Introduction to Exchange-Traded Funds (ETFs)

Exchange-traded funds (ETFs) were introduced in the early 1990s and have proven a durable and popular investment for many. As a result, they have expanded greatly, both in number and what they focus on over time.

An ETF is like a mutual fund, but there are major distinctions between them. Both save you the time-consuming work of analyzing companies and picking stocks, though mutual funds often tend to be less tax-efficient and have higher management fees.

Below, we introduce you to ETFs, explain why they've proven so popular, discuss the benefits and drawbacks that come with them, and describe what to look for when choosing among them for your portfolio.

What Is an Exchange-Traded Fund?

ETFs combine features of both mutual funds and stocks. Like mutual funds, they offer investors an interest in a professionally managed, diversified portfolio of investments. However, unlike mutual funds, ETF shares trade like stocks on exchanges, with prices fluctuating throughout the day based on market demand.

For example, certain ETFs track the S&P 500 or the Barclays Capital U.S. Aggregate Bond Index, which invests in securities in those indexes. But an ETF isn't a mutual fund. Instead, it trades like the shares of a company stock on a public exchange. And, unlike a mutual fund with its net asset value (NAV) calculated at the end of each trading day, an ETF's price changes throughout the day, fluctuating with supply and demand.

While ETFs attempt to replicate the returns on indexes that they track, there is no guarantee that they will do so exactly since each fund has a slight tracking error or difference between how the index would perform and how the ETF does.

ETFs have grown their assets tremendously, increasing from a negligible amount of total U.S. fund assets to about 30% in late 2023, with much of the rest taken up by mutual funds. Below is a chart of their growth in assets since 2010.

ETF Advantages

Diversification: ETFs offer investors instant diversification, whether across the broad market, asset classes, market sectors, or specific industries.

Accessibility and flexibility: Because ETFs trade like stocks, you can buy and sell them anytime during a trading session. You can also short sell them and buy on margin.

Low fees: The expense ratios of most ETFs are lower than those of the average mutual fund. The average expense ratio for an index ETF was 0.16% in 2022. As of 2024, the SPDR S&P 500 ETF (SPY) had an expense ratio of 0.09%.

Liquidity: Popular ETFs are highly liquid. This means they can be sold easily and at a narrower bid-ask spread.

Tax efficiency: Because of their passive management, ETFs usually have fewer capital gains, which means investors may pay less in taxes. In addition, in-kind (as opposed to cash) exchanges for an ETF's securities also result in less capital gains.

ETF Disadvantages

Additional costs: While ETFs may have low expense ratios, you may have other charges related to buying and selling ETFs, such as broker commissions/transaction costs. Moreover, you can expect higher expense ratios if you invest in an actively managed ETF. In addition, the bid-ask spread for an ETF presents a hidden cost for investors.

Excess trading: Because ETFs can be bought and sold intraday, investors may forget their investment goals and trade them unnecessarily in reaction to attention-grabbing news reports or unsupported rumors.

Potentially lower returns: The diversification that makes ETFs (and mutual funds) a smart way to reduce risk can also mean that returns might be less than those obtained by actively selecting and owning individual stocks.

Types of ETFs

ETFs are the most common type of exchange-traded product and typically include baskets of stocks, bonds, or other assets grouped based on the fund's specific goals. Here are some of the major types you'll see as you explore this landscape, though there are hybrid ETFs that hold more than one kind of asset, and funds overlap categories. Let's first review the two broadest categories before looking at the different strategies ETFs can be based upon. Then, we introduce the categories you'll see most often as you look through your brokerage's platform. There's also a table putting the basics of each together.

Actively Managed ETFs

Unlike most ETFs, which passively track an index, these have portfolio managers who actively buy and sell securities to try to outperform a benchmark. In 2023, these made up about 15% of the ETFs trading.

Passive Index ETFs

The first ETF in the U.S. was the SPDR S&P 500 ETF Trust (SPY), which began trading in 1993 and tracks the performance of the S&P 500 by buying the same 500 stocks and weighting them proportional to the index. Like SPY, index ETFs track the performance of a specific market index, such as the S&P 500 or the Dow Jones Industrial Average. Index funds are by far the most popular, making up over 4/5s of the assets under management in the U.S.

Another example is the Invesco QQQ (QQQ) ETF, which tracks the Nasdaq 100 and consists of the 100 largest and most actively traded nonfinancial domestic and international companies on the Nasdaq. It offers investors broad exposure to the tech sector. Its diversification can be a big advantage when there's volatility in the markets. If one tech company falls short of projected earnings, it will likely be hit hard, but owning a piece of a hundred other companies can cushion that blow.

ETF Type by Asset

Within these broad categories, you'll find funds that focus on different assets.

