Exchange-Traded Funds Explained: A Complete Guide to ETFs

An ETF, short for exchange-traded fund, is a basket of securities containing any mix of stocks, bonds, or other assets that can be bought or sold on a stock exchange. Most ETFs track a specific sector benchmark or stock market index, such as the Dow Jones Industrial Average, NASDAQ Composite, of S&P 500. The first ever United States ETF, the SPDR S&P 500 trust (ticker symbol SPY), launched in 1993 and was designed to track the S&P 500 index.

ETFs consist of numerous types of assets and are a popular choice for investors focusing on portfolio diversification. In addition, ETFs are tax efficient, easy to trade, have low expense ratios, and cost less in broker fees than the same individual stocks bought separately.

There are several types of ETFs you can choose from depending on your desired investment strategy and asset allocation. Below are a selection of the most common types, but know that all types are not mutually exclusive, and some may overlap.

1. 1. Index ETFs: The majority of ETFs are designed to track the performance of a specific stock market index, like the Dow Jones Industrial Average, NASDAQ Composite, or S&P 500 index.
2. 2. Bond ETFs: These ETFs offer a large selection of bond types, including corporate bonds, government bonds, municipal bonds, and U.S. treasury bonds.
3. 3. Industry and sector ETFs: This is a basket of securities contained to a specific industry or sector, like energy or healthcare. These ETFs have a higher market volatility since the securities are not very diversified.
4. 4. Commodity ETFs: These securities center around a specific commodity, such as precious metals (e.g., gold or silver), agricultural goods (e.g., wheat or corn), and natural resources (e.g., oil or natural gas).
5. 5. Style ETFs: These ETFs focus on a specific investment style and or asset class, like small-cap, mid-cap, and large-cap stocks. These ETFs can be further combined with different investment approaches, like mid-cap value or small-cap growth.
6. 6. Foreign market ETFs: These are designed to track international markets outside the U.S., like Hong Kong's Hang Seng Index or Germany's DAX index.
7. 7. Inverse ETFs: Also known as short ETFs, this short-term investment contains numerous derivatives that investors hope will decline in value so they can profit by taking a short position on the securities. Some inverse ETFs should technically be classified as exchange-traded notes (ETNs) instead. Unlike ETFs, ETNs are debt securities and do not grant the investor ownership in an asset.

ETFs and mutual funds are both collections of multiple securities, but there are key differences.

• Trading time: ETFs allow for intraday trading, meaning that just like stocks, ETF share prices fluctuate throughout the day, and you can buy or sell ETFs through your brokerage account at the value of the current market price. Mutual funds do not allow intraday trading, meaning that you can only buy or sell mutual funds for the price set after the market closes for the day, known as the net asset value or NAV.
• Tax-efficiency: ETFs are typically more tax-efficient than mutual funds. This is because mutual funds, especially actively managed ones, trade more often and result in more capital gains taxes than ETF investing.
• Fees: Similar to stock investing, you might pay brokerage commissions for ETF investing, but ETFs have fewer fees than mutual funds. On average, expense ratios (the annual fee charged to investors to cover a fund's administrative expenses) are much lower for ETFs than mutual funds.
• Management structures: ETFs are usually, but not always, passively managed funds that aim to match the performance of a specific stock index, while a fund manager manages a mutual fund with the goal of outperforming a stock index (with the exception of index funds).

ETFs and index funds can both be long-term investments for diversifying your portfolio. To decide which is right for you, compare the expense ratios and commission fees of the specific funds you're considering. Differences between these two types of funds include:

• Minimum investment: The minimum initial investment required to invest in an ETFs is low—it’s usually the amount of money to purchase one share. While some online index fund broker-dealers may not have a minimum investment, the majority of index funds require a minimum initial investment that is often a few thousand dollars or more.
• Trading time: ETFs trade like stocks, so you can buy or sell them through a broker-dealer at the current market price at any time throughout the day. Index funds, like mutual funds, can only be bought or sold for the net asset value (NAV) price that's set at the closing of the market day.
• Tax-efficiency: On average, ETFs are more tax-efficient than index funds because when you sell an ETF, the money you receive comes from another investor. With index funds, the issuer of the fund must sell securities to pay investors, which creates more capital gains taxes for all investors in the index fund.

Some of the advantages of ETFs include:

1. 1. Broker commissions: ETFs let you purchase multiple securities in one transaction, meaning there are fewer broker commissions.
2. 2. Risk: The diversification of ETFs across multiple asset classes, industries, and investment types can lower investing risk.
3. 3. Liquidity: ETFs offer greater liquidity due to intraday trading, which means you can buy and sell ETFs at any time throughout regular market hours.
4. 4. Expense ratios: ETFs tend to have low expense ratios since most track a specified index.
5. 5. Taxes: ETFs tend to be tax-efficient since it's less common for ETFs to create capital gains tax liability.

ETFs can contribute to portfolio diversification, but there are some disadvantages to consider before buying or selling ETFs.

1. 1. Fees: Actively managed ETFs may have high management fees.
2. 2. Selling: It can be difficult to sell your ETF at your desired time if the market is volatile or if you own a thinly traded ETF (i.e., an ETF in a more niche sector).
3. 3. Tracking: ETFs designed to track a specific index may fail to actually match that index or may lag behind.
4. 4. Returns: Index ETFs typically won't outperform their underlying index, so you'll only earn average returns.
5. 5. Control: There is no control over the specific securities bought or sold in the ETF—i.e. you can only control the general parameters established by the type of ETF.

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