Exchange Traded Fund (ETF): What It Is & How It Works (2024)

What is an ETF?

An ETF, or exchange-traded fund, is an investment security that combines some of the attributes of stocks and mutual funds. Like stocks, ETFs trade intra-day on an exchange. Like with mutual funds, many ETFs seek to track the performance of a benchmark index, such as the .

How Do ETFs Work?

When you buy an ETF, you're buying a basket of securities wrapped into one investment that trades on an exchange. Most ETFs passively track an underlying index, which is a representation of other securities or asset types, such as stocks, bonds, commodities, or currencies.

Shareholders of ETFs do not directly own shares of the underlying securities or assets; they own shares of the ETF itself. Also, while ETFs do trade on an exchange like stocks, the process of creating and redeeming shares is unique in the investment world.

Here are the steps taken to create a typical ETF before investors can buy shares:

1. An investment company or ETF manager, known as a sponsor, decides to create a new ETF.
2. The ETF sponsor forms an arrangement with a third party, known as an authorized participant, or AP, which is typically a large financial institution.
3. The AP purchases securities in the ETF's benchmark index, then exchanges them for a block of ETF shares of equal value, called "creation units."
4. The AP sells shares of the ETF to investors or market makers on an exchange.
5. Investors can then buy and sell shares of the ETF, which is assigned a unique ticker symbol, on an exchange, much like a stock.

Pros and Cons of ETFs

ETFs have multiple advantages but they're not an ideal fit for every investor. As with any other type of security, investors are wise to weigh the pros and cons of ETFs and determine if these funds are appropriate for their unique investment goals and strategies.

Pros of ETFs

• Diversification: ETFs provide exposure to dozens, or even hundreds, of securities in just one basket. Exposure to multiple securities in a portfolio can reduce risk.
• Specialization: Certain specialty ETFs enable access to niche areas of the market that may otherwise be inaccessible to most investors.
• Low cost: Because ETFs are passively managed, the operational costs are extremely low compared to actively managed portfolios. It's common for an ETF expense ratio to be lower than 0.10%, which is just $10 annually for every $10,000 of investments.
• Tax-efficiency: For the ETFs that track a benchmark index, there is very little turnover (buying and selling within the portfolio), which minimizes management costs and taxable distributions to shareholders.
• Market orders: One of the stock-like aspects that can be a benefit for investors is the ability to place market orders, such as a stop-loss order or a limit order. This feature enables an investor to automate execution of trades at the best price possible.

Cons of ETFs

• Trading costs: Many ETFs can be traded at zero commission and with no transaction fee. However, some brokers will charge commissions to trade certain ETFs on their platform. These commissions can negate the savings of the low expense ratios of ETFs and can really add up over time if an investor trades frequently.
• Illiquidity: ETFs that have low trading volumes can have wide bid-ask spreads, similar to many stocks with low trading volumes. The bid-ask spread is the amount by which the ask price exceeds the bid price. This spread can add to the cost of trading, which erodes the investor's return.
• Settlement: As is the case with stocks, ETF settlement is T+2, which means you'll wait two days after the trade before it settles to cash. Mutual fund settlement is commonly T+1.

Tip: To reduce trading costs and minimize liquidity issues, investors can look for ETFs with a multi-year track record and assets higher than $1 billion. Generally speaking, the more established the ETF and the larger the assets, the greater the trading volume will be and the better odds it will trade free of commission and have narrower bid-ask spreads on the price.

Types of ETFs

There are many different types of ETFs but they can be broken down into six broad categories: equity, fixed-income, commodity, currency, real estate, and specialty ETFs.

1. Equity ETFs

There are dozens of sub-categories within the equity ETF universe. Some of the more common equity ETF types include:

• S&P 500 ETFs
• Dividend ETFs
• International ETFs

Equity ETFs can be further categorized by objective, such as growth and value, and by market capitalization, including micro-, small-, mid-, large-, and mega-cap ETFs.

2. Fixed-Income ETFs

Also known as bond ETFs, these funds track bond market indices, such as the Bloomberg Barclays US Aggregate Bond Index.

