Exchange-Traded Fund (ETF): Definition, Pros, Cons & Examples
What is an Exchange Traded Fund (ETF)
Exchange-traded funds, known as ETFs, is an investment fund which offers shares on the stock-market. Generally, ETFs specialize in an area such as tracking the FTSE 100 or S&P 500. However, they can come in all shapes and sizes ranging from cryptocurrencies to bonds and gold.
ETFs can also come in the form of multi-asset ETFs whereby a basket of assets are held. For instance, some ETFs may have a selection of stocks and bonds in its portfolio. This helps to diversify against risk in the associated markets.
When understanding what an ETF means, it may be useful to break it down. Exchange-traded means that it is readily traded through the exchange system. In other words, the stock market. Now a fund is essentially a basket of stocks, bonds, or other assets which use pooled together resources to buy. So an ETF is an investment fund that is easily bought or sold via the stock market.
- An Exchange Traded Fund (ETF) is an investment fund which is readily traded on the stock-market.
- ETFs offer a wide range of options from tracking an index (e.g. S&P 500), to commodities and bonds.
- As ETFs are readily available on the stock-exchange, they have become easily accessible with low fees, which has accelerated its popularity.
The term Exchange-traded fund can be defined by its parts. ‘Exchange-traded’ simply means that it is readily exchanged by investors over the stock market. This is unlike other funds such as mutual funds which are not so easily and readily traded. For instance, mutual funds trade only once per day after the market closes. By being on the stock market, ETFs can be bought at sold at any time during the day, making it easily accessible and liquid.
As an ETF is a type of investment fund, it holds many types of assets. For instance, it holds many funds rather than just one. This helps achieve diversification against potential risk, which has proven popular with investors. As part of this diversification, some ETFs may have an international focus. For instance, some may invest in the US stock market as well as emerging market stocks.
Other ETFs may have a more domestic focus, for instance, following the S&P 500. Others may even go further and focus on specific markets such as Bitcoin, banking, or gold. These come with greater risk due to the exposure to one asset, but can also present better returns.
There are also multi-asset ETFs which diversify into many asset classes such as bonds, stocks, commodities, and other variable assets. These are generally seen as safer investments because of the greater diversity, but the returns may also be lower due to the lower levels of risk.
What makes an ETF unique is that it is readily available on the stock market alongside a marketable price. It’s easily bought and sold on the market during the day, which is not common for investment funds. Investors can see its market price go up and down during the day and trade them at any point. Yet ETFs are not just available to specialist investors, but the public can also invest in these through an easily accessible brokerage.
Types of ETFs
ETFs come in all shapes and sizes ranging from multi-asset ETFs to more specific ETFs such as industry specific ETFs like banking or mining. Some examples of the types of ETFs can be seen below. This list is by no means comprehensive, but covers the most popular ETFs on the market.
Passive and Active ETFs
ETFs can come as either passive or active funds. Passive ETFs essentially follow a set index or market. For example, a passive ETF would look to purchase stocks in the S&P 500. Or, it may look to invest in gold. Either way, passive ETFs require little in the way of human management or intervention. As a result, they tend to have lower fees.
By contrast, actively managed ETFs come with a large number of fund managers who make decisions on what investments are best for the portfolio. We can look at active ETFs as a higher-risk high-reward investment. The aim is generally to beat the broad ranging passive ETFs such as the S&P 500 and receiving greater returns on investment.
Active ETFs may look at more lucrative assets, but these may also come with more risk. So actively managed ETFs may produce better results, but may also produce greater losses.
Bond/Fixed Income ETFs
Bond ETFs are generally seen as lower risk options which help to diversify an investment portfolio. They provide investors with regular streams of income through investments in assets such as government bonds, corporate bonds, or state and local bonds.
Whilst bonds have an expiry date, bond ETFs don’t expire. Instead, they can be bought from the open market to expand the fund and/or replace expired bonds. This helps the managers of bond ETFs maintain a steady stream of income for investors, whilst obtaining profit bond prices that may fluctuate on the market.
Stock ETFs look at the stock market and diversify within various market places. This might be in a single industry or sector, or in a certain index such as the S&P 500 or FTSE 100. The idea behind this type of ETF is to invest in specific markets but in a way by which risk is spread out.
For instance, investors in the tech industry may see the likes of Google in their portfolio. However, there’s a risk that those big companies eventually come crashing down at some point. So there is an element of diversification into smaller up and coming stocks which may provide great returns.
Industry sectors ETFs are where the fund is invested purely in the stocks and securities of specific industries. This differs from stock ETFs in the fact that it also invests in other securities such as bonds and options.
