What is an ETF (exchange-traded fund)? A beginner’s guide

Exchange-Traded Funds (ETFs) are one of the most popular investment vehicles in the world. They provide investors with a simple and cost-effective way to invest in a diversified portfolio of assets. In this guide, we will provide a comprehensive overview of ETFs, their benefits, risks, and how to invest in them.

What is an ETF?

Exchange-Traded Funds (ETFs) are a type of investment fund that tracks the performance of a specific index or sector. ETFs are similar to mutual funds, but they are traded on stock exchanges like individual stocks. ETFs have become increasingly popular because they offer investors a low-cost and efficient way to invest in a diversified portfolio of assets.

The first U.S. ETF, the SPDR S&P 500 ETF Trust, was launched in 1993. Since then, the ETF market has grown significantly, and thousands of ETFs now trade on exchanges around the world.

Importance of ETFs in the investment world

ETFs have revolutionized the investment industry by offering investors a more cost-effective and efficient way to invest in a diversified portfolio of assets. They have become an essential tool for both individual and institutional investors.

How ETFs work

ETF structure

ETFs are structured like mutual funds but traded on an exchange like individual stocks. ETFs are created when a financial institution purchases a basket of underlying assets that track a specific index or sector. The institution then issues shares that represent ownership in the underlying assets.

Creation and redemption of ETF shares

ETF shares are created or redeemed through an authorized participant (AP), which is typically a large financial institution or market maker. The AP buys or sells the underlying assets in the ETF basket and then delivers them to the ETF issuer in exchange for new ETF shares.

ETF categories at a glance

There are several types of ETFs, including:

• Equity ETFs: These ETFs track the performance of a specific stock market index or sector, such as the S&P 500 or technology stocks.
• Fixed-income ETFs: These ETFs track the performance of bonds or other fixed-income securities.
• Commodity ETFs: These ETFs track the performance of commodities, such as gold, silver, or oil.
• Currency ETFs: These ETFs track the performance of foreign currencies.
• International ETFs: These ETFs track the performance of global stock markets.

Advantages of ETFs

• Diversification: ETFs provide investors with exposure to a diversified portfolio of assets.
• Low cost: ETFs typically have lower fees and expenses than actively managed mutual funds.
• Tax efficiency: ETFs are typically more tax-efficient than mutual funds because of their structure.
• Transparency: ETFs are more transparent than mutual funds because they disclose their holdings daily.
• Liquidity: ETFs are highly liquid and can be bought and sold throughout the trading day.

Disadvantages of ETFs

• Trading costs: ETFs may have brokerage commissions and bid-ask spreads that can increase the cost of trading.
• Tracking error: ETFs may not track their underlying index or sector perfectly, leading to a tracking error.
• Overconcentration: Some ETFs may have a high concentration in a particular industry or stock.
• Lack of flexibility: ETFs can only be bought and sold during market hours.

What is ETF trading?

ETF trading is buying and selling ETF shares on a stock exchange, the same way you trade shares of a company. You place orders through a brokerage account, and they fill at the market price while the exchange is open. A mutual fund works differently: you buy it from the fund company at one price, set after the market closes.

An ETF has two prices. The market price is what buyers and sellers agree on during the day. The net asset value (NAV) is what the fund’s holdings are worth per share. When the two drift apart, authorized participants create or redeem shares, which usually keeps the market price close to the NAV.

Each trade also has a cost in the bid-ask spread, the gap between the highest price a buyer offers and the lowest price a seller accepts. Some brokers charge a commission per trade and many don’t, so check your broker’s fee schedule. If you want to control the price you pay, use a limit order instead of a market order.

Benefits of ETFs

Diversification

One of the main benefits of ETFs is that they provide investors with a diversified portfolio of assets. By investing in an ETF, an investor gains exposure to a basket of underlying assets, such as stocks or bonds, that track a particular index or sector. This diversification can reduce risk, though it does not protect you when the whole market falls.

Low cost

ETFs typically have lower fees and expenses than actively managed mutual funds. This is because ETFs are passively managed and do not require the same level of resources as actively managed funds. Additionally, ETFs typically have lower expense ratios than mutual funds.

Tax efficiency

ETFs are typically more tax-efficient than mutual funds because of their structure. ETFs are structured as open-ended funds, which means they can create and redeem shares as needed. Because shares are usually created and redeemed in kind, by swapping baskets of securities instead of selling holdings for cash, many ETFs pay out fewer capital gains to shareholders. You still owe tax on any gain when you sell your own ETF shares, and tax rules differ by country.

Transparency

ETFs are more transparent than mutual funds because they disclose their holdings daily. This means that investors can see exactly what they are investing in and how their investment is performing.

Liquidity

ETFs are highly liquid and can be bought and sold throughout the trading day. This means that investors can enter and exit positions quickly and easily, making it easier to manage their portfolios.

