What is an exchange-traded fund (ETF)?
An exchange-traded fund (ETF) is an investment fund traded on stock exchanges that combines multiple assets and can be bought or sold just like a single stock.
ETFs are popular due to their diversification, low costs, as well as ease of trading. An ETF lets investors put their money into several assets at once through a single investment.
An ETF is made up of specific assets like oil, gold, or even coffee. However, most ETFs typically consist of a collection of stocks of various companies. These can be stocks of the largest companies in a single country, a specific economic sector, or some ETFs that might represent different regions.
For example, you can have
A tech ETF, which includes stocks from top global technology companies.
A green energy ETF that could have stocks from leading renewable energy businesses.
When you buy a share of an ETF, you own a small piece of all the assets in the fund. If the ETF includes stocks from 100 companies, owning one share means you hold a small portion of each one.
To put it simply, it’s like buying a variety pack of candy, rather than a whole box of just one kind of candy. The mixed pack gives you a selection in one convenient package, and you don’t spend too much on more than you need.
An ETF works the same way — it offers a mix of assets in a single, affordable investment.
History of ETFs
Since their creation in the early 1990s, exchange-traded funds (ETFs) have transformed the way we see investing. Today, they are one of the most popular financial products, diverse and cost-effective for investors from all over the world. But how did ETFs come about? Let’s take a look at their history.
The concept of ETFs emerged in the late 1980s when Nathan Most, an American Stock Exchange (AMEX) executive, created a product that combined the benefits of index investing with the flexibility of stock trading. He aimed to allow investors to buy and sell entire indices as easily as individual shares. However, early efforts were faced with resistance. Vanguard founder John Bogle, for example, doubted the suitability of index funds for intraday trading.
Nevertheless, the first ETF was launched in Canada in 1990. The TIP 35 fund tracked the Toronto Stock Exchange Index, and this paved the way for the global ETF boom.
In the US, the first ETF appeared in 1993. It was the SPDR S&P 500 ETF (SPY), developed by State Street Global Advisors. SPY was designed to track the S&P 500 Index and became an instant success. SPY remains one of the most heavily traded ETFs in the world to this day.
The 1990s and early 2000s saw a surge in ETF innovation.
Fixed-income ETFs were introduced in 2002, allowing investors to access bond markets easily, followed by commodity ETFs like the SPDR Gold Trust (GLD) two years later, which added physical assets like gold.
Over the decades, ETFs have grown exponentially. By 2021, global ETF assets surpassed $8 trillion, with nearly 7 000 funds available. Today, investors can get any ETF of every asset class, ranging from equities and bonds to real estate and commodities.
How ETFs work
When you invest in an ETF, you own shares of the fund but not the underlying assets directly. This means that if you invest in an ETF that tracks a stock index like the S&P 500, you don’t own the individual stocks within the index. However, you may still receive dividends from the stocks included in the index.
If you invest in Vanguard's Consumer Staples ETF (VDC), you simultaneously invest in 104 companies that are part of the MSCI US Investable Market Consumer Staples 25/50 Index. This ETF holds shares in well-known companies like Procter & Gamble, Costco, Coca-Cola, Walmart, and PepsiCo. If you invest $1.00 in VDC, you own $1.00 worth of shares that represent all 104 companies in the fund.
It’s also important to remember that although ETFs aim to match the performance of their underlying asset, their trading price may differ slightly from the asset’s actual value due to market activity. Additionally, long-term ETF returns might vary from the performance of the underlying assets due to fund expenses.
ETFs normally have lower fees than other types of funds, and are often considered cost-effective. However, the level of risk varies depending on the type of ETF.
Key features:
Market Pricing of ETFs is determined throughout the trading day, unlike mutual funds, which are priced once daily after markets close.
Most ETFs in the U.S. have an open-ended structure, meaning there’s no limit to the number of investors who can participate.
ETFs are regulated. They must be registered with the Securities and Exchange Commission (SEC) and often operate under the Investment Company Act of 1940.
ETFs (exchange-traded funds) function as follows:
The first step is asset selection, when the ETF provider chooses a basket of assets, such as the consumer staples companies in the VDC example, and organizes them into a fund with a unique ticker symbol.
Then, investors buy shares in the ETF that represent a portion of the fund’s total assets.
Finally, the shares of the ETF are traded on stock exchanges just like stocks. This makes them easy to buy or sell during the trading day.
Types of ETFs
There are many types of exchange-traded funds (ETFs), and each has its own unique investment strategy and focus. ETFs can be categorized based on their investment approach, the type of securities they hold, or the underlying indices they track. Here are the most common types of ETFs:
Market index ETFs: Track the performance of specific stock exchanges or markets, such as the S&P 500 or the Dow Jones Industrial Average (DJIA).
