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What Is An ETF (Exchange Traded Fund)?

An explanation of EFTs and the different types, their pros and cons, and how to access them

What Is An ETF (Exchange Traded Fund)?

Defining Exchange Traded Fund (ETF)

A portfolio of investments, such as stocks or bonds, makes up an ETF. Exchange-traded funds (ETFs) enable you to make a large number of simultaneous investments in assets, and they frequently have cheaper costs than other types of funds. Additionally, trading ETFs is simpler.

But ETFs aren't a one-size-fits-all answer, just like any other financial instrument. Consider them on their own merits, taking into account administration charges, commission fees (if applicable), ease of purchase or sale, fit into your current portfolio, and investment quality.

So how do they work?

Exchange-traded funds function as follows: The fund manager creates a fund to monitor the performance of the underlying assets, holds those assets, and then sells shares of that fund to investors. An ETF's underlying assets are not owned by shareholders; rather, they own a portion of the fund. Nevertheless, shareholders of an ETF that tracks a stock index may get lump sum dividend payments or reinvestments for the index's constituent equities.

Although ETFs are intended to replicate the value of an underlying asset or index, such as a basket of stocks like the S&P 500 or a commodity like gold, they typically trade at prices that are different from the underlying asset. Additionally, an ETF's longer-term returns will differ from those of its underlying asset due to factors like expenditures.

A short summary of how ETFs operate is as follows:

  1. An ETF provider compiles a basket of assets with a distinctive ticker by taking into account the entire universe of assets, such as stocks, bonds, commodities, or currencies.
  1. Just like purchasing shares of a corporation, investors can purchase a share of that basket.
  1. Like a stock, buyers and sellers trade the ETF on an exchange throughout the day.

Understanding the categories of ETFs

Investors have access to a variety of ETFs that can be used to manage risk in their portfolios, generate income, and engage in speculation and price appreciation, and generate income. Here is a brief summary of some of the ETFs that are currently on the market.

Passive and Active ETFs

ETFs can generally be classified as either passively managed or actively managed. The goal of passive ETFs is to mimic the performance of a larger index, whether it be a more specialized sector or trend or a more diversified index like the S&P 500. Gold mining stocks are an illustration of the latter category: as of February 18, 2022, there are roughly eight ETFs that concentrate on businesses involved in gold mining, omitting inverse, leveraged, and funds with little assets under management (AUM).

Typically, actively managed ETFs do not aim to track an index of assets but rather have portfolio managers choose which securities to hold. Despite being more expensive for investors, these products have advantages over passive ETFs. Below, we look at actively managed ETFs.

Bond ETFs

Bond ETFs are designed to give investors consistent income. Their income distribution is based on how well the underlying bonds perform. Government bonds, corporate bonds, and municipal bonds—also known as state and local bonds—might be among them. Bond ETFs lack a maturity date like their underlying assets do. They typically trade above or below the price of the underlying bond.

Stock ETFs

Stock (equity) ETFs are made up of a collection of equities that track a certain sector or industry. A stock ETF, for instance, might follow equities in the automobile industry or overseas. The goal is to give a single industry with both strong performers and new entrants with growth potential varied exposure. Stock ETFs feature lower costs than stock mutual funds and don't require actual ownership of any securities.

Industry/Sector ETFs

Industry/Sector ETFs Funds that concentrate on a particular industry or sector are known as industry or sector ETFs. For instance, an ETF for the energy sector will include businesses engaged in that industry. Industry ETFs are designed to give investors exposure to an industry's potential growth by monitoring the activity of its constituent companies.

One such is the recent inflow of capital into the technology sector. ETFs do not entail direct ownership of shares, thus the downside of erratic stock performance is likewise limited in them. During economic cycles, industry ETFs are also utilized to cycle in and out of sectors.

Commodity ETFs

Commodity ETFs invest in commodities like crude oil or gold, as their name suggests. The advantages of commodity ETFs are numerous. They first diversify a portfolio, which makes it simpler to hedge downturns.

Commodity ETFs, for instance, can provide as a buffer during a stock market downturn. Second, investing in a commodity ETF is less expensive than buying the commodity outright. This is so that the former does not require spending money on storage and insurance.

Currency ETFs

Currency ETFs are pooled investment instruments that monitor the performance of currency pairs that combine local and foreign currencies. ETFs that invest in currencies have many uses. They can be used to make currency price predictions based on a nation's political and economic trends. Importers and exporters also use them to diversify their portfolios or as a safety net against foreign market volatility. Some of them are additionally employed as inflation hedges. Even an ETF is available for bitcoin.

Inverse ETFs

By shorting equities, inverse ETFs try to profit from stock falls. Shorting is the practice of selling stock in anticipation of a decrease in value and buying it back at a loss. Derivatives are used by an inverse ETF to short a stock. In essence, they are wagers against the market.

