Table of Contents

What is an ETF?

Active vs. Passive ETFs

5 types of ETFs

ETFs, mutual funds, and stocks

Advantages and disadvantages of ETFs

The bottom line



What Are ETFs and How Do They Work?

What Are ETFs and How Do They Work?

Feb 10, 2022


8 min read

An exchange-traded fund (ETF) is a pooled form of investment that is designed to track an index, sector, or commodity, such as oil or gold.

An ETF is a form of passive investment that combines the qualities of a mutual fund and a stock. Investing in an ETF gives you exposure to a range of bonds or stocks by purchasing a single security, which is why scholars call them one of the most important financial innovations in recent decades.

What is an ETF?

An exchange-traded fund (ETF) is a pooled form of investment that is designed to track an index, sector, or commodity. An ETF trades like a stock: investors buy a share of an ETF, and that money is invested to follow a certain objective. The SPDR Gold Shares, for example, is a popular ETF you can buy that tracks gold.

ETFs can be structured to track almost anything, from a commodity, such as oil or gold, to a collection of securities, allowing you to invest broadly with many objectives.

Active vs. Passive ETFs

There are active and passive ETFs:

  • Passive ETFs

    match the performance of the stock index they track. The SPDR, for instance, was the first U.S.-listed ETF. Introduced by State Street in 1993, it tracks the S&P 500 index and remains one of the largest and most recognizable ETFs in the world.

  • Actively-managed ETFs

    , on the other hand, hire portfolio managers to try for better performance using analysis and research to hone in on the ideal exposure to certain stocks or sectors. Active ETFs are becoming increasingly popular.

Most forms of ETFs in the states are required to register with the U.S. Security and Exchange Commission (SEC) under the 1940 Act as investment companies, with the shares they sell regulated under the 1933 Securities Act.

5 types of ETFs

ETFs track a lot of potential investment groupings, including ones focused on foreign securities and fixed-income instruments, as well as actively-managed ETFs. Each type carries its own risks and attributes.

  1. Industry sector ETFs

An industry sector ETF will give you exposure to stocks and securities in specific sectors. Vanguard’s Communication Services ETF, for instance, attempts to track the U.S. communications sector.

What to know about industry sector ETFs:

  • In general, individual sectors tend to be more volatile than the overall market, with each sector carrying its own level of risk.
  • Investing in big sectors like health care can be less expensive than small ones like oil service.

  1. Bond ETFs

Bond ETFs track bonds. An example of a bond ETF is Direxion (TMF), which gives investors exposure to ICE U.S. Treasury 20+ Year Bond Index.

What to know about bond ETFs:

  • Bond ETFs are extolled by financial analysts for their ability to mitigate general market risk, especially in times of fluctuating interest rates.

  1. Commodity ETFs

ETFs of this type track individual or baskets of commodities. They cover a broad array of commodities, including precious metals, oil, livestock, and just about any other physical commodity you can think of.

There are four common types of commodity ETFs:

  • Equity ETFs

    invest in stocks of companies connected to commodities.

  • Exchange-traded notes

    are bank-issued debt instruments.

  • Physically-backed funds

    contain physical commodities, such as oil, gold, or silver.

  • Futures-based funds

    invest in future portfolios. Futures don’t incur the costs typical of holding and storing the underlying commodity.

What to know about commodity ETFs:

  • Analysts tout them as a way to diversify a portfolio since commodities can be negatively correlated with assets like stocks and bonds. When stocks and bonds decline in price, commodities tend to rise.
  • Commodities can also be used as a hedge against inflation since their price often rises when inflation rises as well.

  1. Currency ETFs

These ETFs track the relative value of foreign exchange (forex) or currencies. Two examples of currency ETFs traded in the U.S. are Invesco DB US Dollar Index Bullish Fund (UUP) and the Invesco CurrencyShares Swiss Franc Trust (FXF).

What to know about currency ETFs:

  • These are influenced by large macroeconomic events such as political instability, which can present risk.

  1. Inverse ETFs

Also known as a “Short ETF” or a “Bear ETF,” inverse ETFs are meant to perform inversely to the index they track. The ProShares Short S&P 500 (NYSEMKT: SH), for example, tracks the S&P 500 index with opposite returns. So when the S&P 500 falls by 4%, that ETF would be expected to rise about that percentage.  

What to know about inverse ETFs:

  • Inverse ETFs rely on the value of an underlying benchmark to protect against downward trends in the market.
  • They allow investors to profit from a decline in the value of the benchmark without requiring the investor to sell short.
  • These ETFs usually have higher fees than traditional ETFs.