One of the ideas behind industry ETFs is to benefit from the business cycle. For instance, financial industries tend to do well in the recovery stage whilst consumer goods tend to do well during the boom phase. Industry specific ETFs allow investors to benefit from the industry uplift during these phases. However, a significant level of market knowledge is required and amateur investors must be careful when investing in such a way.
Commodity ETFs are exactly what it says on the tin. It invests in commodities ranging from crude oil to gold and iron ore. Some specialise in specific commodities such as gold, whilst other ETFs diversify through various commodities.
This type of ETF can be beneficial during periods of economic uncertainty whereby the stock market is extremely volatile. Instead, commodity ETFs offer somewhat of a safe haven to help hedge against the ups and downs. At the same time, it provides an easy way into the commodity market which would otherwise be unobtainable to the average investor.
Currency ETFs can be bought or sold over the stock market whilst they track the ups and downs of the foreign exchange market. These can be bought for individual currencies. For example, there is a Swiss Franc ETF, which may be suitable if investors believe it will increase in value.
There are also currency ETFs that come in a basket of various currencies. These generally track major currencies like the US Dollar against a multitude of other currencies such as the Euro, Japanese Yen, or Great British Pound. These can potentially help investors mitigate currency fluctuations against other investments which can help reduce risk.
Inverse ETFs are funds that bet against stocks – otherwise known as ‘shorting stocks’. This is where investors bet against a share price. In other words, they gain money from the stock price declining in value. This works by the investor ‘borrowing’ shares. They then sell those shares, but must return those at a later date. If the price goes down, they can repurchase them and return the borrowed shares at a profit.
A leveraged ETF uses debt to ‘leverage’ the fund and increase returns for its investors. For example, a 1 percent rise in the S&P 500 would return 2 percent for investors with a leverage rate of 2. This is done using derivatives such as options or futures to leverage these returns.
These types of ETFs can be incredibly risky. There is a substantial upside if the ETF does well. However, there is also a substantial downside. These ETFs tend to have higher management fees and also come with interest payments for the debt. This makes this type of ETF a high risk, high reward option that should be taken with caution.
Factor ETFs, also known as ‘smart beta’ is where investment focuses of specific ‘factors’. The factors include elements such as yield, value, low volatility, momentum, and size, among others.
These factors are said to explain much of the gains that occur in investment. However, these can often be cyclical. For example, during periods of slow growth, investors may look towards investments with a high yield.
Sustainable ETFs are exactly what the name would suggest. These are ETFs that take a sustainable approach to its investing. It takes a usual investment approach, but looks at factors such as environmental, social, and governance to guide its investments.
These ETFs have become increasingly popular, driven my government policies and a shift in public perception. At the same time, investments in unsustainable areas can create a negative public perception.
Pros and Cons of ETFs
Advantages of ETFs
ETFs are readily exchanged during the day. These vary throughout the day as the value of its underlying assets go up and down. This provides greater transparency than other funds as investors know exactly what they are paying rather than waiting till the end of the day as with mutual funds.
One of the main advantages of ETFs are that they can easily be traded at any time of the day. By contrast, mutual funds are only traded once at the end of each day once the markets close. In addition, investors only find out the price at the end of the day when the fund’s net asset value is known. Only then do they know the price which is paid. This might be feasible for long-term investors, but some will favour this flexibility.
ETFs allow investors to diversify their investment rather than purchasing one stock. For instance, an ETF that tracks financial services allows the investor to diversify throughout the market. Instead of owning one company, they have an investment in the whole industry which will provide greater stability.
At the same time, there are ETFs which can offer greater diversity through investments in stocks and bonds. This can spread out the risk even further through different markets.
ETFs are extremely liquid. Investors can buy and sell them in an instant as they’re readily traded via the stock-exchange. This allows investors to dip in and out of various ETFs throughout the day. This makes it extremely easy to move money between assess classes such as stocks, bonds, or commodities. For day traders, this can be extremely effective in riding the waves of the ups and downs during the market hours.
To buy an ETF, an investor just needs to open a brokerage account and off they go. There’s no minimum payment and no paperwork, unlike some other funds. This allows even amateur investors to buy equities in some of the wide-ranging markets that are available.
It opens up markets that are tricky for the average investor to enter. For example, gold, corn, and oil are areas where it’s not so straight forward for the average investor to enter. Instead, they can purchase an ETF which tracks such markets with little effort.
As ETFs generally ‘track’ indices ranging from the FTSE 100 to the US financial sector – it is rather low maintenance. This means that it requires very little effort in terms of a fund manager and management team. Thus, the fees for such are generally lower than comparable products.