Bond ETFs

These hold one type or a variety of bonds, providing investors with exposure to fixed-income securities. There are several subcategories of bond ETFs, each focusing on different types of bonds. Government bond ETFs invest in Treasurys and other government securities, offering exposure to debt issued by national governments. Corporate bond ETFs focus on corporate debt securities, and, lastly, high-yield bond ETFs invest in lower credit rating bonds that offer higher yields, but also come with increased risk compared with government or high-quality corporate bonds.

Bond ETFs offer diversification and the potential for generating income, making them attractive to investors looking to put a portion of their portfolio into fixed-income securities.

Commodity ETFs

These invest either directly in physical commodities, such as gold, silver, or oil, or in commodity futures contracts. They offer exposure to commodity markets without the need for direct investment in the underlying assets.

For instance, if you think that natural gas companies are a good prospect, you might consider a fund like the United States Natural Gas Fund (UNG). This ETF tracks natural gas prices by buying natural gas futures contracts.

Crypto ETFs

These track the performance of one or more cryptocurrencies, such as Bitcoin. The U.S. Securities and Exchange Commission (SEC) has expressed concerns about market manipulation, liquidity, and the custody of assets on crypto exchanges. This kept futures-based crypto ETFs off U.S. exchanges until 2021, when ProShares Bitcoin Strategy ETF (BITO) was approved. The approval of Bitcoin futures ETFs, like the ProShares Bitcoin Strategy ETF, marked a significant regulatory breakthrough and set a precedent for other futures-based crypto ETFs. They were approved under the idea that futures markets are more regulated and thus offer higher levels of investor protection than spot cryptocurrency markets.

In January 2024, the SEC relented and allowed the first spot bitcoin (BTCUSD) ETFs to begin trading. This set off massive buying of bitcoin in the first few months of trading, sending it up about 60% in value in the first quarter alone. In a surprise move, on May 23, 2024, the SEC approved the application of three major exchanges—Nasdaq, CBOE, and NYSE—to list ETFs tied to the price of ether. Major investment houses like Fidelity and BlackRock have since been approved for spot ether ETFs, which began trading on U.S. exchanges in July 2024.

Currency ETFs

Currency ETFs are exchange-traded funds that have exposure to foreign exchange markets, allowing investors to trade currencies much like stocks. They track a single currency or basket of them, offering a way to speculate on currency moves or hedge against currency risk.

Investors use currency ETFs to diversify their portfolios beyond traditional asset classes, speculate on economic conditions in different countries, or hedge against currency fluctuations in export and import-driven businesses.

Equities ETFs

These focus on stocks from major indexes like SPY, sectors like health care, or offer dividends. They can also choose to invest in companies with different market capitalization or specific themes, like artificial intelligence, which might involve companies across different sectors. These have, by far, the largest market share in ETFs.

Real Estate Investment Trust (REIT) ETFs

These invest in a portfolio of REITs, giving you exposure to the real estate market without having to buy properties directly. The REITs whose shares the fund holds generally generate income through leasing space and collecting rents, which they then distribute to shareholders as dividends. REIT ETFs are popular for their potential to provide stable income and diversification benefits, as real estate often moves independently of stocks and bonds.

ETF Type by Strategy

Having looked at the kinds of assets that might be involved, we can now turn to the strategies different ETFs use.

Dividend ETFs

These funds focus on dividend-paying stocks across various sectors and provide regular income and the potential for capital appreciation. These ETFs are especially attractive to income-seeking investors, including retirees, because they distribute the dividends they collect from their underlying stock holdings to their shareholders.

Dividend ETFs can vary by targeting high dividend yields, dividend growth, or stability, which allows you to choose a fund that fits your income needs and risk tolerance.

Environmental, Social, and Governance (ESG) ETFs

These funds have been gaining market share among investors looking to make socially responsible investments. They apply ESG criteria to select stocks, aiming to invest in companies with responsible practices. However, they can vary widely in focus. Some target low-carbon emission firms, while others focus on specific themes in sustainable or other ways to have a beneficial social impact.

Global ETFs

These hold a broad range of securities from countries outside the U.S., providing exposure to international markets. Some focus on mature and growth-oriented markets, enabling you to diversify beyond your country's borders. This type of ETF particularly appeals to those looking to mitigate country-specific risks and capitalize on prospects in foreign markets. For example, if you were interested in gaining exposure to some European stocks through the Austrian market, you might consider the iShares MSCI Austrian Index fund (EWO).

For emerging markets, an example includes the iShares MSCI Emerging Markets Index (EEM), an ETF created as an equity benchmark for international securities.

Leveraged and Inverse ETFs

Not every ETF is designed to move in the same direction or even in the same amount as the index it tracks. The prices of inverse ETFs go up when the markets go down and vice versa. They can be very useful to those investors interested in hedging portfolio risk. By buying shares in them, you're hoping to profit when the underlying index or benchmark falls. Leveraged ETFs amplify both gains and losses. Inverse ETFs, meanwhile, aim to profit from a decline in the underlying index, providing negative exposure that is typically equal to -1, -2, or -3 times the daily performance.

