Exchange-Traded Fund (ETF): How to Invest and What It Is

Stocks, commodities like gold, and bonds are the most famous investment instruments. However, not everyone has the knowledge and time to analyze a particular asset. ETFs, or Exchange-Traded Funds, solve this problem for people who want to invest in a basket of assets, commodities, or instruments replicating the broader index.

By definition, an ETF, or Exchange-Traded Fund, is a type of investment vehicle that tracks an underlying index, basket of assets, or commodity. Unlike mutual funds, ETFs trade on stock exchanges, allowing investors to buy and sell shares throughout the trading day. ETFs are essentially baskets of securities that trade like a single stock.

How does an ETF work?

ETFs gather funds from people to purchase a portfolio of securities that track a specific index or asset class. These ETF shares are then traded on a stock exchange. When you buy an ETF, you essentially buy a piece of that portfolio. ETFs are replicas of the securities in them, so when the price of securities changes, the value of ETFs changes, too.

ETFs have lower expense ratios than mutual funds because of the lower management requirement, which makes them more cost-effective for investors. This is because ETFs are traded on stock exchanges, which reduces the need for active management.

ETFs are more tax-efficient than mutual funds, as they typically have lower turnover and fewer capital gains distributions. 

What are the Types of ETFs?

There are many different types of ETFs, each with its unique focus:

• Equity ETFs: Stock ETFs are the biggest portion of the ETF market; they track a basket of stocks, such as the S&P 500 or the Nasdaq 100. Equity ETFs are among the most popular and offer investors exposure to a broad range of stocks. They can be used to invest in the overall stock market or to target specific sectors or industries.
  
• Bond ETFs: Bonds like government or corporate bonds are put in a basket so investors can invest in a basket of bonds instead of a single bond. Bond ETFs provide investors with exposure to the fixed-income market and can be used to generate income and diversify their portfolios. Bond ETFs can be used to invest in government bonds, corporate bonds, municipal bonds, or other types of bonds.
  
• Commodity ETFs: There are also commodity ETFs that track various commodities, such as gold, oil, or wheat. Commodity ETFs offer investors exposure to the commodities market and can be used to hedge against inflation or other market risks. They can be used to invest in physical commodities or commodity futures.
  
• Sector and Industry ETFs: Sector ETFs focus on a specific sector or industry, such as technology, healthcare, or financials, unlike other ETFs, which can pick stocks from different sectors. They allow investors to target specific sectors of the economy and capitalize on growth opportunities.
  
• International ETFs: If you want to invest overseas but do not know how to invest in international markets, ETFs can provide a way for you. These ETFs track a basket of stocks or bonds from foreign markets. International ETFs give investors exposure to global markets and can help diversify their portfolios. They are also used to invest in developed markets, emerging markets, or specific countries.
  
• Thematic ETFs: Thematic ETFs focus on a specific theme, such as clean energy, robotics, or artificial intelligence. Thematic ETFs expose investors to emerging trends and can provide significant growth potential.
  
• Inverse and Leveraged ETFs: These use derivatives to provide inverse or leveraged returns on a specific index or asset class. Inverse ETFs provide inverse returns, increasing when the underlying index decreases. Leveraged ETFs provide amplified returns, meaning they go up or down by a multiple of the underlying index. These types of ETFs are more complex and involve higher risk.

Is an ETF better than a stock?

It depends upon the individual whether ETFs or stocks are better for them. You must analyze your investment goals and risk tolerance and choose between the available options accordingly. ETFs offer diversification and lower costs, while stocks can provide higher potential returns but also come with higher risk.

How do ETFs make you money?

ETFs can generate returns in two ways:

• Capital Appreciation: As the value of the underlying securities in the ETF increases, so does the value of the ETF shares. This is the primary way that ETFs generate returns.
  
• Dividends: Some ETFs distribute dividends to investors from the dividends earned by the underlying securities. These dividends can provide a regular income stream, while capital appreciation can create wealth for investors.

What are the Advantages of Investing in ETFs?

The advantages of investing in ETFs are:

1. Diversification: ETFs provide instant diversification across a basket of securities, reducing the risk of investing in individual stocks. Diversification helps to mitigate the impact of individual company performance, enhancing portfolio resilience and reducing concentration risk.
   
2. Lower Costs: ETFs have lower expense ratios than actively managed mutual funds, resulting in higher net returns for investors. This is because ETFs are passively managed, tracking an underlying index rather than actively selecting individual securities.
   
3. Tax Efficiency: Due to their structure and trading characteristics, ETFs can be more tax-efficient than mutual funds. ETFs often generate less taxable income and capital gains, resulting in lower tax bills for investors. Additionally, ETFs can be used for tax-loss harvesting strategies, which involve selling a losing ETF to offset capital gains from other investments.
   