An inverse ETF appreciates proportionately as the market falls. Investors need to be aware that many inverse exchange-traded funds (ETFs) are actually exchange-traded notes (ETNs), not real ETFs. Although it trades like a stock and is backed by an issuer like a bank, an ETN is a bond. To find out if an ETN is a good fit for your portfolio, be sure to speak with your broker.

Leveraged ETFs

A leveraged ETF aims to return a number of times (such as two or three times) the return of the underlying investments. For instance, a 2x leveraged S&P 500 ETF will return 2% if the index increases by 1% (and 2% less if the index decreases by 1%). To increase their returns, these products use derivatives like options or futures contracts. Leveraged inverse ETFs are another option; they aim to generate an inverse multiplied return.

The ideal ETF

Investors must fill their brokerage account after opening one before purchasing ETFs. The broker will determine exactly how to deposit money into your brokerage account. After you've funded your account, you may conduct a search for ETFs and execute buys and sells just like you would with shares of stock. Using an ETF screening tool is one of the greatest ways to reduce the range of ETF possibilities available to you. These tools are provided by several brokers as a method to navigate the thousands of ETF offers. Typically, you can look for ETFs using some of the following criteria.


You may evaluate the popularity of several funds by looking at their trading volume over a specific time period; the higher the volume, the simpler it might be to trade that fund.


The proportion of your investment that goes toward administrative expenditures decreases as the expense ratio rises. While it may be tempting to always look for funds with the lowest expense ratios, occasionally more expensive funds (such as actively managed ETFs) have strong enough performance that it more than justifies the higher fees.


Performance is a common criterion used to compare ETFs, even if previous performance does not guarantee future results.


Portfolios of various funds are frequently taken into account by screener tools as well, enabling users to compare the various holdings of each potential ETF investment.


Many ETFs are commission-free, which means that no fees are required to execute the transaction. It is still important to determine if this could be a deal-breaker.

The benefits of ETFs

Exchange-traded funds have been extremely popular among investors due to their simplicity, relative affordability, and availability of a diversified product. As for the benefits:


Although it is simple to think of diversity in terms of the major market verticals, such as stocks, bonds, or a specific commodity, ETFs also allow investors to diversify across horizontals, such as industries. To purchase every item in a specific basket would require a significant investment of time and money, but an ETF may add those advantages to your portfolio with the press of a mouse. Your portfolio can be protected from market volatility with the use of diversification. If you had only invested in one sector and that sector had a tremendously horrible year, it's likely that your portfolio also did not do well. You can offer your portfolio more balance by investing across various sectors, company sizes, geographical regions, and other factors. You need not worry about adding diversification to your portfolio because ETFs already have it.


Anyone with an internet connection can look at the exchange price action for a specific ETF. The public is also informed every day of a fund's holdings, as opposed to monthly or quarterly for mutual funds. You are able to keep a close eye on your investments thanks to this transparency. Say you truly don't want to have any oil investments. Compared to a mutual fund, your ETF would make those additions easier to identify.

Tax benefits

ETFs have two significant tax advantages over mutual funds.

If you invest in a mutual fund, you can be required to pay capital gains taxes during the term of your investment (or, the profits on the sale of an asset, like a stock). This is due to the fact that mutual funds, especially actively managed ones, usually engage in more asset trading than ETFs. However, with most ETFs, capital gains taxes are only due when the investment is sold. This implies that overall, you'll pay less tax on your ETF investment.

The investor may be subject to both long-term and short-term capital gains tax since mutual fund managers constantly buy and sell investments, racking up capital gains taxes in the process. You can choose when to sell an ETF investment, which makes it simpler to avoid paying the higher short-term capital gains tax rates.

The drawbacks of ETFs

Exchange-traded funds aren't flawless, yet they may be effective for some investors. Cons are as follows:

Trading expenses

The expense ratio may not be the final cost of an ETF. Since ETFs are exchange-traded, online brokers may charge commission fees for them. However, not all brokers have chosen to reduce their ETF commissions to zero.

Possible liquidity problems

When it comes time to sell, like with any security, you'll be at the mercy of market pricing, but ETFs that aren't traded as regularly may be more difficult to unload.

Risk of the ETF terminating

The main cause of this is when a fund doesn't collect enough assets to meet operating expenses. A shutdown ETF's biggest drawback is that investors are forced to sell sooner than they may have intended—and possibly at a loss. Along with the potential for an unanticipated tax burden, there is also the inconvenience of needing to reinvest that money.

How can I purchase ETFs?

Trading on a variety of platforms has made investing in ETFs quite simple. To start investing in ETFs, adhere to the guidelines listed below.

Find an investing platform

Most online investing platforms, websites for retirement account providers, and investing applications like Robinhood all provide ETFs. The majority of these platforms allow commission-free trading, which means you can buy or sell ETFs without having to pay a fee to the platform's operators.

A commission-free purchase or sale, however, does not guarantee that the ETF provider would also grant cost-free access to their product. Convenience, services, and product diversity are a few ways platform services can set themselves apart from competitors.

