ETF stands for Exchange Traded Fund and they offer you a way to invest in a wide range of bonds or shares in one package. They’ll typically track a specific market or niche. They’re very similar to index funds which also track a market’s performance. The main differentiating factors are: the way they’re traded (bought and sold) and their fees.
Unlike other funds, ETFs are traded on the stock market. That means you can buy or sell them at any time during the day. Other funds are only traded once a day. So while you can request to buy or sell them at any time it won’t actually happen there and then. It’ll go through at the next ‘trade point’ – usually the end of the day. When you buy and sell an ETF you’ll notice that it has two prices – an ask price (the price you can buy an ETF for) and a bid price (the price you can sell the ETF for). The difference between the bid and the ask price is called the ‘spread’.
How ETFs work
An ETF is bought and sold like a company stock during the day when the stock exchanges are open. Just like a stock, an ETF has a ticker symbol and intraday price data can be easily obtained during the course of the trading day. Unlike a company stock, the number of shares outstanding of an ETF can change daily because of the continuous creation of new shares and the redemption of existing shares. The ability of an ETF to issue and redeem shares on an ongoing basis keeps the market price of ETFs in line with their underlying securities.
Although designed for individual investors, institutional investors play a key role in maintaining the liquidity and tracking integrity of the ETF through the purchase and sale of creation units, which are large blocks of ETF shares that can be exchanged for baskets of the underlying securities. When the price of the ETF deviates from the underlying asset value, institutions utilize the arbitrage mechanism afforded by creation units to bring the ETF price back into line with the underlying asset value.
Types of ETFs
Various types of ETFs are available to investors that can be used for income generation, speculation, and price increases, and to hedge or partly offset risk in an investor’s portfolio. Here is a brief description of some of the ETFs available on the market today.
- Passive and Active ETFs
ETFs are generally characterized as either passive or actively managed. Passive ETFs aim to replicate the performance of a broader index—either a diversified index such as the S&P 500 or a more specific targeted sector or trend. An example of the latter category is gold mining stocks: as of November 2022, there are approximately eight ETFs which focus on companies engaged in gold mining, excluding inverse, leveraged, and funds with low assets under management.
Actively managed ETFs typically do not target an index of securities, but rather have portfolio managers making decisions about which securities to include in the portfolio. These funds have benefits over passive ETFs but tend to be more expensive to investors. We explore actively managed ETFs below.
- Bond ETFs
Bond ETFs are used to provide regular income to investors. Their income distribution depends on the performance of underlying bonds. They might include government bonds, corporate bonds, and state and local bonds. Unlike their underlying instruments, bond ETFs do not have a maturity date. They generally trade at a premium or discount from the actual bond price.
- Stock ETFs
Stock (equity) ETFs comprise a basket of stocks to track a single industry or sector. For example, a stock ETF might track automotive or foreign stocks. The aim is to provide diversified exposure to a single industry, one that includes high performers and new entrants with potential for growth. Unlike stock mutual funds, stock ETFs have lower fees and do not involve actual ownership of securities.
- Industry/Sector ETFs
Industry or sector ETFs are funds that focus on a specific sector or industry. For example, an energy sector ETF will include companies operating in that sector. The idea behind industry ETFs is to gain exposure to the upside of that industry by tracking the performance of companies operating in that sector.
Another good example is the technology sector, which has witnessed an influx of funds in recent years. At the same time, the downside of volatile stock performance is also curtailed in an ETF because they do not involve direct ownership of securities. Industry ETFs are also used to rotate in and out of sectors during economic cycles.
- Commodity ETFs
As their name indicates, commodity ETFs invest in commodities, including crude oil or gold. Commodity ETFs provide several benefits. First, they diversify a portfolio, making it easier to hedge downturns. For example, commodity ETFs can provide a cushion during a slump in the stock market. Second, holding shares in a commodity ETF is cheaper than physical possession of the commodity. This is because the former does not involve insurance and storage costs.
- Currency ETFs
Currency ETFs are pooled investment vehicles that track the performance of currency pairs, consisting of domestic and foreign currencies. Currency ETFs serve multiple purposes. They can be used to speculate on the prices of currencies based on political and economic developments for a country. They are also used to diversify a portfolio or as a hedge against volatility in forex markets by importers and exporters. Some of them are also used to hedge against the threat of inflation. There’s even an ETF option for bitcoin.
- Inverse ETFs
Inverse ETFs attempt to earn gains from stock declines by shorting stocks. Shorting is selling a stock, expecting a decline in value, and repurchasing it at a lower price. An inverse ETF uses derivatives to short a stock. Essentially, they are bets that the market will decline.
When the market declines, an inverse ETF increases by a proportionate amount. Investors should be aware that many inverse ETFs are exchange-traded notes (ETNs) and not true ETFs. An ETN is a bond but trades like a stock and is backed by an issuer such as a bank.
- Leveraged ETFs
A leveraged ETF seeks to return some multiples (e.g., 2× or 3×) on the return of the underlying investments. For instance, if the S&P 500 rises 1%, a 2× leveraged S&P 500 ETF will return 2% (and if the index falls by 1%, the ETF would lose 2%). These products use derivatives such as options or futures contracts to leverage their returns. There are also leveraged inverse ETFs, which seek an inverse multiplied return.
These investments offer a number of potential advantages, including:
Tax efficiency — ETFs may be more tax efficient than some traditional mutual funds. A mutual fund manager may trade stocks to satisfy investor redemptions or to pursue the fund’s objectives. Selling shares may create taxable gains for the fund’s shareholders. Because ETFs are like stocks, redemptions aren’t an issue. In addition, managers of index-based ETFs only make trades to match changes in their index, which may mean greater tax efficiency.
Low expenses — ETFs that are passively managed (managers usually only trade shares to mirror underlying benchmarks) may have lower annual expenses than actively managed funds.
Flexible trading — Like stocks, ETFs are sold at real-time prices and trade throughout the day. Mutual funds, on the other hand, do not have this flexibility: Their pricing is based on end-of-day trading prices.
Can be sold short and bought on margin — Because ETFs trade like stocks, investors can use them in certain investment strategies, such as selling short and buying on margin.
No minimum investment — Most mutual funds require a minimum investment, whereas an investor can usually purchase as few shares of most ETFs as desired.
Diversification — An ETF may be a good way to add diversification to your portfolio. Buying shares of a technology sector ETF, for example, could potentially be less risky than purchasing shares of one technology stock — an ETF may own shares of many different technology companies.
The future of ETFs
Exchange-traded funds are growing in popularity because of their simplicity, cost-effective approach to investing, and the diversity they provide. As of November 2022, the U.S. ETF industry has grown to $3.9 trillion from $2.6 trillion pre-pandemic, aided by the 2019 rule passed by the SEC. This is good news for investors looking to expand their ETF portfolios and suggests there may be further growth ahead.
The Bottom Line
With ETFs currently experiencing significant growth, it seems likely that they will continue to be an attractive option for investors looking to diversify their portfolios without increasing the time and effort they need to spend on managing their assets. But with changing technologies reshaping the financial services industry, the long-term future of ETFs remains to be seen.