Nov 23, 2022
What Is an ETF? Definition and Guide
Exchange-traded funds (ETFs) are collections of different securities, providing investors with a way to diversify their holdings with one purchase.
ETFs, or exchange traded funds, are baskets of securities that contain a mix of different investment classes, such as stocks and bonds; they might also contain other commodities like real estate.
When you buy shares of an exchange traded fund, you’re investing in the entire pool of securities held by the fund. Because each fund represents many investments, not just one company or security, ETFs can help add diversity to your portfolio.
ETFs operate much like traditional mutual funds, but, unlike mutual funds, they can be bought or sold on a stock exchange the same way regular stocks can.
In this article, we’ll cover:
- How ETFs work
- Advantages of ETFs
- Disadvantages of ETFs
- Types of ETFs
- Choosing an ETF
- Exchange-traded fund FAQs
How do ETFs work?
ETFs can give you relatively easy investment access to a broad range of asset classes; instead of buying shares of multiple different securities, you get exposure to all the securities held by the fund.
Just like stocks, you can purchase shares in an ETF through a brokerage and trade them anytime during the stock market’s operating hours. The share price may change throughout the trading day as they are bought and sold on the market. Investors make money when assets within the ETF grow in value or generate profits in the form of dividends or interest.
All funds have management costs, and the fund’s strategy can affect how much you pay. As a general rule, passive funds are less expensive than active funds. Here’s the difference:
- Passive funds aim to match a market index, like the Dow Jones Industrial Average or the S&P 500, and most ETFs fall into this category. Fund managers make investments that mirror the index, which minimizes the need for frequent trading. Thus, fees tend to be lower.
- Active funds seek to outperform an index or achieve some other goal. For example, a fund might attempt to track a market sector, like technology or healthcare. That typically requires more oversight from management, including trading, and which can translate into higher fees.
In addition to management fees, ETFs may come with other costs, such as commissions or bid/ask spreads.
|“For anyone that feels overwhelmed at the thought of choosing an individual stock, consider buying a basket of many different stocks through an Exchange Traded Fund (ETF). ETFs are a low-cost way to own many different stocks at once, and are a great option if you don’t have the time, energy, or desire to keep tabs on individual companies.”|
Lauren Anastasio, Director of Financial Advice at Stash
Benefits of ETFs
If you’re new to investing, ETFs can be a great way to get started. ETFs allow you to invest in several assets at once without the pressure or risk of going all in on an individual commodity. Compared to mutual funds, ETF fees are generally lower, and most funds disclose their holdings on a daily basis, making it easier to track performance. These funds may be an efficient way to dip your toe into the world of investing, and they have long-term payoff potential as well.
- Built-in diversification: ETFs contain a basket of diverse investments, which could cushion your portfolio if a single commodity loses value.
- Many options: With over 1,700 ETFs traded on US markets, there’s an ETF available to match a wide range of investing goals interests, and you can gain investment exposure to an entire sector through a single ETF.
- Potential for lower fees: Many ETFs are passively managed funds, which are often less expensive than actively managed funds.
- Intraday trading allowed: ETFs can be traded on the market throughout the day, just like individual stocks, bonds, or other commodities, presenting flexibility that mutual funds do not offer.
- Tax efficient: Often, ETFs distribute smaller and fewer capital gains, which can lower the amount of tax you have to pay.
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Downsides of ETFs
ETFs have many possible benefits, any type of investment presents risk, and ETFs are no exception. While investment advisors often praise the built-in portfolio diversification, it’s not necessarily a given. Additionally, some may come with higher fees or other costs.
- Diversity isn’t guaranteed: While ETFs contain multiple securities, they can be concentrated in one market segment or asset class, offering more limited diversification.
- Fees can be higher: Passively managed ETFs typically boast lower fees than mutual funds, but some ETFs are actively managed and could have higher costs.
- ETFs can be risky: Although many see ETFs as lower risk than individual stocks, every fund has a different level of risk; inverse ETFs and leveraged ETFs are usually considered high risk.
Types of ETFs you can invest in
When it comes to investing in ETFs, there are several types to choose from. These funds usually have a particular focus or objective, like matching the performance of an index, investing in specific sectors, or implementing a particular investing strategy. You can select an ETF that best supports your investment goals, risk tolerance, and personal interests.