Other common fixed-income ETF categories include:

• Government bond
• Corporate bond
• Tax-free municipal bond
• International bond
• Emerging markets bond
• High-yield bond

3. Commodity ETFs

Rather than hold the physical asset, which can be inaccessible or impractical for an investor, commodity ETFs track the price of a commodity, such as gold, grains or oil, or a basket of commodities, such as precious metals or agricultural ETFs.

Some examples of top-performing commodity ETFs include:

• Gold ETFs
• Silver ETFs
• Oil ETFs
• Natural Gas ETFs
• Copper ETFs
• Uranium ETFs

4. Currency ETFs

As is the case with commodities, currency ETFs provide exposure to currency markets and foreign exchange trading (Forex) that may otherwise be inaccessible to the everyday investor. Currency ETFs may hold cash deposits in the currency being tracked or use futures contracts on the underlying currency.

5. Real Estate ETFs

These ETFs typically track an index of publicly traded real estate investment trusts, or REITs, which are companies that own, operate or finance income-generating real estate. Investors that buy real estate or REIT ETFs are often seeking high-yielding investments.

6. Specialty ETFs

One of the advantages of ETFs is specialization in sectors and other niche areas of the market. For example, specialty ETFs may invest in a sector of the economy, such as technology, or a more narrow sub-sector of technology, such as Semiconductor ETFs or Artificial Intelligence ETFs. Other sectors include healthcare, industrials, consumer staples, consumer discretionary, financial services, and utilities.

ETFs vs. Mutual Funds

ETFs and mutual funds share some common features and benefits but there are also some noteworthy differences for investors to know. For example, ETFs and mutual funds are both baskets of securities packaged as a single fund but ETFs trade intra-day, whereas mutual funds settle at the close of the market.

Similarities

• Diversification: Both fund types invest in a basket of securities, which makes them less risky than individual stocks and bonds.
• Variety of choice: ETFs and mutual funds both cover a wide variety of asset types and security types for investors to choose from.
• Professional management: Although ETFs and index mutual funds are passively managed, both types of funds are overseen by a professional manager or management company.

Differences

• Trading: ETFs are priced and traded intra-day, like stocks, whereas mutual funds settle at the close of trading at the fund's net asset value, or NAV.
• Bid-Ask Spread: Since ETFs trade like stocks, there can be a range, or spread, between the ask price and the bid price. This spread can add to the cost of trading. Mutual funds don't have a bid-ask spread.
• Initial Investment Amount: ETFs can be purchased at the cost of one share. This is typically much lower than the minimum initial investment requirement of a mutual fund, which typically ranges between $1,000 and $3,000.

Tip: ETFs are not guaranteed investments. Although ETFs are generally less volatile than individual stocks, investors can reduce risk further by investing in a variety of ETFs from diverse categories, such as different types of equity ETFs, fixed-income ETFs, and commodity ETFs.

How to Invest in ETFs

One of the attractive qualities of investing in ETFs is that buying and selling shares is relatively easy. Because ETFs have been around for nearly 30 years, and they've risen dramatically in popularity since their inception, ETFs are standard products offered at most brokerage companies. The relative liquidity has given rise to a vibrant community of both ETF traders and investors.

Here's how to buy an ETF:

1. Choose a brokerage firm, such as a discount online broker like Charles Schwab, TD Ameritrade, or E*Trade, or a fund company like Vanguard or Fidelity, or an investment app like Robinhood.
2. Choose an account type, such as a joint or individual brokerage account, or a retirement account, like an IRA.
3. Open your account, which can take a matter of minutes online.
4. Add money to your settlement account, or core account, which is typically a money market account that receives and holds cash while it awaits trading in your brokerage account.
5. Choose your ETF, which can be done with the aid of an ETF screener.
6. Buy shares of the ETF, which is identified with a ticker symbol, by placing "buy" trade, selecting the number of shares to purchase, and submitting the trade during regular market hours, Monday through Friday, 9:30am EST to 4:00pm EST. This is largely the same as the process for buys company stocks.

Kent Thune