ETFs, mutual funds, and stocks

ETFs are hybrid investment products. But while ETFs combine aspects of mutual funds and stocks, they have some notable differences.

ETFs vs. stocks

Stocks and ETFs trade on an exchange. The high frequency of trading makes it easy to buy or sell these products. Both also allow you to invest in several indexes, and may pay dividends.

A key difference between ETFs and stocks is the range of securities available to an investor. With stocks, an investor is locked into a stock security, which is only one kind. While many available ETFs invest in stocks, others also invest in other securities such as bonds, currencies, commodities, and even a mix of stocks and bonds, offering greater room for diversification.

ETFs vs. mutual funds

Both ETFs and mutual funds are professionally managed pooled fund investments that attempt to track the performance of the underlying index. They offer investors broad market exposure at a cost that’s generally lower than that of buying individual stocks.

Key differences between ETFs and mutual funds:

  • Trading frequency:

    Unlike mutual funds, which only trade once per day, ETFs trade throughout the day on stock exchanges.

  • Transparency:

    The issuer of an ETF publishes the holdings online, although this is not necessarily true of actively managed mutual funds, which do not have the same requirements for transparency.

  • Minimum purchases:

    ETFs do not have minimum purchasing requirements like mutual funds.

  • Taxes:

    ETFs can be more “tax-efficient,” meaning they tend to incur fewer taxes.

Advantages and disadvantages of ETFs

Whether an ETF presents an advantage or disadvantage depends on your investment strategy and the particulars of the ETF you’re considering.

Proponents of ETFs argue that they are often more convenient, tax-efficient, and reliable than other investments, largely because of their inherent diversification. But what you save on management fees and tax efficiency can be spoiled by the costs of trading ETFs, which includes commissions, fees, inflated prices, and tracking errors.

Advantages of ETFs:

  1. Inexpensive:

    ETFs tend to be less expensive than mutual funds, primarily due to lower management fees. (This isn’t always true, though, as we note in the disadvantages section below.)

  2. Tax efficiency:

    They can be more tax efficient than mutual funds. The Internal Revenue Service treats mutual funds and ETFs the same way, but ETFs are structured to provide  lower tax bills.

  3. Diversification:

    This type of investment gives access to a broad range of asset classes.  ETFs often track business sectors and indexes, offering broad market exposure. Purchasing a single ETF will offer more diversification than a single stock. To diversify with stocks is more costly since that requires purchasing shares of a variety of stocks.

  4. Transparency:

    Fluctuations in ETF prices are easier to track throughout the day, and the contents of many ETFs are published regularly.

Disadvantages of ETFs

  1. Tracking errors:

    Even though ETFs are designed to perform similarly to the index they track, sometimes “tracking errors” occur. This means the ETF performs differently than what it’s tracking. Since an ETF invests in a “representative” sample of what it tracks, that sample can perform differently than the actual index. Other factors can also cause tracking errors. ETFs, which cannot be invested in directly, have fees, which the index does not—meaning even if an ETF were to perfectly track an index, its returns would be lower because of the fees associated with the ETF.

  2. Liquidity:

    While ETFs are easier to buy and sell than mutual funds, not all ETFs have the same level of liquidity. Several factors can affect an ETF’s liquidity, including the trading volume of the ETF and of the securities in that ETF, as well as the overall market. Some analysts argue that liquidity can become a problem for low-volume ETFs. If, for example, the communications sector becomes highly sought after, ETFs related to communications would as well, creating temporary liquidity issues until the firm could issue more ETFs.

  3. Commissions and fees:

    ETFs are normally praised for being inexpensive, but this varies widely. Some of the costs of owning an ETF include commissions, operating expenses, bid/ask spreads, and discounts and premiums to the net asset value. Depending upon the frequency and the expense ratio of any given ETF, it may not be less expensive. The expense ratio will vary per ETF, and you should investigate this before purchasing one. In addition, commissions and trading fees can lower returns to investors.

  4. Artificially inflated prices:

    Even though they make diversification less expensive, ETFs may also inflate the cost of the holdings within an ETF. Multiple ETFs include popular stocks, for instance, which artificially inflate the price of stocks within these ETFs compared to stocks that are outside of these ETFs.

The bottom line

ETFs offer you a way of investing broadly, but individual ETFs vary widely and they carry some possible disadvantages that should not be ignored.

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