What Is an ETF? Are They Right for You?

A common misconception is that exchange-traded funds (ETFs) are mutual funds. However, despite some similar characteristics, they are not the same.

The first American ETF was created in 1993 to track the S&P 500 Index. The popular SPDR S&P 500 ETF Trust (SPY) still exists. Today, it is the largest ETF with approximately $500 billion of assets under management (AUM).

What Is an ETF?

An ETF is a type of investment that works like a mutual fund but trades like a stock. An ETF invests in dozens to thousands of securities. In the case of stocks, ones tracking broad indexes, like the Wilshire 5000 or total market, invest in thousands of equities. On the other hand, narrow sector ETFs may invest in just dozens of individual stocks.

However, unlike mutual funds, ETFs work like stocks trading on an exchange throughout the day. Mutual funds trade only once per day after the market closes.

According to the U.S. Securities and Exchange Commission (SEC) website, “Exchange-traded funds (ETFs) are SEC-registered investment companies that offer investors a way to pool their money in a fund that invests in stocks, bonds, or other assets.”

Because of their structure, ETFs have several advantages and disadvantages.

Pros of ETFs

1. Diversification – Because of their structure, an ETF provides instant diversification, like mutual funds. By spreading investments across many equities, the risk is reduced. Poor performance by one equity may be offset by better performance in another.
2. Low Expense Ratios – ETFs are inherently inexpensive. They often trade on stock exchanges without brokerage commissions. Additionally, their total expense ratios (TER) are extremely low. The TER consists of management, trading, legal, auditor, etc. fees. Often, an ETF will have a lower expense ratio than a comparable mutual fund.
3. Liquidity – Next, many ETFs are liquid. They can easily be bought or sold on an exchange, like the NASDAQ or New York Stock Exchange (NYSE). Because they trade on an exchange, people can place varying types of orders, including market, limit, and stop-loss.
4. Transparency – Lastly, ETFs are transparent about their investment objectives, allowing investors to make informed decisions about ownership. They must also publish their holdings daily so investors know exactly what they own. Expense ratios and performance are also readily available.

Cons of ETFs

1. Illiquidity – Some ETFs are thinly traded and have minimal assets. Consequently, they may be more difficult to buy or sell. They may also have large price swings, resulting in irrational trading. Also, niche ETFs may not be priced efficiently.
2. Higher Costs – Despite having low expense ratios, when comparing ETFs and stocks, they have reduced costs. Stocks do not have expense ratios.
3. Tracking Error – Because ETFs follow an index, they usually have a tracking error caused by technical issues, like dividend payments and changes to the benchmark. In addition, cash held to pay administrative and management fees will cause tracking errors.

How Do They Work?

ETFs are structured to track a large basket of securities or even individual commodities. For example, the S&P 500 ETFs track the S&P 500 Index, while gold ETFs follow physical gold and related equities. They must be registered with the SEC and are subject to the Investment Company Act of 1940.

Shares of an ETF are bought and sold daily when stock exchanges are open. Hence, they have ticker symbols and continuous pricing data. For instance, the SPDR S&P 500 ETF Trust’s symbol is SPY.

The number of shares in a specific ETF fluctuates daily to keep its market price aligned with its holdings. As a result, the sponsoring financial institution continuously creates and redeems shares.

A person buying $100 of an ETF will own a security representing all holdings in the ETF. For example, the SPDR S&P 500 Trust contains 503 equities. The $100 would represent a small fraction of each of those.

Types of ETFs

Thousands of ETFs exist with different attributes. They are characterized by the types of assets they hold, investment strategy, and industry or sector. The two largest providers of ETFs by assets are BlackRock and Vanguard. BlackRock offers over 400 to institutional and retail investors. Vanguard’s ETF list is smaller, and many are large funds for individuals. Below, we discuss some of the most important types.

Stock ETFs

Stock ETFs are comprised of a basket of equities that track an index. The benchmarks, such as the S&P 500, Wilshire 5000, or Russell 2000, can be well-known. Some ETFs follow certain market capitalization indexes. It may also be a more niche index, especially in the case of an industry or sector ETF. Stock ETFs are diversified and usually less volatile than owning a handful of individual equities.

Bond ETFs

Bond ETFs own bonds, allowing investors to gain exposure to this asset class. The largest one is the Vanguard Total Bond Market ETF (BND), which offers exposure to the entire investment-grade bond market. It owns U.S. T-Bills, Treasury bonds, corporates, mortgage-backed securities (MBS), and agency bonds. Other bond ETFs will own a subset of these categories. Other types exist, too, like municipal bonds.

Although bonds have a maturity date, an ETF does not. Hence, it can be used to generate income through interest payments.

Commodity ETFs

Buying and selling commodities is challenging and risky for the average retail investor. In many cases, buying a commodity requires taking possession of and storing it. However, gold, silver, oil, coffee, wheat, corn, soybeans, etc., may diversify a portfolio. 

Commodities often perform well during periods of high inflation when other asset classes typically do not. An option is to hold a commodity ETF. Besides actual commodities, some of these ETFs buy and sell equities of related corporations.

International ETFs

Exposure to international securities may diversify a portfolio and improve returns. However, buying and selling stocks or bonds in overseas markets can be expensive and risky for an individual investor. ETFs are an option because they track regions, specific countries, or equities outside North America. For example, the iShares Core MSCI EAFE ETF (IEFA) gives broad exposure to stocks in developed markets outside of the United States. 

Sector and Industry ETFs

The U.S. market is divided into 11 sectors. Each one consists of businesses selling products and services in that sector. For example, Microsoft (MSFT) is part of the Technology sector, while Exxon Mobil (XOM) is a member of the Energy sector. Some investors prefer these ETFs to rotate in and out of sectors during the economic cycle. The Energy sector may do well when oil and natural gas prices are high during economic expansion. However, the reverse is also true, and they can have poor returns when prices are low during contraction.

Like sector ETFs, industry ETFs focus on a specific one in a sector. For example, Aerospace & Defense ETFs invest in companies typically in the Industrial sector but only operate in those two areas.

Bitcoin ETFs

One of the newest ETF types invests in Bitcoin (BTC), a cryptocurrency. Earlier this year, the SEC approved several spot Bitcoin ETFs that track its price. Consequently, Bitcoin can be bought and sold through brokerage accounts. Currently, the largest ETF is the Grayscale Bitcoin Trust (GBCT).

How to Buy ETFs?

ETFs are readily available from most brokerages and investment platforms. Which one to use is primarily a matter of personal preference. However, differences will exist in the number of offerings, accessibility, platform features, and fees. Even though ETFs are usually traded free of commission, some platforms have access fees. Taking this one step further, they may also construct portfolios of ETFs, and an investor must only pick one.

The steps to buy ETFs are simple:

1. Open a brokerage account – People need a brokerage account to buy and sell securities. It is where investments are held. There are many options, including full-service and discount brokerages. Some may also offer access to robo-advisors or a financial advisor for a fee, which is useful if you need help.
2. Research ETFs—There are many ETFs on the market, and the goal is to narrow the number down. Investors can use screeners to filter out undesirable options. Some things to check are commission, TER, volume, holdings, performance, and type.
3. Buy the ETF – The last step is to buy the ETF by placing the order on the platform. If a person buys one for retirement, they will hold it for a long time. The holding period may be shorter if you are trying to follow the economic cycle.

Is an ETF Right for You?

Exchange-traded funds are a way to gain exposure to different securities without purchasing them. Their attributes allow people to invest with smaller sums of money. ETFs are generally low-cost and offer instant diversification, making them good options for many people.

This article originally appeared on Wealth of Geeks.