These ETFs use financial derivatives like futures, options, and swaps to achieve their goals. For example, the Direxion Daily Financial Bear 3x Shares (FAZ) is a triple bear fund. It attempts to move 300% in value in the opposite direction of the Financial Select Sector Index. It uses derivatives and other types of leverage to boost its performance returns. However, because of their complex nature and the risks of compounding effects over longer periods, leveraged and inverse ETFs are best suited for experienced investors who understand the potential for rapid and significant value changes.

Options-Based ETFs

These use options strategies for potential income generation, downside protection, or magnified returns compared with traditional index-tracking investments. An option is a financial derivative that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price, known as the strike price, on or before a specific date. Call options give the holder the right to buy an asset at the strike price within a particular time frame. Put options give the holder the right to sell the underlying asset at the strike price within a specific time frame.

A common options-based strategy is the covered call, where the ETF holds an underlying asset and sells call options on it, generating income from the option premiums. Other methods include using put options for hedging or combining options for specific risk and return profiles.

Preferred Stock ETFs

These are funds that hold a type of stock that shares characteristics of both equity and debt instruments. Preferred stocks come before common stocks for dividend payments and asset distribution in case of liquidation, but they usually don't carry voting rights like common stocks. They typically have higher dividends than common stocks and even some bonds, making preferred stock ETFs attractive for income-seeking investors.

While generally less volatile than common stock, preferred stock ETFs can be sensitive to changes in interest rates. Like bonds, their prices typically fall as interest rates rise. Among the better-known funds is the iShares U.S. Preferred Stock ETF (PFF), which holds a portfolio of diverse U.S. preferred stocks. It has assets of about $15 billion, an expense ratio of 0.46%, and five-year returns of 3.01%.

Preferred stock ETFs are suited for institutional investors wanting higher yields than those typically available from corporate bonds, with a moderately higher risk profile. They serve as a good tool for diversifying an income-generating portfolio, especially in a low-interest-rate environment when traditional fixed-income instruments may have lower yields.

Sector or Industry-Specific ETFs

These focus on technology, health care, energy, and other parts of the economy. This allows you to gain targeted exposure to specific market areas that interest you. For example, if you're bullish on people having excess money for consumer goods, you might invest in a sector ETF to gain exposure to firms in the sector.

These ETFs are also useful for diversifying without having to select individual stocks. In addition, sector funds can serve as a hedge against sector-specific risks and are valuable for thematic investing, where the investor can take positions based on expected economic shifts or trends affecting particular industries.

Volatility ETFs

These funds track volatility indexes, most commonly the CBOE Volatility Index (VIX). The VIX measures the stock market's expectations of volatility using S&P 500 index options. Volatility ETFs are typically used as trading instruments for hedging risk or speculating on changes in market volatility rather than long-term investing.

Factors To Consider When Investing in an ETF

When reviewing specific funds, there are several of the main factors to review first:

Objectives and strategies: Understand the ETF's investment objectives and strategies. Consider whether it aligns with your own goals, risk tolerance, and time horizon.

Underlying assets: Look at the ETF's holdings and asset composition. Ensure that you understand what the ETF is invested in and you're comfortable with the risks it involves.

Expense ratio: This is the annual fees charged by the fund. Lower expense ratios can help keep costs down and improve your overall returns.

Tracking error: For index-tracking ETFs, consider the tracking error, which measures how closely the ETF's performance matches that of its underlying index. A lower tracking error indicates better accuracy in replicating the index's returns.

Liquidity: Look at the ETF's trading volume and bid-ask spread. Higher trading volume and narrower spreads generally indicate better liquidity, making it easier to buy and sell shares at a fair price, both when entering and exiting from your position in it.

Issuer and fund size: Consider the reputation and financial stability of the ETF issuer. In addition, review the fund's total AUM, as larger funds may have better liquidity and lower operating costs.

Performance history: While past performance doesn't guarantee future results, reviewing an ETF's historical returns can help you consider how it's done in various market conditions.

Portfolio fit: Assess how the ETF fits within your overall investment portfolio. Ensure that it contributes to the asset allocation you want and helps you maintain proper diversification.

Tax implications: Be aware of the tax implications of investing in the ETF, such as capital gains distributions or tax treatment of dividends. This can help you manage your tax liability more effectively.

Before investing in any ETF, always review its prospectus and related documents to gain a broad understanding of its goals, risks, fees, and other characteristics.

The Bottom Line

ETFs combine features of both mutual funds and stocks. They are listed on stock exchanges and can be bought and sold throughout the trading day like individual stocks. ETFs typically track a specific market index, sector, commodity, or other asset class, providing investors with exposure to a diverse range of securities in a single investment. Their benefits include liquidity, lower expenses than mutual funds, diversification, and tax advantages.

When considering an ETF, review its goals and strategy, underlying assets, expense ratio, tracking error, liquidity, issuer and fund size, performance history, risks, and how it fits within your overall portfolio.