ETFs

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 way 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. 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.

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 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.

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.

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.

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. Here is a brief description of some of the ETFs available on the market today.

Bond ETFs

Bond ETFs are used to provide regular income to investors. Their income distribution depends on the performance of underlying bonds. They might include government bonds, corporate bonds, and state and local bonds—called municipal bonds. Unlike their underlying instruments, bond ETFs do not have a maturity date. They generally trade at a premium or discount from the actual bond price.

Stock ETFs

Stock ETFs comprise a basket of stocks to track a single industry or sector. For example, a stock ETF might track automotive or foreign stocks. The aim is to provide diversified exposure to a single industry, one that includes high performers and new entrants with potential for growth. Unlike stock mutual funds, stock ETFs have lower fees and do not involve actual ownership of securities.

Industry ETFs

Industry or sector ETFs are funds that focus on a specific sector or industry. For example, an energy sector ETF will include companies operating in that sector. The idea behind industry ETFs is to gain exposure to the upside of that industry by tracking the performance of companies operating in that sector. One example is the technology sector, which has witnessed an influx of funds in recent years. At the same time, the downside of volatile stock performance is also curtailed in an ETF because they do not involve direct ownership of securities. Industry ETFs are also used to rotate in and out of sectors during economic cycles.

Commodity ETFs

As their name indicates, commodity ETFs invest in commodities, including crude oil or gold. Commodity ETFs provide several benefits. First, they diversify a portfolio, making it easier to hedge downturns. For example, commodity ETFs can provide a cushion during a slump in the stock market. Second, holding shares in a commodity ETF is cheaper than physical possession of the commodity. This is because the former does not involve insurance and storage costs.

Currency ETFs

Currency ETFs are pooled investment vehicles that track the performance of currency pairs, consisting of domestic and foreign currencies. Currency ETFs serve multiple purposes. They can be used to speculate on the prices of currencies based on political and economic developments for a country. They are also used to diversify a portfolio or as a hedge against volatility in forex markets by importers and exporters. Some of them are also used to hedge against the threat of inflation.

Inverse ETFs

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. An inverse ETF uses derivatives to short a stock. Essentially, they are bets that the market will decline. When the market declines, an inverse ETF increases by a proportionate amount. 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 good fit for your portfolio.

In the U.S., most ETFs are set up as open-ended funds and are subject to the Investment Company Act of 1940 except where subsequent rules have modified their regulatory requirements. Open-end funds do not limit the number of investors involved in the product.

How to Begin Investing in 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.

1. 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 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. For example, smartphone investing apps enable ETF share purchase at the click of a button. This may not be the case for all brokerages, which may ask investors for paperwork or a more complicated situation. Some well-known brokerages, however, offer extensive educational content that helps new investors become familiar with and research ETFs.
2. 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 like 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:
3. What is your time frame for investing?
4. Are you investing for income or growth?
5. Are there particular sectors or financial instruments that excite you?
6. 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.

How to Buy and Sell ETFs

ETFs trade through online brokers and traditional broker-dealers. You can view some of the top brokers in the industry for ETFs with Investopedia’s list of the best brokers for ETFs. An alternative to standard brokers are robo-advisors like Betterment and Wealthfront who make use of ETFs in their investment products.

Real-World Examples of ETFs

Below are examples of popular ETFs on the market today. Some ETFs track an index of stocks creating a broad portfolio while others target specific industries.

• The SPDR S&P 500 (SPY) 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) indexes the Nasdaq 100, which typically contains technology stocks.
• The SPDR Dow Jones Industrial Average (DIA) represents the 30 stocks of the Dow Jones Industrial Average.
• Sector ETFs track individual industries such as oil (OIH), energy (XLE), financial services (XLF), REITs (IYR), Biotech (BBH).
• Commodity ETFs represent commodity markets including crude oil (USO) and natural gas (UNG).
• Physically backed ETFs: The SPDR Gold Shares (GLD) and the iShares Silver Trust (SLV) hold physical gold and silver bullion in the fund.

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.

An ETF’s expense ratio is the cost to operate and manage the fund. ETFs typically have low expenses because 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 that is less time-intensive. However, not all ETFs track an index in a passive manner.

Actively managed ETFs

There are also actively managed ETFs, wherein portfolio managers are more involved in buying and selling shares of companies and changing the holdings within the fund. Typically, a more actively managed fund will have a higher expense ratio than passively managed ETFs. It is important that investors determine how the fund is managed, whether it’s actively or passively managed, the resulting expense ratio, and the costs versus the rate of return to make sure it is worth holding.

