May 13, 2022
What Is an ETF? Definition and Guide
By Stash Team
Exchange-traded funds (ETFs) are collections of different securities, providing investors with a way to diversify their holdings with one purchase.
In this article:
An ETF, or exchange-traded fund, is a basket of securities you invest in, versus a single security like a stock or bond. ETFs are similar to mutual funds, but with key differences, and they can offer easy diversification and lower costs.
Exchange-traded funds (ETFs) definition
An exchange-traded fund (ETF) is a basket of securities. ETFs generally contain a mix of stocks, bonds, or a mix of both. They might also hold other kinds of investment classes, like commodities and real estate. When you buy shares of an ETF, you’re investing in the fund itself: the entire pool of securities held by the fund.
Investing in ETFs can often help diversify your portfolio, because each fund represents many investments, not just one company or security. Diversification may lower the risk of investing; if one stock in the fund falters, another could hold steady or increase in value.
Trading ETFs is simple; it works just like stocks. You can place an order to buy or sell through your brokerage at any time during the day when markets are open. When you purchase shares of mutual funds, in contrast, the trade isn’t actually executed until the end of the day, at whatever the share price is at that time. Since the share price of an ETF may fluctuate throughout the day, many investors see the ability to trade any time as an advantage.
How do ETFs work?
ETFs usually have a particular focus or objective, like matching the performance of an index, investing in specific sectors, or implementing a particular investing strategy. A growth ETF, for example, might focus on up-and-coming companies with rising share prices, while a fixed-income ETF might invest in bonds. The fund’s managers choose securities that match the fund’s goals.
To invest in an ETF, you purchase shares of the fund through a brokerage. You can trade your shares of an ETF any time during the market’s operating hours, though keep in mind that your brokerage may have a set schedule of times they execute trades throughout the day.
Ideally, you’ll earn a return by selling your shares at a profit later or receiving income like dividends or interest on bonds. Like any investment, it’s possible your shares could lose value, and some funds are riskier than others. Selecting ETFs in line with your risk tolerance can help you manage risk.
All funds have management costs, and the fund’s strategy can affect how much you pay. As a general rule, passive funds are less expensive than active funds. Here’s the difference:
- Passive funds aim to match a market index, like the Dow Jones Industrial Average or the S&P 500, and most ETFs fall into this category. Fund managers make investments that mirror the index, which minimizes the need for frequent trading. Thus, fees tend to be lower.
- Active funds seek to outperform an index or achieve some other goal. For example, a fund might attempt to track a market sector, like technology or healthcare. That typically requires more oversight from management, including trading, and which can translate into higher fees.
In addition to management fees, ETFs may come with other costs, such as commissions or bid/ask spreads.
Types of ETFs
There are thousands of ETFs available, and you can probably find one to complement almost any investment strategy. Here are some of the most common types.
Also called equity funds, these ETFs try to match a market index. Funds that reproduce index performance accurately could be lower-risk investments because they invest in a broad array of securities, leading to greater diversification.
Similar to a market ETF, these funds aim to match the overall performance of an index, but focus on a specific sector or industry, such as technology. These funds may offer diversification within a given sector, but if the entire sector’s performance falls, the value of the fund’s shares may also drop.
Even more narrowly focused than sector ETFs, these funds target a subset of a sector; for instance, the fund may invest in stocks related to esports or video games rather than technology overall. The narrow focus of these funds may tend to offer less diversification.
Also called fixed-income ETFs, these funds invest exclusively in bonds. Because bonds tend to be less volatile than stocks, they’re often considered lower risk. Bond ETFs might help you balance out riskier investments in your portfolio.
Commodities are raw materials such as oil, gold, and agricultural goods. Some commodity ETFs actually purchase the commodities, though this is limited to precious metals. Other funds invest in companies that produce or handle commodities; this can give investors exposure to commodities without the costs associated with physical possession of goods.
Foreign market ETFs
Like market EFTs, these funds attempt to mirror an index. The difference is that these target a non-U.S. index, like the Nikkei Index, an index of the Tokyo Stock Exchange. Foreign market ETFs could bring more geographic diversity to your portfolio.
Currency ETFs, also called foreign currency ETFs, track the relative value of one or more currencies. These funds can give investors exposure to trading currencies without the complexity and burden of trading on the foreign exchange market.
Unlike most other funds, these ETFs are designed to increase in price when a given market index declines in price. Inverse ETFs require active management, which may increase fees, and they tend to represent significant risk.
Pros of ETFs
Including ETFs in your portfolio can have several advantages:
- Built-in diversification: ETFs contain a basket of investments, which could cushion your portfolio from a single component that loses value.
- Many options: There’s an ETF available for almost any investment goal or interest, and you can get exposure to an entire sector through a single ETF.