4. Flexibility and Liquidity: ETFs trade on stock exchanges, allowing you to buy or sell them throughout trading. Trading on exchanges means greater flexibility and the ability to react to real-time market movements. ETFs offer intraday pricing, providing more information and transparency when making investment decisions.
   
5. Transparency: ETFs are required to disclose their underlying holdings, providing transparency into the investments they hold. Transparency allows investors to understand the composition of the ETF and assess its risk exposure.

What are the Disadvantages of Investing in ETFs?

The disadvantages of investing in ETFs are:

1. Trading Costs: ETFs are subject to trading costs, including brokerage commissions, exchange fees, and bid-ask spreads. These costs can erode returns, especially for frequent traders or small investments. For example, if you frequently trade ETFs, the accumulated trading costs can significantly impact your overall returns.
   
2. Tracking Errors: ETFs may not perfectly track the performance of their underlying index due to factors such as sampling error, trading costs, and differences in the way the ETF is constructed. This tracking error can impact the ETF’s performance, as the ETF’s returns may deviate from the index’s returns.
   
3. Market Risks: ETFs are subject to market risk, meaning their prices can fluctuate based on overall market conditions. High market fluctuation can lead to losses if the market declines, regardless of the ETF’s underlying holdings.
   
4. Sector-Specific Risks: Sector ETFs are concentrated investments, meaning they are exposed to the performance of a specific sector. If that sector underperforms, the ETF will also underperform. For example, if you invest in a technology ETF and the technology sector experiences a downturn, your ETF’s performance will likely decline.
   
5. Leveraged and Inverse ETFs: Leveraged and inverse ETFs can be highly volatile and risky and are unsuitable for all investors. These ETFs use leverage to amplify the returns or losses of the underlying index, which can lead to significant gains or losses in a short period.

What is the Process of Buying and Selling ETFs?

The process of buying and selling ETFs is similar to trading individual stocks. You can buy and sell ETFs through a brokerage account.

How to Buy ETFs:

To buy an ETF, you’ll need to open a brokerage account with a firm that offers ETF trading. Research ETFs that align with your investment goals and risk tolerance; this might be hard for you if you are a beginner, but you can get help from experts. Once you’ve selected an ETF, place a buy order through your brokerage account, specifying the number of shares you want to purchase and the price you’re willing to pay. The ETF shares will typically settle in your brokerage account within a few days.

How to Sell ETFs:

You’ll need to place a sell order through your brokerage account to sell ETFs, just like you do for other assets. Specify the number of shares you want to sell and the price you will accept. The proceeds from the sale will be credited to your brokerage account.

ETF Trading Strategies:

• Buy and Hold: This is a long-term strategy in which you purchase and hold ETFs for an extended period. The strategy aims to capture the underlying index’s long-term growth potential.
  
• Dollar-Cost Averaging: According to dollar-cost averaging, you regularly invest a fixed amount in ETFs, regardless of market conditions. Doing so can reduce the impact of market volatility and potentially lower your average purchase price.  

• Tactical Allocation: You must shift your ETF investments based on market conditions and your investment goals. A tactical allocation strategy involves actively managing your portfolio to take advantage of short-term market opportunities or to hedge against potential risks.

What is the Role of ETFs in a Portfolio?

Asset Allocation: ETFs can diversify your portfolio by providing exposure to different asset classes, sectors, or geographic regions. This diversification can reduce your overall risk and enhance your returns. Combining ETFs with other asset classes like stocks, bonds, and cash can create a well-balanced portfolio that is less susceptible to market fluctuations.

Risk Management: ETFs can be used to hedge against market risk or specific sector risks. For example, if you’re concerned about market volatility, you can invest in a defensive ETF focusing on low-volatility stocks. ETFs can also reduce the overall volatility of your portfolio. By diversifying your investments across different ETFs, you can smooth out the impact of market fluctuations.

Long-term Investment Strategies: ETFs offer a low-cost way to invest in broad market indices, providing long-term exposure to the stock market. By investing in index ETFs, you can capture the long-term growth potential of the market without the need for active stock picking. ETFs can also be used to target specific sectors of the economy, allowing you to capitalize on growth opportunities in particular industries. This can be a valuable strategy for long-term investors who believe in the growth potential of certain sectors.

What are the Costs Associated with ETFs?

Following are the different types of costs associated with ETFs:

1. Expense Ratios: ETFs charge annual fees, known as expense ratios, to cover operating costs. These fees are typically expressed as a percentage of the ETF’s average net assets. Higher expense ratios can reduce your overall returns, as they directly impact the money you earn from your investment.
   
