Exchange-Traded Fund (ETF)
An exchange-traded fund (ETF) is a type of pooled investment security that operates much like a mutual fund.
Typically, ETFs will track a particular index, sector, commodity, or other assets, but unlike mutual funds, ETFs can be purchased or sold on a stock exchange the same way that a regular stock can. An ETF can be structured to track anything from the price of an individual commodity to a large and diverse collection of securities.
The first ETF was the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index, and which remains an actively traded ETF today.
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.1
ETFs can contain all types of investments, including stocks, commodities, or bonds; some offer U.S.-only holdings, while others are international.
ETFs offer low expense ratios and fewer broker commissions than buying the stocks individually.
Understanding Exchange-Traded Funds (ETFs)
An ETF is called an exchange-traded fund because it’s traded on an exchange just like stocks are. The price of an ETF’s shares will change throughout the trading day as the shares are bought and sold on the market.
This is unlike mutual funds, which are not traded on an exchange, and which trade only once per day after the markets close. Additionally, ETFs tend to be more cost-effective and more liquid compared to mutual funds.
An ETF is a type of fund that holds multiple underlying assets, rather than only one like a stock does. Because there are multiple assets within an ETF, they can be a popular choice for diversification. ETFs can thus contain many types of investments, including stocks, commodities, bonds, or a mixture of investment types.
An ETF can own hundreds or thousands of stocks across various industries, or it could be isolated to one particular industry or sector. Some funds focus on only U.S. offerings, while others have a global outlook. For example, banking-focused ETFs would contain stocks of various banks across the industry.
An ETF is a marketable security, meaning it has a share price that allows it to be easily bought and sold on exchanges throughout the day, and it can be sold short.
Diversification
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.
Liquidity
ETFs with very low AUM or low daily trading averages tend to incur higher trading costs due to liquidity barriers. This is an important factor to consider when comparing funds that may otherwise be similar in strategy or portfolio content.
Examples of Popular ETFs
Below are examples of popular ETFs on the market today. Some ETFs track an index of stocks, thus creating a broad portfolio, while others target specific industries.
The SPDR S&P 500 (SPY): The “Spider” is the oldest surviving and most widely known ETF that tracks the S&P 500 Index.
The iShares Russell 2000 (IWM) tracks the Russell 2000 small-cap index.
The Invesco QQQ (QQQ) (“cubes”) tracks the Nasdaq 100 Index, which typically contains technology stocks.
The SPDR Dow Jones Industrial Average (DIA) (“diamonds”) represents the 30 stocks of the Dow Jones Industrial Average.
Sector ETFs track individual industries and sectors such as oil (OIH), energy (XLE), financial services (XLF), real estate investment trusts (IYR), and biotechnology (BBH).
Commodity ETFs represent commodity markets, including gold (GLD), silver (SLV), crude oil (USO), and natural gas (UNG).
Country ETFs 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).
Advantages and Disadvantages of ETFs
ETFs provide lower average costs because it would be expensive for an investor to buy all the stocks held in an ETF portfolio individually.
Investors only need to execute one transaction to buy and one transaction to sell, which leads to fewer broker commissions because there are only a few trades being done by investors.
Brokers typically charge a commission for each trade. Some brokers even offer no-commission trading on certain low-cost ETFs, reducing costs for investors even further.
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
How to Buy ETFs
With a multiplicity of platforms available to traders, investing in ETFs has become fairly easy. Follow the steps outlined below to begin investing in ETFs.
Find an Investing Platform
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 you don’t have to pay fees to the platform providers to buy or sell ETFs.
However, a commission-free purchase or sale does not mean that the ETF provider will also provide access to their product without associated costs. Some areas in which platform services can distinguish their services from others are convenience, services, and product variety.
Research ETFs
The second and most important step in ETF investing involves researching them. There is a wide variety of ETFs available in the markets today. One thing to remember during the research process is that ETFs are unlike individual securities such as stocks or bonds.
You will need to consider the whole picture—in terms of sector or industry—when you commit to an ETF. Here are some questions you might want to consider during the research process:
- What is your time frame for investing?
- Are you investing for income or growth?
- Are there particular sectors or financial instruments that excite you?
Consider a Trading Strategy
If you are a beginning investor in ETFs, dollar-cost averaging or spreading out your investment costs over a period of time is a good trading strategy. This is because it smooths out returns over a period of time and ensures a disciplined (as opposed to a haphazard or volatile) approach to investing.
It also helps beginning investors learn more about the nuances of ETF investing. When they become more comfortable with trading, investors can move out to more sophisticated strategies like swing trading and sector rotation.
A brokerage account allows investors to trade shares of ETFs just as they would trade shares of stocks.
Hands-on investors may opt for a traditional brokerage account, while investors looking to take a more passive approach may opt for a robo-advisor. Robo-advisors often include ETFs in their portfolios, although they choice of whether to focus on ETFs or individual stocks may not be up to the investor.
What to Look for in an ETF
After creating a brokerage account, investors will need to fund that account before investing in ETFs. The exact ways to fund your brokerage account will depend on the broker. After funding your account, you can search for ETFs and make buys and sells in the same way that you would shares of stocks.
Volume: Trading volume over a particular period of time allows you to compare the popularity of different funds; the higher the trading volume, the easier it may be to trade that fund.
Expenses: The lower the expense ratio, the less of your investment is given over to administrative costs. While it may be tempting to always search for funds with the lowest expense ratios, sometimes costlier funds (such as actively managed ETFs) have strong enough performance that it more than makes up for the higher fees.
Performance: While past performance is not an indication of future returns, this is nonetheless a common metric for comparing ETFs.
The Bottom Line
Exchange-traded funds, or ETFs, represent a cost-effective way to gain exposure to a broad basket of securities with a limited budget. Instead of buying individual stocks, the investor can simply 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.