Risks of ETFs

Tracking error

ETFs may not track their underlying index or sector perfectly, leading to a tracking error. This can occur for a variety of reasons, including changes in the underlying index or sector, trading costs, or management fees.

Overconcentration

Some ETFs may have a high concentration in a particular sector or stock. This can increase the risk of the ETF and lead to significant losses if the industry or stock experiences a downturn.

Liquidity risk

While ETFs are highly liquid, there may be times when trading volumes are low or there are no buyers for the ETF. This can lead to a situation where an investor may not be able to sell their shares at the desired price.

Counterparty risk

Some ETFs are subject to counterparty risk, which is the risk that the financial institution on the other side of a contract may default on its obligations. This mainly applies to synthetic ETFs, which use swaps to track their index, and to ETFs that lend out their securities. This can lead to losses for investors.

How to invest in ETFs

Determine your investment goals and risk tolerance

Before investing in ETFs, it is crucial to determine your investment goals and risk tolerance. This will help you to choose the right ETFs to meet your investment needs.

Choose an online broker

To invest in ETFs, you must open an account with an online broker offering ETF trading. Some popular online brokers include Fidelity, Charles Schwab, and Vanguard.

Research and select ETFs

Once you have opened an account with an online broker, you can research and select ETFs that meet your investment goals and risk tolerance. You can use various resources to explore ETFs, including the ETF issuer’s website, financial news sources, and investment research websites. To pull ETF prices into a spreadsheet, you can use the GOOGLEFINANCE function in Google Sheets.

Place an order to buy or sell ETFs

Once you have selected the ETFs you want to invest in, you can place an order to buy or sell the ETFs through your online broker. You can place a market order, which will execute at the current market price, or a limit order, which will execute at a specified price.

Factors to consider before investing in ETFs

Investment goals and risk tolerance

Before investing in ETFs, defining your investment goals and risk tolerance is essential. This will help you choose the right ETFs to meet your investment needs. Are you investing for long-term growth or short-term gains? What level of risk are you comfortable with?

ETF fees and expenses

ETFs have lower fees and expenses compared to mutual funds. However, it’s still important to consider the expense ratio, trading costs, and any other fees associated with investing in an ETF.

Fund size and liquidity

ETFs with larger assets under management tend to have higher liquidity and lower bid-ask spreads. Smaller funds may be more susceptible to liquidity risks, making buying and selling shares at a favorable price more challenging.

Tracking error

ETFs aim to track an underlying index or sector, but there may be slight discrepancies between the performance of the ETF and its benchmark. Researching the ETF’s tracking error ensures it aligns with your investment objectives.

Trading volume and bid-ask spread

ETFs with high trading volumes tend to have lower bid-ask spreads, saving investors money when buying and selling shares. Low trading volume can increase the bid-ask spread and make it more difficult to trade the ETF.

How to choose an ETF?

Define your investment objectives

Before choosing an ETF, define your investment objectives. Are you looking for growth, income, or a combination of both? What level of risk are you willing to take?

Assess the fund’s underlying index

Understand the index that the ETF is tracking. Is it a broad-based index or a specific sector or industry? How well does the index represent the market you want to invest in?

Analyze the fund’s holdings and sector exposure

Review the ETF’s holdings to ensure they align with your investment objectives. Understand the ETF’s sector exposure to determine if it’s diversified enough or overly concentrated in a specific sector.

Evaluate the fund’s historical performance and risk

Review the ETF’s historical performance to understand its performance in different market conditions. The CAGR formula turns a multi-year return into an average yearly growth rate, so you can compare funds on the same basis. Evaluate the ETF’s risk profile to ensure it aligns with your investment objectives.

Compare fees and expenses

Compare the expense ratios and any other fees associated with investing in the ETF. Understand how these fees may impact your investment returns over time.

Common ETF investing strategies

The approaches below are general information to help you understand the terms, not investment advice. Which one fits depends on your goals, time horizon, and risk tolerance.

• Buy and hold means buying a broad index ETF, such as one that tracks the S&P 500 or a total market index, and keeping it for years. Low costs and wide diversification make ETFs a common choice for it.
• Dollar-cost averaging means investing a fixed amount at regular intervals, for example every month, whatever the price. You buy more shares when prices are low and fewer when they are high, and you don’t have to time the market.
• A core and satellite portfolio keeps most of the money in one or two broad ETFs and a smaller share in sector or regional ETFs.
• Asset allocation splits money between stock ETFs, bond ETFs, and sometimes others in set proportions. Rebalancing from time to time brings the mix back to its target.
• An income approach uses dividend-focused equity ETFs or bond ETFs that pay regular distributions.

