Exchange-traded funds (ETFs) operate like a mutual fund, but trade on an exchange just like a stock. When you invest in an ETF, you gain access to a bundle of investments like stocks or bonds. You can buy or sell ETFs during normal trading hours.
ETFs can be an easy and low-cost investing strategy. There are many different types you can choose from which will help you diversify your portfolio. But ETFs aren’t going to be the right fit for everyone, and you should do your research before investing. This article will explain what an ETF is and how it works.
Vault’s Viewpoint on ETFs
- Exchange-traded funds (ETFs) are pooled funds that can include stocks, bonds or other assets.
- ETFs trade on an exchange and typically track an index.
- ETFs are a great way to diversify your portfolio and tend to come with low costs.
What Is an Exchange Traded Fund (ETF)?
Exchanged traded funds (ETFs) are pooled funds that often include investment options like stocks, bonds or other assets. An ETF has to register with the SEC, and once it’s approved, the fund becomes an investment company. The company will buy and hold assets and sell shares to investors.
ETFs trade on an exchange, typically tracking a specific index. Some of the most popular indexes ETFs track include:
- Dow Jones Industrial Average
- Standard and Poor’s 500 (S&P 500)
- Nasdaq Composite
When you buy shares in an ETF, you have access to a collection of assets you can buy and sell during market hours. And like stocks, ETFs will often experience price fluctuations throughout the day.
Many investors like ETFs because they’re easy to trade and are a great way to diversify your portfolio. You can invest in many different securities at once, and ETFs usually come with lower fees than other types of assets.
Types of ETFs
ETFs are traded like a stock, but operate more like mutual and index funds. There are many different types of ETFs available, and the assets can vary significantly depending on the fund’s investment goals. Here are the most popular types of ETFs you can expect to encounter.
Stock ETF
Stock ETFs are a collection of stocks that tracks a specific industry or sector. For example, international ETFs own stocks of companies outside the U.S. Some ETFs own stocks in companies with similar business types or market capitalizations. Stock ETFs are best for long-term growth, and tend to be less risky than buying shares of individual stocks.
Bond ETFs
Bond ETFs include a portfolio of bonds issued by municipalities, governments or corporations. Unlike buying individual bonds, bond ETFs don’t have a maturity date so you can use them to generate regular cash payments. They are an excellent way to diversify your portfolio outside of stocks.
Commodity ETFs
Commodity ETFs provide exposure to the price changes of raw materials like agricultural goods, natural resources, or metals. They’re typically structured in one of two ways: buying and storing the physical commodity itself or investing in future contracts.
Sector ETFs
The stock market is divided into different sectors, and different companies operate within each sector. Sector ETFs are a way to invest in different types of companies you find interesting. For example, you can invest in companies within the energy, technology, healthcare or financial sectors. But sector ETFs come with more risk than broad-market ETFs.
Pros and Cons of ETFs
Pros
- Low costs: ETFs tend to come with low costs, especially when compared to actively managed mutual funds.
- Diversification: When you invest in an ETF, you’ll gain exposure to stocks across different industries, sectors or countries. Diversifying your portfolio helps protect it against market volatility.
- Tax benefits: When you invest in ETFs, you only have to pay capital gains taxes when you sell which means you’ll pay fewer taxes on your investment.
Cons
- Potential broker fees: ETFs have low expense ratios, but are still subject to commission fees from online brokers.
- Possible tracking errors: ETFs can stray from the index they’re supposed to track which can cost investors money.
- The ETF could close: If the fund doesn’t bring in enough money to cover the administrative costs, it could be forced to close. That means investors may have to sell at a loss. And if you do earn a profit, you’ll have to pay capital gains taxes.
ETFs vs. Mutual Funds
ETFs are often compared to mutual funds, and the two investments are similar in many ways. Both must register with the SEC and they’re structured in a similar way. And both offer exposure to a wide variety of asset classes and markets.
But there are some important differences between the two investments. ETFs are a mostly passive investment while a mutual fund may be handled by a portfolio manager. Let’s look at the biggest differences between the two investments.
| ETFs | Mutual Funds | |
| Management style | Most are passively managed and track a market index | Can be passively or actively managed |
| Costs | Possible trade commission and operating expense ratio | Possible sales loads or early redemption fees |
| Minimum investment | Don’t require a minimum investment and are purchased as shares | Most require a minimum investment ranging from $500 to $5,000 |
| Tax consequences | You only have to pay capital gains taxes when you sell | A sales of securities within the mutual fund could require investors to pay capital gains taxes |
Factors to Consider When Investing in ETFs
ETFs could be a good addition to your portfolio, but here are a few factors to consider first:
- Total assets: Any ETF you choose should have a minimum level of assets of at least $10 million. If a fund’s assets are below that number, it’s unlikely to bring in much interest from other investors.
- Underlying asset: You also want to consider the underlying asset the fund is based on since the underlying asset is what determines how well-diversified the fund is. For example, if you’re focused on maximizing your returns and achieving long-term growth, you may want a fund where stocks are the underlying asset.
- Trading activity: Trading volume is an important indicator to track an ETF’s momentum. The higher the trading volume, the better it’s performing. It’s also one indicator of an ETF’s overall liquidity or how quickly and easily an asset can be bought or sold without impacting its market price.
- Performance: You can use certain metrics like tracking difference and tracking error to track an ETF’s overall performance. Tracking difference measures the difference between an ETF’s performance and the benchmark index’s performance. Tracking error measures the volatility of the difference between the actual returns of an ETF and its benchmark over the previous year.
- Costs: You also want to consider the expense ratio and any transaction fees. The expense ratio is calculated annually and transaction fees are paid when the fund is bought or sold.
Should I Invest in an ETF?
ETFs are a diversified investment and require very little money to get started so they’re a great choice for new investors. To get started, you’ll need to set up an online brokerage account. Look for a broker that offers commission-free trading on ETFs.
Once your account is funded, you can decide how many ETF shares you want to purchase. If you don’t feel confident picking ETFs on your own, you can use a robo-advisor that will automatically invest on your behalf.
Frequently Asked Questions
How is an ETF Different From a Stock?
A stock represents a percentage of ownership in a company and its assets. In comparison, an ETF is a pool of assets and securities like stocks and bonds. Buying an individual stock gives you exposure to just one company while an ETF gives you exposure to hundreds of companies.
This makes investing in ETFs less risky than buying individual stocks. But stocks can generate potentially higher returns than ETFs.
Are ETFs Safer Than Stocks?
ETFs are considered safer than stocks because an ETF holds a variety of different assets which helps diversify your investment and lower your risk. There are no guaranteed returns on your investment when you buy an individual stock. That being said, buying stocks can be a good long-term investment strategy.
What Happens When an ETF Shuts Down?
When an ETF closes, any remaining shareholders will receive a payout based on their initial investment. But this means you may have to sell out sooner than you wanted to, and you’ll have to pay capital gains taxes on any profits.
