Exchange-Traded Fund (ETF) Guide

With the popularity of index mutual funds, it was just a matter of time before a spinoff investment appeared. Back in the early 1990s, the first exchange-traded fund (ETF) was created and sold. Since then, this innovative investment vehicle has grown by the billions (though they still pale in comparison to mutual funds held), more often becoming the security of choice around which to build a portfolio. Strong performance and flexibility keep these securities among investors’ favorites—and more new ETFs are being introduced all the time.

Table of Contents

What Is an Exchange-Traded Fund (ETF)?
Understanding Exchange-Traded Funds (ETFs)
Types of ETFs
How To Fit ETFs Into Your Portfolio
How To Choose the Right ETFs
Examples of Popular ETFs
How to Buy and Sell ETFs
How To Track Your ETFs
Advantages and Disadvantages of ETFs
Actively Managed ETFs
Special Considerations For ETFs
People Also Ask FAQs

What Is an Exchange-Traded Fund (ETF)?

ETFs are exactly what they sound like: funds that trade on open exchanges. Just like buying stock, you’ll need to place a brokerage order to buy ETF shares over an exchange. The very first ETF, which tracked the S&P 500 Index, was traded in 1993 on the AMEX.

Though at first investors were confused by these new securities, they soon caught on among investors and brokers alike. Today, ETFs claim more than 500 billion of investing dollars. Sounds huge, but it’s not when compared with the total mutual fund market, which starts counting in the trillions.

Given the very real advantages of ETFs, though, they may eventually outpace mutual funds as the diversified investment of choice. Each ETF tracks a specific index (like the Dow Jones Industrial Average or the Russell 2000, for example), meaning that it holds the same basket of securities as the index.

Some ETFs represent stock indexes; other represent bond indexes. There are also more specialized ETFs that allow you to invest in real estate, commodities (like gold), or international securities.

Understanding Exchange-Traded Funds (ETFs)

ETFs trade on exchanges like stocks, so they’re called exchange-traded funds. Shares of an ETF fluctuate in value as they are bought and sold throughout the trading day. Mutual funds, on the other hand, are not traded on an exchange and are traded only once a day after the market closes. Compared to mutual funds, ETFs are generally more cost-effective and more liquid.

Unlike stocks, ETFs hold multiple underlying assets instead of just one, like a mutual fund. Diversifying through ETFs is popular since they include multiple assets within them. Stocks, commodities, bonds, and a combination of these types of investments can be included in ETFs. ETFs can own hundreds or thousands of stocks, or they can be industry-specific. The majority of funds are based in the U.S., but others are global in outlook. Banking-focused ETFs would include stocks of various banks in the industry.

ETFs are marketable securities, which means they can be easily bought and sold on exchanges throughout the day, and they can also be sold short. Most ETFs in the United States are set up as open-ended funds and are subject to the Investment Company Act of 1940, except where subsequent rules modify that requirement. In open-end funds, the number of investors is not limited.

Learn more about the differences between ETFs and mutual funds.

Types of ETFs

An investor may choose from a variety of ETFs for income generation, speculation, and price increases, as well as to hedge or partially offset risk in their portfolio. The following are a few of the ETFs available on the market today.

Passive and Active ETFs

ETFs can either be passively managed or actively managed. An ETF that invests passively replicates the performance of an underlying index, whether it be a broad index like the S&P 500 or a more specific trend or sector. In the latter category are gold mining stocks: as of February 18, 2022, there are approximately eight ETFs focused on gold mining companies, excluding leveraged, inverse, and smaller-sized funds.

Portfolio managers make decisions about which securities should be included in actively managed ETFs, which do not typically target an index of securities. Compared to passive ETFs, these funds have benefits but are more expensive.

Fixed-income ETFs

Fixed-income ETFs allow investors to capitalize on the benefits of bonds with the convenience of stocks and the inherent diversification of bond mutual funds. These ETFs are a little different than the equity variety, as they hold portions of bonds that are included in their tracking index (whereas equity ETFs hold whole stocks).

Investors get their bond interest as dividends (though it still usually counts as interest for tax purposes). You can invest in total bond market ETFs, which hold corporate and government bonds of varying maturities.

You can also invest in more specialized bond ETFs, such as those that focus on specific maturities (like only tracking bonds with maturities of less than three years), or inflation-indexed bonds.

Equity ETFs

Equity ETFs cover the stock markets from every conceivable angle. There are broad-based, total U.S. market ETFs, such as those tracking the S&P 500, the Dow Jones Industrial Average, and the Russell 3000.

