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An exchange-traded fund, or ETF, bundles many investments together in one neat package so it can be sold as shares and traded on an exchange, similar to stocks. The purchase of one ETF provides exposure to dozens or even hundreds of different investments at once, and there are numerous types of ETFs on the market.
ETFs are generally passive investments, i.e. they don’t have active managers overseeing the fund’s portfolio. Rather most ETFs track an index like the S&P 500, the Russell 2000, and so forth.
ETFs are an investment vehicle that allows even small and less-established investors to build diversified portfolios, and to do so at a relatively low cost. But before you start buying ETFs, it’s important to understand how they work, and their pros and cons.
What Does ETF Mean?
An ETF is a type of pooled investment fund that bundles together different assets, such as stocks, bonds, commodities, or currencies, and then divides the ownership of the fund into shares. Unlike mutual funds, ETFs give investors the ability to trade shares on an exchange throughout the day, similar to a stock.
Unlike investing in a single stock, however, it’s possible to buy one ETF that provides exposure to hundreds or thousands of investment securities. ETFs are often heralded for helping investors gain diversified exposure to the market for a relatively low cost.
This is important to understand: Just like a mutual fund, an ETF is the suitcase that packs investments together. For example, if you are invested in a stock ETF, you are invested in the underlying stocks. If you are invested in a bond ETF, you are invested in the underlying bonds.
Most ETFs are passive, which means to track a market index. Their aim is to provide an investor exposure to some particular segment of the market in an attempt to return the average for that market. If there’s a type of investment that you want broad, diversified exposure to, there’s probably an ETF for it.
Though less popular, there are also actively managed ETFs, where a person or group makes decisions about what securities to buy and sell within the fund. Generally, these will charge a higher fee than index ETFs, which are simply designed to track an index or segment of the market.
💡 Quick Tip: How to manage potential risk factors in a self-directed investment account? Doing your research and employing strategies like dollar-cost averaging and diversification may help mitigate financial risk when trading stocks.
How Do ETFs Work?
Most ETFs track a particular index that measures some segment of the market. For example, there are multiple ETFs that track the S&P 500 index. The S&P 500 index is a measure of the stock performance of 500 leading companies in the United States.
Therefore, if you were to purchase one share of an S&P 500 index fund, you would be invested in all 500 companies in that index, in their proportional weights.
What Is the Difference Between an ETF And a Mutual Fund?
ETFs are similar to mutual funds. Both provide access to a wide variety of investments through the purchase of just one fund. But there are also several differences between ETFs and mutual funds.
• ETFs and mutual funds have different structures. A mutual fund is fairly straightforward: Investors use cash to buy shares, which the fund manager, in turn, uses to buy more securities. An ETF relies on a complex system whereby shares are created and redeemed, based on underlying securities that are held in a trust.
• ETFs trade on an open market exchange (such as the New York Stock Exchange) just as a stock does, so it is possible to buy and sell ETFs throughout the day. Mutual funds trade only once a day, after the market is closed.
• ETF investors buy and sell ETFs to and from other ETF investors, not the fund itself, as you would with a mutual fund.
• ETFs are typically “passive” investments, which means that there’s no investment manager making decisions about what should or should not be held in the fund, as with many mutual funds. Instead, passive funds aim to provide the same return for the benchmark index they track. For example, an ETF for technology stocks would mimic the returns of technology stocks overall.
Recommended: Active vs Passive Investing
Common Types of ETFs
The ETF market is very diverse today but much of it reflects its roots in trying to capture a broad swathe of large public equities. The first U.S. ETF was the Standard & Poor’s Depository Receipt, known today as the SPDR. It was launched on the American Stock Exchange in 1993. Today, ETFs that cover the S&P 500 are one of the largest sectors of the industry.
Since the SPDR first debuted, the ETF industry has gotten more diverse as ETF trading and investing has gotten more popular with individual investors and institutions. But even so, market or index ETFs play a major role.
These are some of the most common types of ETFs.
These provide exposure to a representative sample of the stock market, often by tracking a major index. An index, like the S&P 500, is simply a measure of the average of the market it is attempting to track.
These ETFs track a sector or industry in the stock market, such as healthcare stocks or energy stocks.
These track a particular investment style in the stock market, such as a company’s market capitalization (large cap, small cap, etc.) or whether it is considered a value or growth stock.
Foreign Market ETFs
These ETFs provide exposure to international markets, both by individual countries (for example, Japan) and by larger regions (such as Europe or all “developed” countries except the United States).
Bond ETFs provide exposure to bonds, such as treasury, corporate, municipal, international, and high-yield.
Commodity ETFs track the price of a commodity, such as a precious metal (like gold), oil, or another basic good.
Real Estate ETFs
Real estate ETFs provide exposure to real estate markets, often through what are called Real Estate Investment Trusts (REITS).
In addition, there are inverse ETFs, ETFs for alternative investments, and actively-managed ETFs. (While most ETFs are passive and track an index, there are a growing number of managed ETFs.)
What Are the Advantages of ETFs?
