What Is an Exchange-Traded Fund?
An exchange-traded fund (ETF) contains investments organized around a strategy, exposure, or theme. The approach might do one of the following:
Track a sector of the stock market, such as energy or technology.
Invest in a certain type of bond, such as municipal or high-yield.
Track a market index, such as the NASDAQ composite index or S&P 500.
An ETF trades on exchanges. The price fluctuates throughout the day, and the fund is liquid and flexible.
How Does an Exchange-Traded Fund Work?
An ETF lets investors purchase a potentially diversified investment:
One ETF can provide exposure to hundreds or thousands of stocks, bonds, and other investments.
The price change of the assets determines the ETF’s performance.
The diversification significantly reduces risk because some investments will likely increase in value while others decrease.
Types of Exchange-Traded Funds
The ETF market continues to expand. Thousands of funds with dozens of investment objectives are listed on US exchanges.
Common types of ETFs include:
Index ETFs: Track a market index, such as the Nasdaq composite or S&P 500.
Actively managed ETFs: Funds managed by a team of professionals to outperform passively managed funds, such as an index ETF.
Fixed-income ETFs: Provide exposure to diverse bonds, such as US Treasury, corporate, municipal, international, and high-yield.
Style ETFs: Focus on a specific investing style, such as value or growth, or market capitalization, such as small or large, or a combination of investing style and market capitalization, such as small-cap growth or large-cap value.
Sector and industry ETFs: Invest in stocks in a specific sector, such as health care, utilities, or energy, or in a specific industry within those sectors, such as pharmaceuticals, water, or oil.
Commodity ETFs: Track the price of a commodity, such as gold, timber, or oil.
Foreign market ETFs: Provide exposure to non-US markets and international companies, such as Hong Kong's Hang Seng index or Japan's Nikkei index.
Inverse ETFs: Profit from a decline in the underlying market or index. Because these types of ETFs are risky and more complex, they are typically used by experienced investors for short-term trading objectives.
Leveraged ETFs: Considered higher-risk investments, these funds track the price movement of a market, a segment of the market, or an index by magnitudes, like two or three times the price change.
Advantages of Exchange-Traded Funds
Investing in ETFs offers the following advantages:
Lower fees: ETFs have an expense ratio, which is the cost of being invested. For instance, an ETF with a 0.18% expense ratio on a $1,000 investment would cost $1.80 in fees annually. These administrative costs are typically lower than those of similar mutual funds.
Easily tradable: Because ETFs are listed on public exchanges, they can be bought and sold like stocks.
Tax efficiency: ETFs are structured to help shareholders reduce the annual taxes on their holdings. A gain or loss is realized when shares are sold.
Disadvantages of Exchange-Traded Funds
Investing in ETFs can have the following disadvantages:
Trading Costs
Buying or selling ETFs through certain financial institutions can include commissions and additional fees, including the bid-ask spread:
Specialized ETFs have a low trading volume.
A small number of buyers and sellers creates a price gap between what someone will pay for the ETF (the bid) and what someone is willing to receive to sell it (the ask).
A lower trading volume typically increases the spread between the bid and ask.
A large spread could mean taking a discount on the sale or paying a premium to buy.
Lack of Customization
Since ETFs are premade funds, buyers and sellers do not influence what they are invested in. Investing in a fund requires comfort with exposure to the securities.
Potential Tracking Errors
Certain market indexes and indicators that passive ETFs aim to track help investors mimic the benchmark’s performance. However, an ETF’s performance can miss the index’s performance or the indicator’s price changes, leading to tracking errors.
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*This information is for educational purposes only.
Do you invest or plan to invest in exchange-traded funds? Let me know in the comments!
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