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Exchange-traded funds are a type of investment fund that offer the best attributes of two popular assets: They have the diversification benefits of mutual funds while mimicking the ease with which stocks are traded.
Exchange-traded fund (ETF) definition
An exchange-traded fund, or ETF, is a fund that can be traded on an exchange like a stock, meaning it can be bought and sold throughout the day. ETFs often have lower fees than other types of funds. Depending on the type, ETFs have varying levels of risk.
But like any financial product, ETFs aren’t a one-size-fits-all solution. Evaluate them on their own merits, including management costs and commission fees (if any), how easily you can buy or sell them, and their investment quality.
How do ETFs work?
An ETF works like this: The fund provider owns the underlying assets, designs a fund to track their performance and then sells shares in that fund to investors. Shareholders own a portion of an ETF, but they don’t own the underlying assets in the fund. Even so, investors in an ETF that tracks a stock index may get lump dividend payments, or reinvestments, for the stocks that make up the index. (Related: Learn how to invest in index funds, or compare index funds and ETFs.)
While ETFs are designed to track the value of an underlying asset or index — be it a commodity like gold or a basket of stocks such as the S&P 500 — they trade at market-determined prices that usually differ from that asset. What’s more, because of things like expenses, longer-term returns for an ETF will vary from those of its underlying asset.
Here is the abbreviated version of how ETFs work:
1. An ETF provider considers the universe of assets, including stocks, bonds, commodities or currencies, and creates a basket of them, with a unique ticker.
2. Investors can buy a share of that basket, just like buying shares of a company.
3. Buyers and sellers trade the ETF throughout the day on an exchange, much like a stock.
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ETF pros and cons
According to ETF.com (a subsidiary of the Chicago Board Options Exchange), $507.4 billion flowed into U.S.-listed ETFs in 2020. That number is up 55% from the inflows into ETFs in 2019. Investors have flocked to ETFs because of their simplicity, relative cheapness and access to a diversified product.
Pros of ETF investments:
Diversification: While it’s easy to think of diversification in the sense of the broad market verticals — stocks, bonds or a particular commodity, for example — ETFs also let investors diversify across horizontals, like industries. It would take a lot of money and effort to buy all the components of a particular basket, but with the click of a button, an ETF delivers those benefits to your portfolio.
Transparency: Anyone with internet access can search the price activity for a particular ETF on an exchange. In addition, a fund’s holdings are disclosed each day to the public, whereas that happens monthly or quarterly with mutual funds.
Tax benefits: Investors typically are taxed only upon selling the investment, whereas mutual funds incur such burdens over the course of the investment.
Cons of ETF investment:
Trading costs: ETF costs may not end with the expense ratio. Because ETFs are exchange-traded, they may be subject to commission fees from online brokers. Many brokers have decided to drop their ETF commissions to zero, but not all have.
Potential liquidity issues: As with any security, you’ll be at the whim of the current market prices when it comes time to sell, but ETFs that aren’t traded as frequently can be harder to unload.
Risk the ETF will close: The primary reason this happens is that a fund hasn’t brought in enough assets to cover administrative costs. The biggest inconvenience of a shuttered ETF is that investors must sell sooner than they may have intended — and possibly at a loss. There’s also the annoyance of having to reinvest that money and the potential for an unexpected tax burden.
5 Types of ETFs: Stock ETFs dominate the market
ETFs may trade like stocks, but under the hood they more resemble mutual funds and index funds, which can vary greatly in terms of their underlying assets and investment goals. Below are a few common types of ETFs — just note that these categories aren’t mutually exclusive. For example, a stock ETF might also be index-based, and vice versa. These ETFs aren’t categorized by management type (passive or active), but rather by the types of investments held within the ETF.
These comprise stocks and are usually meant for long-term growth. While typically less risky than individual stocks, they carry slightly more risk than some of the others listed here, such as bond ETFs.
» Related: 25 best performing high-dividend ETFs
Commodities are raw goods that can be bought or sold, such as gold, coffee and crude oil. Commodity ETFs let you bundle these securities into a single investment. With commodity ETFs, it’s especially important to know what’s inside them — do you have ownership in the fund’s physical stockpile of the commodity, or own equity in companies that produce, transport and store these goods? Does the ETF contain futures contracts? Is the commodity considered a “collectible” in the eyes of the IRS? These factors can come with serious tax implications and varying risk levels.
Unlike individual bonds, bond ETFs don’t have a maturity date, so the most common use for them is to generate regular cash payments to the investor. These payments come from the interest generated by the individual bonds within the fund. Bond ETFs can be an excellent, lower-risk complement to stock ETFs.
Foreign stocks are widely recommended for building a diverse portfolio, along with U.S. stocks and bonds. International ETFs are an easy — and typically less risky — way to find these foreign investments. These ETFs may include investments in individual countries or specific country blocs.
The U.S. stock market is divided into 11 sectors, and each is made up of companies that operate within that sector. Sector ETFs provide a way to invest in specific companies within those sectors, such as the health care, financial or industrial sectors. These can be especially useful to investors tracking business cycles, as some sectors tend to perform better during expansion periods, others better during contraction periods. Often, these typically carry higher risk than broad-market ETFs. Sector ETFs can give your portfolio exposure to an industry that intrigues you, such as gold ETFs or marijuana ETFs, with less risk than investing in a single company.
How to invest in ETFs
There are a variety of ways to invest in ETFs, and how you do so largely comes down to preference. For hands-on investors, investing in ETFs is but a few clicks away. These assets are a standard offering among the online brokers, though the number of offerings (and related fees) will vary by broker. On the other end of the spectrum, robo-advisors construct their portfolios out of low-cost ETFs, giving hands-off investors access to these assets. One trend that’s been good for ETF shoppers — many major brokerages dropped their commissions on stock, ETF and options trades to $0.
» Need some guidance? Learn how to invest in ETFs
Top low-cost ETFs
For all their simplicity, ETFs have nuances that are important to understand. Armed with the basics, you can decide whether an ETF makes sense for your portfolio, embark on the exciting journey of finding one — or several.
There are lots of great ETFs out there, but here are a few of the top picks from our list of the top-rated ETFs.
BNY Mellon US Large Cap Core Equity ETF (BKLC)
SoFi Select 500 ETF (SFY)
JP Morgan Betabuilders U.S. Equity ETF (BBUS)
iShares Core S&P 500 ETF (IVV)
» Check out our full list of the best ETFs
Disclosure: The author held no positions in the aforementioned securities at the original time of publication.