Indexed-stock ETFs

An indexed-stock ETF provides investors with the diversification of an index fund as well as the ability to sell short, buy on margin, and purchase as little as one share because there are no minimum deposit requirements. However, not all ETFs are equally diversified. Some may contain a heavy concentration in one industry, or a small group of stocks, or assets that are highly correlated to each other.

Dividends and ETFs

Though ETFs provide investors with the ability to gain as stock prices rise and fall, they also benefit from companies that pay dividends. Dividends are a portion of earnings allocated or paid by companies to investors for holding their stock. ETF shareholders are entitled to a proportion of the profits, such as earned interest or dividends paid, and may get a residual value in the event that the fund is liquidated.

ETFs and taxes

An ETF is more tax-efficient than a mutual fund because most buying and selling occurs through an exchange and the ETF sponsor does not need to redeem shares each time an investor wishes to sell or issue new shares each time an investor wishes to buy. Redeeming shares of a fund can trigger a tax liability, so listing the shares on an exchange can keep tax costs lower. In the case of a mutual fund, each time an investor sells their shares, they sell it back to the fund and incur a tax liability that must be paid by the shareholders of the fund.

ETFs market impact

Because ETFs have become increasingly popular with investors, many new funds have been created, resulting in low trading volumes for some of them. The result can lead to investors not being able to buy and sell shares of a low-volume ETF easily.

Concerns have surfaced about the influence of ETFs on the market and whether demand for these funds can inflate stock values and create fragile bubbles. Some ETFs rely on portfolio models that are untested in different market conditions and can lead to extreme inflows and outflows from the funds, which have a negative impact on market stability.

Since the financial crisis, ETFs have played major roles in market flash-crashes and instability. Problems with ETFs were significant factors in the flash crashes and market declines in May 2010, August 2015, and February 2018.

ETF Creation and Redemption

The supply of ETF shares is regulated through a mechanism known as creation and redemption, which involves large specialized investors called authorized participants (APs).

ETF creation

When an ETF wants to issue additional shares, the AP buys shares of the stocks from the index—such as the S&P 500 tracked by the fund—and sells or exchanges them to the ETF for new ETF shares at an equal value. In turn, the AP sells the ETF shares in the market for a profit. The process by which an AP sells stocks to the ETF sponsor in return for shares in the ETF is called creation.

Creation when shares trade at a premium 

Imagine an ETF that invests in the stocks of the S&P 500 and has a share price of $101 at the close of the market. If the value of the stocks that the ETF owns was only worth $100 on a per-share basis, then the fund’s price of $101 is trading at a premium to the fund’s net asset value (NAV). The NAV is an accounting mechanism that determines the overall value of the assets or stocks in an ETF.

An authorized participant has an incentive to bring the ETF share price back into equilibrium with the fund’s NAV. To do this, the AP will buy shares of the stocks that the ETF wants to hold in its portfolio from the market and sells them to the fund in return for shares of the ETF. In this example, the AP is buying stock on the open market worth $100 per share but getting shares of the ETF that are trading on the open market for $101 per share. This process is called creation and increases the number of ETF shares on the market. If everything else remains the same, increasing the number of shares available on the market will reduce the price of the ETF and bring shares in line with the NAV of the fund.

ETF redemption

Conversely, an AP also buys shares of the ETF on the open market. The AP then sells these shares back to the ETF sponsor in exchange for individual stock shares that the AP can sell on the open market. As a result, the number of ETF shares is reduced through the process called redemption.

The amount of redemption and creation activity is a function of demand in the market and whether the ETF is trading at a discount or premium to the value of the fund’s assets.

Redemption when shares trade at a discount

Imagine an ETF that holds the stocks in the Russell 2000 small-cap index and is currently trading for $99 per share. If the value of the stocks the ETF is holding in the fund is $100 per share, then the ETF is trading at a discount to its NAV.

To bring the ETF’s share price back to its NAV, an AP will buy shares of the ETF on the open market and sell them back to the ETF in return for shares of the underlying stock portfolio. In this example, the AP is able to buy ownership of $100 worth of stock in exchange for ETF shares it bought for $99. This process is called redemption, and it decreases the supply of ETF shares on the market. When the supply of ETF shares is decreased, the price should rise and get closer to its NAV.

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