You can also find global (with or without U.S. stocks included) ETFs, such as those tracking the MSCI All Country World Index (ACWI). More targeted international ETFs track more focused indexes, like the MSCI EAFE (Europe, Australia, Far East) Index or the MSCI Emerging Markets Index.

If you want to keep your money in U.S. securities with a more narrow focus, you can look into sector ETFs, which track niche portions of the stock market (like utilities or technology). If value investing is your passion, there are ETFs for that, such as those tracking the S&P 500 Value Index (a subset of the whole market index). The same goes for growth investing, where you can get an ETF that tracks, for example, the Russell 3000 Growth Index.

Industry/Sector ETFs

Funds focused on a specific industry or sector are known as industry or sector ETFs. An energy sector ETF, for example, includes energy companies. An industry ETF seeks to track the performance of companies that operate in that industry in order to gain exposure to its upside.

Technology is an example of a sector that has seen an influx of funds in recent years. As an ETF does not involve direct ownership of securities, the downside of volatile stock performance is also limited. During economic cycles, industry ETFs can also be used to flip between sectors.

Commodity ETFs

Commodities ETFs will hold either the goods themselves (like gold) or futures on the goods. They may track single commodities, a basket of several commodities, or shares in companies that produce commodities.

ETFs that invest in commodities offer several benefits. To begin with, they help hedge against market downturns by diversifying a portfolio. Commodity ETFs, for example, can provide a cushion during a market slump. In addition, it is cheaper to hold shares in a commodity ETF than to own the commodity physically. This is because there are no insurance and storage costs involved.

Currency ETFs

Currency ETFs track money movement, holding either foreign currencies themselves or future contracts. You’ll find single currency ETFs (such as those focusing on the Japanese yen or the euro) as well as currency-basket ETFs (which hold several different currencies).

The purpose of currency ETFs is multifaceted. Based on the political and economic developments for a country, they can be used to speculate on currency prices. In addition, importers and exporters use them as a hedge against volatility in forex markets. Some of them are also used as an inflation hedge. There is even an ETF for bitcoins.

Inverse ETFs

Inverse ETFs allow investors to bet against the market—these funds move opposite to a major market index, basically by short selling the index components. For example, an inverse S&P 500 ETF would go up 1 percent for every 1 percent the index itself went down, and of course, the ETF would drop every time the real index increased.

Inverse ETFs employ securities such as put options (and similar derivatives) and/or employ strategies such as “going short”

Take the S&P 500, for example. If you were bullish on that index, you might choose an ETF such as SPY. However, if you were bearish on that index and wanted to seek gains by betting that it would go down, you could choose an ETF such as SH.

You can take two approaches to Inverse ETFs:

Hoping for a downfall: If you’re speculating on a pending market crash, a bearish ETF is a good consideration. In this approach, you’re actually seeking to make a profit based on your expectations. Those folks who aggressively went into bearish ETFs during early or mid-2008 made some spectacular profits during the tumultuous downfall of late 2008 and early 2009.
Hedging against a downfall: A more conservative approach is to use bearish ETFs to a more moderate extent, primarily as a form of hedging, whereby the bearish ETF acts like a form of insurance in the unwelcome event of a significant market pullback or crash. I say “unwelcome” because you’re not really hoping for a crash; you’re just trying to protect yourself with a modest form of diversification. In this context, diversification means that you have a mix of both bullish positions and, to a smaller extent, bearish positions.

Leveraged ETFs

Leveraged ETFs seek multiple returns from underlying investments (e.g., 2× or 3×). If the S&P 500 increases by 1%, a 2× leveraged S&P 500 ETF will return 2% (and if the index falls by 1%, the ETF will lose 2%). To leverage their returns, these products use derivatives such as options and futures contracts. Inverse leveraged ETFs also exist, which seek inverse multiplied returns.

How To Fit ETFs Into Your Portfolio

ETFs can be used to enhance diversification in your portfolio. With just a few strategically selected ETFs, you can create a well-diversified set of core holdings, covering virtually every corner of the market. For far less than the cost of holding individual stocks, your ETF can give you exposure to all the major equity classes: every size of market capitalization and every market sector.

You can round out your holdings with one or two fixed-income ETFs. These offer you the benefit of steady income, just like you’d get by holding individual bonds or bond funds, with the flexibility of stock trading; bond ETFs trade over exchanges, whereas bonds, can only be bought through brokers or TreasuryDirect.

For more portfolio protection, you can branch out into foreign ETFs. These offer you a hedge against problems in the U.S. markets, as other countries may be doing well when the U.S. markets are down. Global ETFs let you stick your toe in international securities, so you don’t have to figure out which securities—or which countries—to invest in.