2. Trading Commissions: When buying or selling ETFs, you may incur brokerage commissions charged by your broker. These fees can vary depending on your brokerage firm and your trade size. Frequent trading can significantly increase your overall trading costs.
   
3. Bid-Ask Spreads: The bid-ask spread is the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept for an ETF. A wider bid-ask spread can increase transaction costs, as you may pay more than the ETF’s fair market value.  
4. Hidden Fees: Some ETFs have additional fees, such as redemption or creation fees. These fees can vary depending on your ETF and trading platform.

What are the Tax Implications of ETFs?

• Tax Efficiency of ETFs: ETFs can be more tax-efficient than mutual funds due to their structure and trading characteristics. ETFs often distribute in-kind, meaning they distribute shares of the underlying securities rather than cash. This can defer capital gains taxes, as you won’t realize the gain until you sell the ETF shares.
  
• Capital Gains Taxes: Capital gains from ETFs are generally taxed differently than ordinary income. Short-term capital gains from ETFs held for less than one year are taxed as ordinary income, while long-term capital gains from ETFs held for more than one year are typically taxed at a lower rate.
  
• Dividend Taxes: ETFs may distribute dividends from the underlying securities. These dividends are generally taxed as ordinary income unless they qualify for a lower long-term capital gains tax rate.
  
• Tax Strategies for ETF Investors:
  
  1. Tax-loss harvesting: Strategically selling losing ETFs to offset capital gains from other investments.
  
  2. Tax-Deferred Accounts: Holding ETFs in tax-deferred accounts like IRAs or 401(k) plans can defer capital gains taxes.
  
  3. Consult a Tax Advisor: Seek professional advice to understand the specific tax implications of your ETF investments.

What are the Key Considerations When Choosing an ETF?

Key considerations before choosing ETF for investment:

• ETF Performance: Analyze the ETF’s past performance and compare it to its benchmark index. Consider long-term returns, risk-adjusted returns (measured by metrics like the Sharpe or Sortino ratio), and how the ETF has performed during different market conditions.
  
• Expense Ratio: Compare the expense ratios of different ETFs to find the most cost-effective option. Lower expense ratios can lead to higher overall returns, as you’ll pay less in fees.
• Fund Size and Liquidity: Know the ETF’s trading volume to ensure liquidity and avoid wide bid-ask spreads. A high trading volume indicates that the ETF is actively traded and can be easily bought or sold. Larger ETFs may have better liquidity and lower trading costs. However, it’s important to note that fund size alone does not guarantee performance.
  
• Tracking Difference: Also, Measure how closely the ETF tracks its underlying index. A lower tracking error indicates that the ETF’s performance is closely aligned with the index. A higher tracking error may suggest that the ETF’s manager is actively trying to outperform the index, which can also increase risk.
  
• Underlying Index: Choose an ETF that aligns with your investment goals and risk tolerance. Consider factors such as your desired level of risk, return expectations, and investment horizon. Understand the composition of the underlying index and the types of securities it holds. This will help you assess the ETF’s exposure to different sectors, industries, or geographic regions.

What are Some Popular ETFs to Consider?

Examples of Well-Known ETFs:

• SPY: SPDR S&P 500 ETF Trust
• QQQ: Invesco QQQ Trust
• VTI: Vanguard Total Stock Market ETF
• VOO: Vanguard S&P 500 ETF
• IWM: iShares Russell 2000 ETF

FAQs

Q. What is the difference between an ETF and a mutual fund? 

ETFs trade on stock exchanges, while mutual funds are bought and sold directly from the fund company. ETFs offer greater liquidity and lower costs.

Q. Are ETFs risky investments? 

ETFs are subject to market risk, meaning their prices can fluctuate. However, they can also offer diversification and potentially lower costs.

Q. How do I choose the right ETF? 

Consider factors such as your investment goals, risk tolerance, and the ETF’s expense ratio, tracking error, and underlying index.

Q. Can I invest in ETFs through a retirement account? 

Yes, you can invest in ETFs through retirement accounts like IRAs or 401(k) plans.

Q. How often should I rebalance my ETF portfolio? 

Rebalancing frequency depends on your investment strategy and risk tolerance. Consider rebalancing periodically to maintain your desired asset allocation.

Braden Chase

Braden Chase is an investor, trading specialist, and former research specialist for Forex.com who helps aspiring investors develop the confidence and habits they need to make an income from the market. Braden has served as a registered commodity futures representative for domestic and internationally-regulated brokerages and has also spoken & moderated numerous forex and finance industry panels across the globe.

Read more about Braden Chase