Small differences in cost and return add up over many years. The rule of 72 gives a quick estimate of how long an investment takes to double. To see what a lower expense ratio is worth, run two growth rates through a compound interest formula in Google Sheets and compare the results.

Types of ETFs

Equity ETFs

Equity ETFs track a specific index or sector of the stock market. They can provide exposure to various market segments, including large-cap, mid-cap, small-cap, and international stocks.

Most equity ETFs are index ETFs. They follow a published index, such as the S&P 500, instead of relying on a manager to pick stocks. Sector ETFs are a narrower kind of equity ETF that hold companies from one industry, such as technology or healthcare.

Fixed-income (bond) ETFs

Fixed-income ETFs invest in bonds and other debt securities. They can provide exposure to various segments of the bond market, including government, corporate, and high-yield bonds.

Commodity ETFs

Commodity ETFs invest in physical commodities like gold, silver, oil, or agriculture. They expose investors to commodity prices without needing to physically own the commodity.

Currency ETFs

Currency ETFs invest in currencies from different countries. They can provide exposure to the currency market and can be used to hedge against currency risk.

International ETFs

International ETFs provide exposure to international markets, including emerging markets and developed markets. They can offer diversification benefits and help investors take advantage of growth opportunities in other countries.

Market, sector, and currency risk

Market risk

The performance of an ETF is subject to market risk, which is the risk of loss due to changes in market conditions.

Sector risk

An ETF may be subject to sector risk if it is focused on a specific sector or industry. This is the risk of loss due to changes in the performance of a particular sector or industry.

Currency risk

If an ETF invests in international securities, it may be subject to currency risk. This is the risk of loss due to changes in currency exchange rates.

What is an ETF expense ratio?

Expense Ratio is the annual fee charged by the ETF provider to manage the fund. It covers the operating expenses of the ETF, including management fees, administrative costs, and other expenses. It is expressed as a percentage of the fund’s assets under management.

How to evaluate an expense ratio

Investors should consider the expense ratio when choosing an ETF to invest in. A higher expense ratio can eat into your returns, so selecting an ETF with a low expense ratio that fits your investment goals is important.

What is an ETF fund?

An ETF fund is a collection of securities bundled together and traded on an exchange. ETFs can be grouped into various categories based on their investment objectives, such as equity ETFs, fixed-income ETFs, commodity ETFs, currency ETFs, and international ETFs.

How ETF funds are created and redeemed

ETF shares are created and redeemed through an authorized participant (AP), who is typically a prominent institutional investor. The AP purchases the underlying securities of the ETF and delivers them to the ETF provider in exchange for ETF shares.

What is a leveraged ETF?

A leveraged ETF is an ETF that uses financial derivatives and debt to amplify the returns of the underlying securities. This type of ETF can provide investors with the potential for higher returns, but it also comes with higher risk due to its use of leverage.

Leveraged ETFs use financial derivatives such as options and futures to increase the exposure to the underlying securities. The ETF borrows money to invest in the derivatives, which amplifies the returns. It amplifies losses too. Most leveraged ETFs reset their leverage every day, so over weeks or months their returns can be very different from two or three times the index return.

What is the SPY ETF?

SPY ETF, or SPDR S&P 500 ETF Trust, is one of the largest and most popular ETFs. It tracks the performance of the S&P 500 Index, which is a benchmark index of 500 large-cap U.S. stocks.

Investors can invest in SPY ETF by opening a brokerage account and placing a trade through their brokerage firm.

ETF vs. mutual fund

ETFs and mutual funds are both investment vehicles that provide investors with exposure to various asset classes and market segments. The main difference between ETFs and mutual funds is that ETFs are traded like stocks on an exchange, while mutual funds are bought and sold through the fund company at the end of the trading day.

ETFs offer low fees and expenses, the ability to trade like stocks, and tax efficiency. Mutual funds offer professional management, automatic investment, and convenience. Consider your investment goals and preferences when choosing between ETFs and mutual funds.

Conclusion

ETFs are a popular investment vehicle that exposes investors to various asset classes and market segments. They offer diversification benefits, low fees and expenses, and the ability to trade shares like stocks.

When investing in ETFs, it’s critical to consider your investment goals and risk tolerance, fees and expenses, fund size and liquidity, tracking error, and trading volume and bid-ask spread.

When choosing an ETF, define your investment objectives, assess the fund’s underlying index, analyze the fund’s holdings and sector exposure, evaluate the fund’s historical performance and risk, and compare fees and expenses.

The popularity of ETFs is expected to continue to grow in the future. As more investors seek low-cost, diversified investment options, ETFs are likely to play an important role in portfolios.

Once you own a few ETFs, you can build a stock portfolio spreadsheet to track holdings, costs, and returns in one place. If your finance team keeps its numbers in several spreadsheets, Sheetgo’s AI finance virtual employee can pull them into one up-to-date file.