- Potential for lower fees: Many ETFs are passively managed funds, which are often less expensive than actively managed funds.
- Intraday trading allowed: ETFs trade like a stock, so traders can buy or sell stocks any time during the day, with a chance of profiting off daily price changes.
Cons of ETFs
Before you invest, make sure you understand the potential downsides of ETFs:
- Diversity isn’t guaranteed: While ETFs contain many securities, they can be concentrated in one market segment or asset class, offering limited diversification.
- Fees can be higher: Passively managed ETFs typically boast lower fees than mutual funds, but some funds are actively managed and could have higher costs.
- ETFs can be risky: Although many see ETFs as lower risk than individual stocks, certain types can be high-risk, such as inverse ETFs.
How to invest in ETFs
The process for investing in ETFs is just like investing in stocks, and it’s relatively simple. In fact, many brokerages allow you to apply for and open an account entirely online, so you can start investing right from your phone.
Step 1: Open a investment account
You’ll need a brokerage account to purchase ETFs. There are many options available, from full-service brick-and-mortar firms to online and app-based platforms. Brokerages all have different fees, requirements, and options, so you may want to do a bit of research to decide what fits you best.
Step 2: Choose your investments
Once you have a few ETFs in mind, consider doing your homework before you buy. For example, you can read the fund’s prospectus and check its past performance. You might also investigate what fees the fund and your brokerage will charge.
Step 3: Make your purchases
With your account open and your picks mapped out, you’re ready to buy shares. Just place your order, and your brokerage will purchase shares based on your instructions.
Step 4: Monitor your portfolio
You’ll probably want to keep an eye on how your ETFs are performing; once a month is a good frequency for many investors. It’s normal for share prices to fluctuate somewhat, and the amount of volatility you can tolerate is a personal decision.
ETFs vs. mutual funds
ETFs and mutual funds are similar; both are funds consisting of several securities. But they have some important differences:
- Trading times: Mutual fund purchases are executed at the end of the day when the fund’s net asset value is calculated. So the share price could change, maybe significantly, between when you place an order and when it’s executed. ETFs, on the other hand, trade throughout the day.
- Fees: Mutual funds often charge load fees and 12b-1 fees, though this is not always the case. ETFs don’t charge those fees, although they do generally have some costs.
- Disclosures: Mutual funds typically disclose their holdings quarterly; many ETFs disclose them daily.
ETFs vs. stocks
While ETFs may contain stocks, they are distinct from individual stocks. Here’s how:
- Diversification: A share of stock is a piece of ownership in one company, while an ETF represents many companies or other securities. So ETFs may protect investors from a particular business’s difficulties; hopefully, one falling stock price will be balanced out by others that hold steady. This sort of built-in diversification, however, is reduced if the ETF focuses only on one sector or type of security.
- Voting rights: Some stocks come with privileges like the right to vote on major company decisions; ETFs do not.
- Fees: Unlike stocks, most ETFs have management fees; the fees for passively managed funds tend to be lower than actively managed funds.
Should you invest in ETFs?
When deciding where to invest your money, “What is an ETF?” is a smart question for a new investor to ask. ETFs are generally considered a good choice for beginners because they tend to have lower fees, can add diversity to your portfolio, and offer options for many investment styles. For example, someone with a moderate risk profile might add a lower-risk bond ETF to their portfolio to balance riskier stock investments. It’s important, however, to understand the potential pitfalls so you can make choices that match your risk tolerance and financial goals. With a little know-how and research, you may find ETFs that are a good fit for your portfolio.
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1. Are ETFs good investments for beginners?
They can be. ETFs offer some diversification in a single purchase, they are often less expensive than mutual funds, and there’s one for virtually any investment strategy.
That said, not all ETFs are created equal. Some are quite risky, and not all add meaningful diversity to a portfolio. As with any investment, it’s important to fully understand an ETF before buying shares.
2. What is a leveraged ETF?
A leveraged ETF is a high-risk, short-term investment that uses borrowed money and derivatives to amplify a market index’s performance. Both gains and losses are multiplied. Leveraged ETFs tend to have relatively high fees and can lead to fast, significant losses.
3. Are ETFs safer to invest in than stocks?
It depends. For example, a market or index ETF is likely less risky than any given individual stock, because it relies on the performance of many companies, rather than just one. If one company’s value falls, others may rise, shielding you from the struggling company’s price dip. On the other hand, a leveraged ETF is probably riskier than buying shares of a long-established company with many decades of stable performance.
As a general rule, a basket of stocks tends to be less risky than an individual stock, but it’s important to research any investment before buying.
Investment advisory services offered by Stash Investments LLC, an SEC registered investment adviser. Investing involves risk and investments may lose value.
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