Holding ETFs does not mean you can’t also hold mutual funds. Managed mutual funds are designed to outperform the markets, while ETFs aim mainly to match the markets.

A combination of core ETFs and some more aggressive mutual funds can keep your portfolio profitable without risking too much stability.

How To Choose the Right ETFs

When it comes to figuring out which ETFs make sense for your portfolio, the process is very similar to mutual fund selection.

The first thing you need to do is revisit your financial plan. Your immediate and long-term goals, your current holdings, and your feelings about risk will all inform your ETF choices.

After that, you can typically take into consideration the following criteria for searching ETFs:

Expenses: If you choose a broad-based ETF that holds basically the same securities as an index mutual fund, carefully measure which one will cost you the least to own, remembering to take trading costs into account. There’s no reason to buy the ETF if a no-load mutual fund will offer you the same returns at a lower cost.

Current trading prices: You’ll also want to check the current trading prices; while mutual funds are bought and sold at their net asset value, ETFs often trade at premiums or discounts to the NAV, based on the day’s market activity.

Fees and charges: Consider the different fees charged by different ETF families. Competition among ETFs is increasing as more players come into the market, and one way to draw new business is to lower fees. Compare ETFs to see which offers the best expense ratio, especially if you plan to add only one of these securities to your portfolio.

At Least $10million in assets: Make sure the ETF you’re considering holds at least $10 million in assets, as smaller offerings may not be as liquid (meaning you may have trouble selling when you want to). Don’t assume that every ETF sponsor is the same; you want to make sure your investment dollars are in good hands.

The trading volume of the ETFs: Look into the trading volume of the fund you’re interested in, as that will also tell you how easy it will be to sell when you’re ready. Popular ETFs see volume in the millions every day (meaning more than 1 million shares exchange hands daily), while others may see virtually no trading activity at all.

Examples of Popular ETFs

Here are a few examples of popular exchange-traded funds. The ETFs track indices of stocks, thus creating a broad portfolio, while others target specific industries.

The SPDR S&P 500 (SPY): These funds tracked the S&P 500 and gained the nickname spiders, which comes from SPDR (Standard & Poor’s Depositary Receipts). SPDRs trade on the NYSE, with SPY for their ticker symbol. Along with the broad index ETF, you’ll also find SPDRs that track specific market sectors, aptly named Select Sector SPDRs.
The SPDR Dow Jones Industrial Average (DIA) (“diamonds”): When you buy a share of Diamonds (NYSE: DIA), you are buying a fraction of each of the stocks in the Dow Jones Industrial Average. Like SPDRs, Diamonds are exchange-traded funds bought and sold on the NYSE, and sponsored by State Street Global Advisors.
The iShares Russell 2000 (IWM) tracks the Russell 2000 small-cap index.
The Vanguard ETFs: These ETFs are issued by Vanguard, a leading mutual fund provider. Vanguard Exchange-Traded Funds (which are formally known as Vanguard Index Participation Equity Receipts) cover the U.S. stock and bond markets, as well as some international equity markets.
The Invesco QQQ (QQQ) (“cubes”) tracks the Nasdaq 100 Index, which typically contains technology stocks.
Sector ETFs track specific industries and sectors such as oil (OIH), energy (XLE), financial services (XLF), real estate investment trusts (IYR), and biotechnology (BBH).
Commodity ETFs: ETFs that represent commodity markets include gold (GLD), silver (SLV), crude oil (USO), and natural gas (UNG).
Country ETFs: Despite tracking foreign stock indexes, country ETFs are traded in the United States and denominated in U.S. dollars. China (MCHI), Brazil (EWZ), Japan (EWJ), and Israel (EIS) are examples. Others track a wide range of foreign markets, such as ones that track emerging market economies (EMEs) and developed market economies (EFAs).

How to Buy and Sell ETFs

Trading ETFs is just like trading stocks—literally. You place a buy or sell order with your broker, and he fills the order for you, adding the securities to your account when the transaction is closed. Whenever the market is open, you can make a trade.

And just like stock orders, you can add conditions to your ETF trading orders. For example, you can place a limit order for an ETF, just like you would for a stock. In fact, everything you can do to order a stock trade, you can do to order an ETF trade, from time-sensitive to price-driven orders.

Many investors take an active approach to ETF trading, which is much less common with mutual fund holders. Though the ETFs themselves take a passive investment approach, simply tracking an existing index, traders can buy and sell ETF shares in the same way they would with individual stocks.