It can also prove cheaper than buying the stocks individually. For example, each transaction usually comes with a small fee. So to buy 5 stocks will occur that fee 5 times, whilst buying an ETF will only occur a one-off fee.
This can depend on the type of ETF, but in general, most can help reduce risk – although not eliminate it. Those that track indices such as the FTSE 100 or S&P 500 are often seen as low risk. These tend to generally rise over an extended period of time, whilst specific stocks may just tank.
Limited Capital Gains Tax
Mutual funds require any capital gains to be distributed to shareholders when a profit is made. These returns are then liable for capital gains tax. Yet ETFs are more tax-efficient because fewer capital gains are realized. Instead, these are often re-invested into the fund rather than distributed to shareholders.
Disadvantages of ETFs
Although ETFs generally have lower fees than alternatives such as mutual funds, it must be noted that they do occur transactional fees. When buying through a brokerage, there are usually associated fees that they charge. These can range between $8 to $30 per transaction. For small casual investors, this may affect some of their margins if they are investing only modest amounts. However, some brokers offer a cap after x number of trades, which can limit the cost.
The vast majority of ETFs are passively managed. Yet there are still small management fees that occur due to normal operation of the fund. The fee that is charged is known as the funds operating expense ratio (OER). This fee is paid to the fund each year and covers expenses ranging from employee salaries, marketing costs, to the fund manager’s expertise.
Whilst mutual funds tend to charge higher fees, there is still a cost to be aware of. These may prove to make an investment less lucrative than some other investment options, with fees averaging at around 0.5 percent. For actively managed funds, this may be even higher.
Low Trading Volume
One of the main issues with ETFs is that the trading volumes are generally quite low. When comparing to stocks in the leading indices, it is night and day. For some specialist ETFs, investors may struggle to sell due to a lack of demand in that specific sector. Furthermore, the bid-ask spread is likely to be unfavorable, with investors unable to obtain the price they expect.
ETF managers will try and keep the fund in line with the underlying indices or equities it is associated with. The issue that occurs is that the fund can end up deviating away from the intended benchmark. For example, some companies may drop out of the FTSE 100, with other companies replacing it. The fund then has to liquidate the fund that dropped out, whilst purchasing the fund that has entered.
The issue with this is that the fund that has dropped out may drop further, whilst the stock entering the index may increase in value. At the same time, it must sell the old stock and purchase the new ones. This may create some deviation from the overall index.
Potentially Less Diversification
Most ETFs will offer a good deal of diversification as they contain a multitude of different securities across various assets classes. However, there are some ETFs which are more focused on a specific sector. For example, some focus on gold which doesn’t have a great deal of diversification as it’s purely one commodity. There are also others which focus on specific industries such as the financial sector. Now this offers slightly more diversification than gold, but again, leaves the investor at the whim of cyclical fluctuations.
ETFs come in all shapes and sizes. Some are relatively straight forward such as gold. Others are more complex and use multi-assets where the associated risk may not be so clear and obvious. These may contain stocks, corporate bonds, and commodities. For the average investor, this may be difficult to obtain the necessary cost-benefit analysis.
Lack of Liquidity
Whilst ETFs are more liquid than some alternatives such as mutual funds, they can also lack liquidity at times. Liquidity is where an investor can readily sell an asset in return for cash. The issue with ETFs is that they are usually traded at low volumes – meaning it can prove difficult to sell quickly at times. Certain types of ETFs have greater liquidity issues than others. For those who have a short-term focus, this can prove a key factor when choosing a suitable option. Those with higher trade volumes may prove more popular as they can quickly be sold if markets turn.
Lower Dividend Yield
For investors looking for a steady dividend yield, an ETF may not necessarily be the best option. This is because high dividend stocks can become diluted by other low paying stocks that are included within the fund. Therefore, the average yield is brought down.
Issues of Control
To a certain degree, ETFs are part of a passive investment strategy. Instead, investors rely on fund experts and indexes for returns. Whilst there is an element of control in regards to choosing a suitable ETF, it doesn’t offer the same level of control as buying individual stocks does.
The vast majority of ETFs track some kind of index, sector, or commodity. This means that it won’t outperform the overall market – at least in the majority of cases. A S&P 500 tracker won’t provide better results than the overall market, because that’s the whole point.
However, such funds do provide greater security and lower levels of risk. For those who want higher returns, they may pick specific stocks, but this can come at a greater risk. So although the returns might be average, they can also lower risk in comparison.