For instance, investment apps for smartphones make it possible to buy ETF shares with a single button press. Not all brokerages will operate in this manner; some may require investors to submit papers or deal with more intricate circumstances. However, several reputable brokerages provide comprehensive educational content that aids new investors in learning about and researching ETFs.

Research ETFs

Researching ETFs is the second and most crucial phase in the investing process. ETFs come in a huge range of options on the market right now. When conducting research, keep in mind that ETFs differ from individual securities like stocks or bonds.

When investing in an ETF, you must take the sector or industry as a whole into account. During your investigation, you might wish to think about the following questions:

  • What time frame do you have for investing?
  • Do you invest for growth or income?
  • Do you have any favorite industries or financial products?

Think about a trading plan

Dollar-cost averaging, or spreading out your investment fees over time, is a smart trading approach for new ETF investors. This is due to the fact that it spreads out gains over time and ensures a disciplined approach to investing (as opposed to one that is haphazard or erratic).

Additionally, it aids novice investors in understanding the specifics of ETF investment. Investors can advance to more complex tactics like swing trading and sector rotation as they gain trading experience.

Traditional vs. Online brokers

Both traditional broker-dealers and online brokers are used to trade ETFs. The list of the finest brokers for ETFs on Investopedia allows you to browse some of the top brokers in the market. ETFs can often be purchased in retirement accounts as well. A Robo-advisor, such as Betterment or Wealthfront, which heavily utilizes ETFs in its investment products, is an alternative to traditional brokers.

Investors can trade shares of ETFs through a brokerage account in the same way they would trade shares of equities. Investors who prefer to be more hands-on can choose a regular brokerage account, and those who prefer to be more passive can choose a Robo-advisor. Robo-advisors frequently include ETFs in their portfolios, albeit the investor may not have a choice as to whether to prioritize ETFs over individual stocks.

Examples of Popular ETFs

Here are some examples of popular ETFs available right now. While some ETFs focus on particular industries, others track stock indices to build broader portfolios.

  • SPY, the SPDR S&P 500 ETF: The "Spider" is the oldest and best-known S&P 500 index-tracking ETF still in existence.
  • The Russell 2000 small-cap index is followed by the iShares Russell 2000 (IWM).
  • Technology firms often make up the Nasdaq 100 Index, which is tracked by the Invesco QQQ (QQQ) ("cubes").
  • The 30 stocks that make up the Dow Jones Industrial Average are represented by the SPDR Dow Jones Industrial Average (DIA) ("diamonds").
  • Oil (OIH), energy (XLE), financial services (XLF), real estate investment trusts (IYR), and biotechnology are just a few examples of the different businesses and sectors that are tracked by sector ETFs (BBH).
  • Markets for commodities such as gold (GLD), silver (SLV), crude oil (USO), and natural gas are represented through commodity exchange-traded funds (ETFs) (UNG).
  • Country ETFs follow the major stock indices of other nations, although they are traded in the US and are priced in USD. China (MCHI), Brazil (EWZ), Japan (EWJ), and Israel are among the examples (EIS). Others follow a broad range of overseas markets, including those that follow developed market economies (DMEs) and emerging market economies (EMEs) (EFA).


Which Exchange-Traded Fund (ETF) was the first?

Frequently, the SPDR S&P 500 ETF (SPY), introduced by State Street Global Advisors on January 22, 1993, is recognized as the first exchange-traded fund (ETF). However, there were some securities called Index Participation Units that were listed on the Toronto Stock Exchange (TSX) and tracked the Toronto 35 Index before the SPY was created. These securities first emerged in 1990.

What distinguishes an ETF from an Index Fund?

A mutual fund that follows an index is typically referred to as an index fund. Similar in design, an index ETF will hold the companies that make up an index, tracking it. An ETF, on the other hand, is frequently more affordable and liquid than an index mutual fund. A mutual fund can only be traded through a broker at the end of each trading day, in contrast to an ETF that can be purchased directly on a stock market at any time of the day.

How do ETFs work?

An ETF provider develops an ETF based on a specific methodology and sells investors shares of that fund. The vendor buys and sells the ETF's portfolio's individual securities. Investors may still be qualified for dividend payments, reinvestments, and other advantages even when they do not own the underlying assets.

What is an ETF account?

Most of the time, investing in ETFs does not require the creation of a separate account. The fact that ETFs can be traded all day long and with the same flexibility as stocks is one of their main appeals. This is why investing in ETFs is often achievable with a simple brokerage account.

What does an ETF cost?

Investors often pay the administrative and overhead charges associated with ETFs. These expenses, also referred to as the "expense ratio," normally make up a modest portion of an investment. ETFs are among the most economical investment vehicles as a result of decreasing expense ratios generally brought about by the expansion of the ETF industry. However, depending on the type of ETF and its investment approach, expense ratios might fluctuate widely.