People who do this are typically trying to beat an index, but their profits can be eaten up in trading commissions—and their strategy may turn out to be less profitable than simply following the index.

Learn more about how to open a brokerage account for stock trading.

How To Track Your ETFs

Keeping track of your ETF holdings is as easy as—you guessed it— keeping track of stocks. Every financial reporting service, from the Wall Street Journal to Reuters to the ETF sponsor, maintains current pricing and yield (for income ETFs) information for the ETFs on the market.

To track your ETFs, you’ll need to know their trading symbols. Then all you have to do is look at a current price table, whether in the newspaper or online, to find out everything you need to know.

Most ETF price tables contain data like closing price, the dollar and percent change from the previous trading day’s closing price, and trading volume. Some also include the year-to-date price change, the day’s high and low prices, and the annual high and low.

Advantages and Disadvantages of ETFs

The average cost of investing in an ETF portfolio is lower than the cost of buying all the stocks in the portfolio individually. Since investors make few trades, there are fewer brokerage commissions since only one purchase and one sale are required. Each trade usually involves a brokerage commission. Some brokers even offer commission-free trading in certain low-cost ETFs, further reducing costs for investors.

Expense ratios describe the cost of operating and managing an ETF. Because ETFs track an index, they typically have low costs. For example, if an ETF tracks the S&P 500 Index, it may include all 500 stocks from the index, making it less time-intensive than a passively managed fund. The expense ratios of some ETFs may be higher because they do not passively track an index.

Pros

Stocks from many different industries are available
Reduced broker commissions and low expense ratios
Diversification to manage risk
ETFs exist that focus on specific industries

Cons

Actively managed ETFs charge higher fees
ETFs that focus on a single industry limit diversification
Transactions are hindered by a lack of liquidity

Actively Managed ETFs

ETFs can also be actively managed, where portfolio managers buy and sell shares of companies and adjust holdings within the fund. In general, actively managed funds have higher expense ratios than passively managed ETFs.

In order to determine whether an ETF is worth holding, investors must determine how the fund is managed, whether it is actively or passively managed, and the associated expense ratio versus the rate of return.

Special Considerations For ETFs

Indexed-Stock ETFs

In addition to diversification, an index-stock ETF provides investors with the option to short sell, to buy on margin, and to purchase as few as one share since there is no minimum deposit requirement. There are, however, some ETFs that are not equally diversified. Certain portfolios may be heavily concentrated in one industry, may contain a small number of stocks, or assets with high correlations.

Dividends and ETFs

You can find ETFs that include high-dividend income stocks (typically 4 percent or higher) as well as ETFs that include stocks of companies that don’t necessarily pay high dividends but do have a long track record of dividend increases that meet or exceed the rate of inflation. Given these types of dividend-paying ETFs, it becomes clear which is good for what type of stock investor:

If I were a stock investor who was currently retired, I’d choose the high-dividend stock ETF. Dividend-paying stock ETFs are generally more stable than those stock ETFs that don’t pay dividends, and dividends are important for retirement income.
If I were in “pre-retirement” (some years away from retirement but clearly planning for it), I’d choose the ETF with the stocks that had a strong record of growing the dividend payout. That way, those same dividend-paying stocks would grow in the short term and provide better income down the road during retirement.

Keep in mind that dividend-paying stocks generally fall within the criteria of human need investing because those companies tend to be large and stable, with good cash flows, giving them the ongoing wherewithal to pay good dividends.

ETFs and Taxes

Because most of the buying and selling occurs on an exchange, ETFs are more tax-efficient than mutual funds because the ETF sponsor does not have to redeem shares each time an investor wishes to sell or issue new shares each time an investor wishes to buy. The tax liability for redeeming a fund’s shares can be substantial, so the shares can be listed on an exchange to reduce tax costs. A mutual fund incurs a tax liability every time an investor sells their shares and the fund buys them back, thereby incurring a tax liability.

ETFs’ Market Impact

ETFs have become increasingly popular with investors, resulting in the launch of many new low-volume funds. Low-volume ETFs can make it difficult for investors to buy and sell them easily.

Concerns have been raised about the impact of ETFs on the market and whether these funds can lead to a rise in stock values and the formation of fragile bubbles. Some ETFs rely on portfolio models that have not been tested under various market conditions and can lead to extreme inflows and outflows from the funds, negatively impacting market stability.

ETFs have been a major contributor to market volatility and flash crashes since the financial crisis. Several flash crashes and market declines have been attributed to ETF issues, including those in May 2010, August 2015, and February 2018.