Below are some examples of ETFs on the market. These are wide ranging and show a list of some of the most popular options. However, whilst these are popular and well traded, they do come with varying levels of risk. This list should not be taken as a recommendation or advice, but purely as an educative example of some of the leading players in the market.
- The SPDR S&P 500 (SPY) this ETF is among the oldest, running back to its origins in 1993. It tracks the S&P 500 Index.
- ProShares UltraPro QQQ (TQQQ) among the most popular leveraged ETF options on the market. This ETF offers 3x daily long leverage to the NASDAQ-100 Index, making it a good option for those with a short-term outlook.
- ProShares UltraPro Short QQQ (SQQQ) another popular leveraged ETF option, but one that uses leverage to short stocks on the NASDAQ-100 Index.
- ProShares Ultra VIX Short-Term Futures ETF (UVXY) this fund invests in short-term future commodities contracts. One of the most popular among commodities.
- iShares Russell 2000 (IWM) this fund tracks the Russell 2000 small-cap index.
- iShares iBoxx $ High Yield Corporate Bond ETF (HYG) founded in 2007, this fund looks to replicate a benchmark which represents the U.S. dollar-denominated high yield corporate bond market.
- iShares MSCI Emerging Markets ETF (EEM) founded in 2003, it’s one of the oldest funds on the market. It offers investors exposure to stock markets in emerging economies, namely the BRICs (Brazil, Russia, India, China)
- Invesco QQQ Trust (QQQ) founded in 1999, this fund tracks the Nasdaq 100 Index. Its holdings generally include tech stocks ranging from Apple and Google to Amazon and Microsoft.
- There are various high-dividend yielding ETFs such as Multi-asset (RYLD), MLPs (AMLP), and S&P 500 (JEPI).
ETFs vs Mutual Funds vs Stocks
ETFs and mutual funds are very similar in a number of ways. However, ETFs also have similarities with Stocks – namely in the fact that they are readily exchangeable on the stock market. There are many similarities and differences between the three. Some of which can be seen in the table below:
|Exchange-traded funds (ETFs) generally track an index or a group or securities. They use pooled resources to purchase a number of securities such as stocks, bonds, commodities, and other assets.||Mutual funds also use pooled resources to purchase securities such as stocks, bonds, commodities, and other assets.||Stocks are shares of a company that are readily exchangeable on the stock market.|
|ETFs are easily exchangeable on stock market||Mutual funds only trade once at the end of the day||Stocks are readily exchangeable on stock market|
|Some ETFs are commission-free and are cheaper than mutual funds because they do not charge marketing fees. However, a brokerage fee may be charged.||Mutual funds tend to be more expensive as they charge administrative and marketing fees.||Only charge to stocks are that due to the relevant brokerage.|
|Investors in ETFs don’t own the stocks.||Mutual funds own the stocks in their basket.||Stocks involve the actual ownership of a company.|
|ETFs diversify risk by investing in different securities and industries.||Mutual funds diversify by investing in various asset-classes.||Risk is concentrated to the specific company in which stock is held.|
|As ETF trading is done in-kind, they cannot directly be redeemed for cash.||Shares in mutual fund can be cashed out at the end of the trading day.||Stocks are readily bought and sold for cash.|
|As ETF shares are treated as in-kind, they benefit from lower levels of tax.||Mutual funds offer tax benefits when they return capital or include certain types of tax-exempt bonds in their portfolio.||Stocks are taxed by the investors income tax rate, or through capital gains tax.|
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FAQs on ETFs
It is generally accepted that the first exchange traded fund (ETF) was the SPDR S&P 500 ETF (SPY), which was founded on January 22nd in 1993 by State Street Global Advisors.
ETFs and an index fund can be relatively similar in the fact that both hold and track stocks in an index. However, ETFs have greater liquidity, as it is essentially a stock itself. There are also various cost-benefits such as lower taxes associated with ETFs. They can be brought directly from the stock exchange throughout the day, whilst index funds can only be brought at the end of the trading day.
ETFs have become increasingly popular over the years, with hundreds of new options appearing each year. Since 2003, the total number has risen from 276 to over 8,552 in 2021.
ETFs are created through an investment company such as iShares, Invesco, and Vanguard. These companies then manage and sell shares to investors. The investors in those ETFs won’t actually own those shares, but instead act as a pooled resource and will therefore also be eligible for dividends.
All that an investor needs to do to invest in an ETF is open a brokerage account. This will grant access to various stock exchanges where thousands of ETFs are easily accessible.
Paul Boyce is an economics editor with over 10 years experience in the industry. Currently working as a consultant within the financial services sector, Paul is the CEO and chief editor of BoyceWire. He has written publications for FEE, the Mises Institute, and many others.