mind: securities can be stocks, bonds, commodities, or a hybrid of the three). You can buy and sell ETFs through a brokerage. They often reflect a particular index or sector of the market via a diversified approach.
So, what exactly does that mean?
For the average investor, an ETF collects securities from various companies. It’s a way to diversify your portfolio better, and do so in a single move. You can buy shares of an ETF and be invested in anywhere from a handful to hundreds of companies. These companies could span across industries or hone in on a particular niche.
While these ETFs may follow a specified index, that doesn’t mean they’ll trade at the same value, or even reap the same returns. Investors should take market prices and expenses into consideration when evaluating if an ETF is right for them.
While the highs may not be as substantial as some individual stocks, people like ETFs because they offer the chance for notable returns without as much risk of volatility. Many folks use ETFs as a way to supplement their individual stock picking, or even as a way to save for retirement. They also give investors a chance to target a specific industry or index, which is difficult to do one stock at a time.
Related: What are the advantages of ETFs?
How do ETFs work?
ETFs work with the help of a fund provider. Logically, this fund provider owns the assets that underlie the fund.
The provider designs the fund around these assets. The collection of securities in an ETF is called a ‘basket’ and can contain stocks, bonds, commodities, or currencies. Each ETF gets a ticker, just like any stock or fund on the public market — this helps it differentiate itself from other positions.
Ultimately, the fund provider’s goal is to sell off shares to interested investors. These investors become shareholders of the ETF basket, but not the assets that underlie the fund. However, it’s still comparable to owning shares of a company.
Investors earn dividends from most ETFs, which can get reinvested into the position. People who buy and sell ETFs can do so throughout the course of the day on any given exchange.
Related: How do dividends work?
ETFs vs stocks vs mutual funds
For the average Joe and Jane, it takes a while to get used to investing jargon. Seeing terms like ETFs, stocks, and mutual funds all in a row can make a novice’s head spin. However, there are marked differences between the three. Here’s the rundown:
All funds come with fees, whether we like it or not. One of these types of fees is an expense ratio. You might see an expense ratio of 0.32% (for example), which means that fund will take $32 for every $10,000 you invest. Actively managed funds incur higher expense ratios while passively managed funds are lower. In most instances, a lower expense ratio is better. ETFs typically have lower expense ratios than mutual funds.
When you’re picking individual stocks, you’re dealing with singular companies. This can be risky because if that company plummets, you’re going down with it. Like mutual funds, ETFs are a diversified alternative to stocks.
Investors trade stocks throughout the day. However, mutual funds only trade after the market closes at 4:00 p.m. each business day. You can buy and sell ETFs throughout the day, making them more like stocks than mutual funds in this regard.
Since mutual funds receive more transactions, investors incur higher capital gains, which cause higher tax dues. With that in mind, ETFs tend to be more tax efficient than mutual funds, which is another way to balance your portfolio.
There are actively managed ETFs, but you’re more likely to stumble upon passively managed ETFs — which is likely why their expense ratios are lower. Right now, there are less available ETFs than mutual funds.
Types of ETFs
There are five main categories of ETFs. However, some exchange traded funds may mix and match across these categories. Basically, these types of ETFs showcase the types of securities they hold.
- Sector ETF: An ETF geared toward a particular sector (or industry). The US stock market defines 11 distinct sectors, ranging from financial to technology.
- International ETF: This includes international companies and positions, which can help you diversify a US-heavy portfolio.
- Commodity ETF: These are baskets of commodities investments, like precious metals and oil. Do your due diligence to understand the tax implications that may come with a commodity investment.
- Bond ETF: These don’t have a set date of maturity, but investors do receive cash payments on a regular basis. Fund providers can compose the ETF using various types of bonds (government, corporate, state, and local/municipal).
- Stock ETF: An ETF made up of a basket of stocks, which are typically held for the long term.
Other types include currency ETFs (which invest in foreign currencies) and inverse ETFs (which focus on shorting stocks, a practice you might be familiar with if you know how Public makes money).
Common ETFs in the market
There are tons of resources online touting the best ETFs around but the truth is a bit trickier. What’s right for someone else may not be a smart move for your portfolio, and vice versa.
With that in mind, here are some common ETFs you may want to consider, depending on your risk tolerance and portfolio needs:
- SPDR S&P 500 ETF (SPY)
- Invesco QQQ ETF (QQQ)
- SPDR Dow Jones Industrial Average ETF (DIA)
- VanEck Vectors Gold Miners ETF (GDX)
- Invesco Solar ETF (TAN)
- ARK Autonomous Technology & Robotics ETF (ARKQ)
- iShares MSCI EAFE ETF (EFA)
Related: What is the S&P 500?
If you’re ready to diversify your portfolio in a pinch, ETFs may be the way to go. They can help you save for retirement or earn capital for a medium-term goal. Whatever you’re after, be sure to evaluate the fees associated with each fund, make sure you’re comfortable with what you’re investing in, and take reviews of any funds with a grain of salt.