Sector ETFs: Focused on particular industries, these ETFs target areas like technology, healthcare, or energy.
Bond ETFs: Designed to follow the performance of bond markets, such as government or corporate bonds.
Commodity ETFs: Invest in commodities like gold, oil, or agricultural products.
Thematic ETFs: Track themes like renewable energy or artificial intelligence.
Additionally, there are ETFs that employ alternative strategies, such as socially responsible investing or volatility and risk reduction approaches.
Before choosing an ETF, investors should carefully evaluate their investment goals and risk tolerance to ensure the fund aligns with their financial objectives.
Pros and cons of ETFs
Pros:
Invest in a variety of stocks from different industries with one ETF
Reduce risk by spreading your investment across many assets
Save money with low fees and fewer broker commissions
Start with a smaller deposit instead of buying expensive individual stocks
Buy and sell easily just like stocks for more flexibility
Earn dividends from ETFs that hold stocks
Choose ETFs focused on specific industries or trends you're interested in
Cons:
Market risk due to market fluctuations.
Tracking errors as an ETF might not perfectly match the performance of its underlying assets.
Management fees ETFs charge for administration - these are generally low.
Risks of investing in ETFs
Market risk. If the market or sector the ETF tracks goes down, the value of the ETF will also drop, no matter how well it’s managed.
Broken ETFs. These occur when something goes wrong with the markets they track. This can cause prices to disconnect from the underlying assets.
Confusing labels. The thousands of ETFs to choose from, with some looking similar but holding different types of investments, can lead to big differences in performance.
Complex investments. Some ETFs focus on complicated assets like commodities or currencies. These can be harder to understand and may not behave the way you expect.
The ETF may shut down. If the fund fails to attract enough investors and shuts down, you might face unexpected tax costs and fees.
How to invest in ETFs
Choose a broker. To buy or sell ETFs you will need access to a broker account.
Select the right ETF. Passive index funds are usually the best choice for beginners. They are cheaper than actively managed funds.
Buy ETF shares.
Monitor performance. It’s good to keep in mind that ETFs are low-maintenance investments, and it's best to let them grow over time without frequent checking or emotional trading.
Most popular ETFs for investors
SPDR S&P 500 ETF (SPY): One of the most popular ETFs, providing exposure to the S&P 500 index.
Vanguard Total Stock Market ETF (VTI): Provides exposure to the entire U.S. stock market.
Invesco QQQ ETF (QQQ): Tracks the NASDAQ-100, focusing on technology and growth stocks.
SPDR Dow Jones Industrial Average (DJIA): An ETF that represents the 30 stocks of the Dow Jones Industrial Average.
Tax implications of ETFs
If you buy ETFs in a standard brokerage account, any gains from selling them will be taxed as capital gains. Dividends you receive may also be taxable.
However, ETFs are generally more tax-efficient than mutual funds. If you hold an ETF for a longer period, you may qualify for lower long-term capital gains tax rates. Additionally, the way ETFs are structured can help minimize taxable distributions.
ETFs vs. mutual funds vs. stocks
The main difference between ETFs and mutual funds lie in how you buy and sell them.
Mutual funds are priced once a day, and you invest a set amount - either through a brokerage, or directly with the issuer. On top of that, the transaction isn't immediate and there are typically higher fees.
ETFs trade like stocks on exchanges like the NYSE and Nasdaq. You choose how many shares to buy, and their prices change throughout the day. That means you buy them whenever the stock market is open. ETFs offer lower management fees.
Stocks represent ownership in a single company. They also trade throughout the day like the ETF, and the prices fluctuate based on company performance and market conditions. But keep in mind that stocks are riskier because your investment is tied to the performance of one single company and lacks diversification.
How to choose the right ETF
Set your investment goals
Think about what you're aiming for: Do you want broad market exposure, specific sectors, or commodities? This will help you pick an ETF that works best for your financial goals.
Check the costs
Look at the expense ratio of the ETF, which shows how much you'll pay in management fees. Keep in mind that costs can vary between ETFs, even if they track the same index.
Make liquidity assessment
Make sure the ETF is liquid enough, meaning it’s easy to buy and sell without high trading costs. This ensures you can access your money when needed.
Review diversification and performance
Check how well-diversified the ETF is to make sure it fits with your investment strategy. Also, review its performance against the benchmark to see if it has met your expectations.
Consider active vs. passive management
Decide whether you prefer an actively managed ETF, where fund managers make decisions based on research, or a passively managed one that simply tracks an index.
