What is an ETF?

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Updated on Thursday, January 24, 2019

As an investing category, exchange-traded funds, commonly referred to as ETFs, are experiencing something of a boom. Between January and November 2018, fund managers added 575 new ETF offerings, according to research in Pensions & Investments, compared to the 458 funds that were added the year before.

But what is an ETF?

At its most basic, an ETF is a lot like a mutual fund. It’s a basket of investments put together to achieve some kind of goal or exposure — such as a group of stocks that track a particular index or that represent a specific industry. When you buy a share of an ETF, your money is distributed among those investments.

The difference between an ETF and a mutual fund are in how these investments are traded. When you buy or sell a mutual fund share, the sale or purchase of your shares happens at the end of the day, no matter when you put your order in. What you pay per share is determined by the price of the shares at the end of the day.

With an ETF, shares are bought and sold like a stock. “They trade throughout the day, and the prices move up and down, based on what the underlying stocks are doing inside of the ETF,” said Mark Beaver, a financial planner in Dublin, OH.

Pros and cons of ETFs

There are a variety of advantages to ETFs. First, they tend to be low-cost because the majority of them are passively managed, meaning a computer does the buying and selling based on an algorithm. That may be because managers of ETFs must disclose what the fund owns on a daily basis, whereas a mutual fund is only required to do this quarterly, Beaver said — and few active managers want to reveal what they’re buying and selling every day.

ETFs also tend to be more tax efficient than mutual funds, because transactions count as an exchange, which doesn’t trigger a tax event. When mutual funds are bought and sold, those transactions are considered sales, resulting in capital gains distributions.

Lastly, there are many choices for investors interested in ETFs. “Options range from things as broad as a total US stock market where it seeks to track the entirety of the US stock market to being as specific as companies that are just in Singapore,” said Howard Pressman, a financial planner in Vienna, VA. “You can get them in pretty much every area of bonds, commodities; there’s no end to the creativity of the folk who are out there creating these today.”

On the con side, your preference for an ETF versus a mutual fund may depend on how you want to invest. If you’re looking to invest a set amount of money on a regular basis — with a 401(k) contribution, for instance, or by investing $100 a month — you should know that ETFs are sold by the share, not the dollar amount. If shares of an ETF cost $30 at the time of your purchase and you’re putting $100 toward the buy, you’ll be left with a balance of $10 in cash until your next transaction. “An ETF will leave some cash uninvested because the price changes and you’re actually buying shares,” Beaver said.

Mutual funds, on the other hand, may allow you to buy partial shares, so you’ll be able to fully invest whatever money you’re hoping to contribute.

ETFs may also be considered slightly less liquid than mutual funds. While mutual fund companies are required to repurchase their shares if you want to sell them, an ETF share must find a buyer. If you’re in a large, broad ETF with many shareholders, that’s likely not an issue, but if you’re in a smaller or highly specific ETF, it may sell at a lower price than you’d hoped because the market for that ETF isn’t as big.

How to invest in ETFs

There’s a wide range of ETFs available to investors. “You can buy ETFs that represent a pretty broad market, or you can get really specific,” Beaver said. “I think I saw one that had to do with pet care recently.”

There are also ETFs that take very specific risks — such as inverse ETFs that base their investments on the theory that an index will decline in value, or leveraged ETFs that seek to provide two to three times the earnings of the index they’re tracking.

Particular ETFs or ETFs that bet on the market likely aren’t for beginners. “If you’re new to investing, don’t go anywhere near a leveraged ETF,” Beaver said. “It’s a lot of volatility and risk.”

Instead, newer investors may be better off getting broad exposure via an index fund or broad market fund. For instance, younger investors might look at ETFs that track a major index, such as the S&P 500, or that track the broader market, such as the Vanguard Total Stock Market ETF. “Beginners should be focusing on index ETFs that are focused on asset classes,” Pressman said.

That said, it’s worth looking at what an ETF owns before diving in. “There are ETFs out there that, while they track a particular index, they don’t actually own the underlying shares,” Pressman said. “What they own may be some sort of derivatives or synthetic investments that are meant to follow the index they track. Some of those can have unpredictable results.”

Bottom line

ETFs are an inexpensive way to invest, giving shareholders access to low-cost index funds and broad market investments for a diversified portfolio. Although it’s possible to get very specific and take some big bets on the market, the more complicated ETFs generally aren’t recommended for most investors. Stick to the basics for a balanced portfolio.

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