There are a number of benefits of holding ETFs in an investment portfolio, including:
• Ease of trading
• Lower fees
ETFs are traded on the stock market, with prices updated by the minute, making it easy to buy and sell them throughout the day. Trades can be made through the same broker an investor trades stocks with. In addition to the ease of trading, investors are able to place special orders (such as limit orders) as they could with a stock.
ETFs often have lower annual fees (called an expense ratio) — typically lower than that of mutual funds — and no sales loads. Brokerage commissions, which are the costs of buying and selling securities within a brokerage account, may apply.
Using ETFs is one way to achieve relatively cheap and easy diversification within an investment strategy. With the click of a button, an investor can own hundreds of investments in their portfolio. ETFs can include stocks, bonds, commodities, real estate, and even hybrid funds that offer a mix of securities.
Thanks to the way ETFs are structured, ETF shares are considered more liquid than mutual fund shares.
💡 Quick Tip: Investment fees are assessed in different ways, including trading costs, account management fees, and possibly broker commissions. When you set up an investment account, be sure to get the exact breakdown of your “all-in costs” so you know what you’re paying.
What Are the Disadvantages of ETFs?
There are some potential downsides to trading ETFs, too, including:
Trading Might Be Too Easy
With pricing updated instantaneously, the ease of ETF trading can encourage investors to get out of an investment that may be designed to be long term.
Even if ETFs average lower fees than mutual funds, a brokerage might still charge commissions on trades. Commission fees plus fund management fees can potentially make trading ETFs pricier than trading standalone stocks.
ETFs can be great for investors looking for exposure to a broad market, index, or sector. But for an investor with a strong conviction about a particular asset, investing in an ETF that includes that asset will only give them indirect exposure to it — and dilute the gains if it shoots up in price relative to its comparable assets or the markets as a whole.
What Is ETF Trading?
ETF trading is the buying and selling of ETFs. To know how to trade ETFs, it helps to understand how stocks are traded because ETF trades are very similar to stock trades.
Stocks trade in a marketplace called an “exchange,” open during weekday business hours, and so do ETFs. It is possible to buy and sell ETFs as rarely or as frequently as you could a stock. You’ll be able to buy ETFs through whomever you buy or sell stocks from, typically a brokerage.
That said, many investors will not want to trade ETFs frequently; a simple ETF trading strategy is to buy and hold ETFs for the purpose of long-term growth. Whether you choose a buy and hold strategy or decide to trade more often, the ease of trading ETFs makes it possible to build a broad, diversified portfolio that’s easy to update and change.
When it comes to trading flexibility, ETFs can be used in different, more innovative ways than mutual funds. For example, advanced investors might choose to leverage or short markets using ETFs. ETFs also trade in such a way as to avoid short-term capital gains taxes, giving investors more control over their annual taxes.
3 Steps to Invest in ETFs
If you want to start investing in ETFs, there are a few simple steps to follow.
1. Do Your Research
Are you looking to get exposure to an entire index like the S&P 500? Or a sector like technology that may have a different set of prospects for growth and returns than the market as a whole? Those decisions will help narrow your search.
2. Choose an ETF
For any given market, sector, or theme you want exposure to, there is likely to be more than one ETF available. One consideration for investors is the fees involved with each ETF.
3. Find a Broker
If you’re already trading stocks, you’ll already have an investment broker that can execute your ETF trades. If you don’t have a broker, finding one should be relatively painless, as there are many options on the market. Once your account is funded, you can start trading stocks and ETFs.
How to Build an ETF Portfolio
Are you willing to take more risk to attempt more growth? How will you handle market volatility? Investment strategies vary based on criteria like personal risk tolerance and age. Once you have determined your desired asset allocation — that proportional mix of different asset classes — ETFs can help fulfill the exposure to those markets.
For example, if you decide that you would like to invest in a traditional mix of stocks and bonds at a ratio of 70% and 30%, you could buy one or several stock ETFs to gain exposure to the stock market with 70% of your money and another few ETFs to fulfill your 30% exposure to the bond market.
For diversification purposes, some investors like to have both U.S. and foreign stock ETFs in their portfolios, as well as both government and corporate bond ETFs. Some investors also add alternative assets to their investment strategy: gold and other commodities, emerging markets, and ETFs that invest in real estate.
Once you’ve determined your desired allocation strategy and purchased the appropriate ETFs, upkeep throughout the year is necessary. This could mean rebalancing your portfolio once a year or utilizing a more active approach. ETFs provide the flexibility to pursue any number of investment styles, philosophies, and techniques.
ETFs bundle different investments together, offering exposure to a host of different underlying securities in one package. There’s likely an ETF out there for every type of investor, whether you’re looking at a particular market, sector, or theme. ETFs offer the bundling of a mutual fund, with the trading ease of stocks.
Though a DIY approach to investing using ETFs is doable, many investors prefer to have the help of a professional who can provide guidance throughout the investment process.
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Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at [email protected]. Please read the prospectus carefully prior to investing. Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.
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