- Market ETFs
- Passive and active ETFs
- Sector ETFs
- Thematic ETFs
- Bond ETFs
- Commodity ETFs
- Foreign market ETFs
- Currency ETFs
- Inverse ETFs
- Leveraged ETFs
Also called equity funds, these ETFs try to match a specific market index, such as the S&P 500. Funds that reproduce index performance accurately could be lower-risk investments because they invest in a broad array of securities, leading to greater diversification.
Passive and active ETFs
Passive ETFs generally follow a buy-and-hold indexing strategy that tracks a particular benchmark. They tend to be lower in cost and more transparent than their active counterparts. Active ETFs have a manager or team making decisions about the portfolio allocation, and they may deviate from the index as they see fit.
Similar to a market ETF, these funds aim to match the overall performance of an index, but focus on a specific sector or industry, such as technology. These funds may offer diversification within a given sector, but if the entire sector’s performance falls, the value of the fund’s shares may also drop.
Even more narrowly focused than sector ETFs, these funds target a subset of a sector; for instance, the fund may invest in stocks related to esports or video games rather than technology overall. The narrow focus of these funds may tend to offer less diversification.
Also called fixed-income ETFs, these funds invest exclusively in bonds. Because bonds tend to be less volatile than stocks, they’re often considered lower risk. Bond ETFs might help you balance out riskier investments in your portfolio.
Commodities are raw materials such as oil, gold, and agricultural goods. Some commodity ETFs actually purchase the commodities, though this is limited to precious metals. Other funds invest in companies that produce or handle commodities; this can give investors exposure to commodities without the costs associated with the physical possession of goods.
Foreign market ETFs
Like market EFTs, these funds attempt to mirror an index. The difference is that these target a non-U.S. index, like the Nikkei Index, an index of the Tokyo Stock Exchange. Foreign market ETFs could bring more geographic diversity to your portfolio.
Currency ETFs, also called foreign currency ETFs, track the relative value of one or more currencies. These funds can give investors exposure to trading currencies without the complexity and burden of trading on the foreign exchange market.
Unlike most other funds, these ETFs are designed to increase in price when a given market index declines in price. Inverse ETFs require active management, which may increase fees, and they tend to represent a significant risk.
Leveraging, an investing strategy that uses borrowed funds to buy options and futures to increase the impact of price movements, can lead to significant gain and equally significant loss. Since leveraged ETFs follow this strategy, using financial derivatives and debt to boost the returns of an underlying index, they can be just as risky.
How to pick an ETF
With so many types of ETFs, it may feel overwhelming to choose the right fund to invest in. When you’re making a decision, consider factors like your investment objective, the costs and operating expense ratios, which index you’d prefer to track, and the ETF’s tracking record. Assess your investment risk tolerance as well. The EFT market has become increasingly competitive, so also consider a fund’s market position before committing. The first ETF issuer for a particular sector has a better chance of garnering assets before similar funds hit the market.
Protect your portfolio with a diverse and defensive strategy
Whichever assets you choose, it’s usually wise to protect your portfolio with a diverse and defensive investment strategy. A single investment in an ETF can provide diversification and the flexibility you need to stay defensive as your portfolio grows. Stash can help you start investing in ETFs; with over 90 options, you can find the fund that matches your investing goals.
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1. Are ETFs good investments for beginners?
They can be. ETFs offer some diversification in a single purchase, they are often less expensive than mutual funds, and there’s one for virtually any investment strategy.
That said, not all ETFs are created equal. Some are quite risky, and not all add meaningful diversity to a portfolio. As with any investment, it’s important to fully understand an ETF before buying shares.
2. Are ETFs safer to invest in than stocks?
It depends. For example, a market or index ETF is likely less risky than any given individual stock, because it relies on the performance of many companies, rather than just one. If one company’s value falls, others may rise, shielding you from the struggling company’s price dip. On the other hand, a leveraged ETF is probably riskier than buying shares of a long-established company with many decades of stable performance.
As a general rule, a basket of stocks tends to be less risky than an individual stock, but it’s important to research any investment before buying.
Investment advisory services offered by Stash Investments LLC, an SEC registered investment adviser. Investing involves risk and investments may lose value.
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