What is an ETF?
An exchange traded fund (ETF) is a type of security that tracks an index, sector, commodity, or other asset, but which can be purchased or sold on a stock exchange the same as a regular stock. An ETF can be structured to track anything from the price of an individual commodity to a large and diverse collection of securities. ETFs can even be structured to track specific investment strategies.
A well-known example is the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index.
ETFs can contain many types of investments, including stocks, commodities, bonds, or a mixture of investment types. An exchange traded fund is a marketable security, meaning it has an associated price that allows it to be easily bought and sold.
KEY TAKEAWAYS
- An exchange traded fund (ETF) is a basket of securities that trade on an exchange, just like a stock.
- ETF share prices fluctuate all day as the ETF is bought and sold; this is different from mutual funds that only trade once a day after the market closes.
- 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.
An ETF is called an exchange traded fund since it’s traded on an exchange just like stocks. 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 trade only once per day after the markets close. Additionally, ETFs tend to be more cost-effective and more liquid when compared to mutual funds.
Cash Invested in ETFs
Types of ETFs
There are various types of ETFs available to investors that can be used for income generation, speculation, price increases, and to hedge or partly offset risk in an investor’s portfolio. Below are several examples of the types of ETFs.
- Bond ETFs might include government bonds, corporate bonds, and state and local bonds—called municipal bonds.
- Industry ETFs track a particular industry such as technology, banking, or the oil and gas sector.
- Commodity ETFs invest in commodities including crude oil or gold.
- Currency ETFs invest in foreign currencies such as the Euro or Canadian dollar.
- Inverse ETFs attempt to earn gains from stock declines by shorting stocks. Shorting is selling a stock, expecting a decline in value, and repurchasing it at a lower price.
Investors should be aware that many inverse ETFs are exchange traded notes (ETNs) and not true ETFs. An ETN is a bond but trades like a stock and is backed by an issuer like a bank. Be sure to check with your broker to determine if an ETN is a right fit for your portfolio.
Advantages and Disadvantages of ETFs
ETFs provide lower average costs since 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 since 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.
An ETF’s expense ratio is the cost to operate and manage the fund. ETFs typically have low expenses since they track an index. For example, if an ETF tracks the S&P 500 index, it might contain all 500 stocks from the S&P making it a passively-managed fund and less time-intensive. However, not all ETFs track an index in a passive manner.
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 focus ETFs limit diversification
- Lack of liquidity hinders transactions
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