What Is an ETF? Access Low-Cost Diversification - MagnifyMoney

What Is an ETF?

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Exchange-traded funds (ETFs) are a type of pooled investment that gives you the diversification of a mutual fund with the trading flexibility of a stock.

As the name implies, these funds trade on stock exchanges and typically track a market index, commodity or sector. And since the launch of the first ETF — the SPDR S&P 500 (SPY) — in 1993, investors, financial advisors and even robo-advisors have looked to these investments for their low costs and high liquidity.

What is an ETF?

Much like mutual funds, exchange-traded funds are pooled investments that hold large “baskets” of assets — often thousands of individual holdings like stocks and bonds. However, you can trade ETFs throughout the market day, unlike mutual funds, which only trade once at market close.

Like stocks and other exchange-traded assets, exchange-traded funds will fluctuate in price throughout the market day. Therefore, you can buy and sell exchange-traded funds as needed during market hours, which can help lower your exposure to a particular strategy or market sector and potentially decrease your risk.

ETF benefits

Investors, advisors and robo-advisors all gravitate toward exchange-traded funds for multiple reasons, including:

  • Low costs. ETFs tend to have lower management costs than mutual funds.
  • Diversification. As ETFs tend to hold thousands of individual assets, one exchange-traded fund can potentially offer the same diversification of a far more expensive portfolio of individual securities.
  • Flexibility. Since ETFs can be bought and sold like stocks, they can add liquidity to a wide range of investment strategies.
  • Taxes. Compared to mutual funds, ETFs are generally more tax-efficient and incur fewer capital gains — a benefit for taxable portfolios.

How do ETFs work?

Exchange-traded funds typically mimic broader stock market indexes or pursue specific investment strategies. Like mutual funds, an exchange-traded fund’s manager will select a basket of securities or other assets designed to fulfill the fund’s strategy.

Once a fund is built, the manager can handle the fund’s day-to-day using one of two management methods: passive or active.

Passively managed ETFs

Goal: to match the performance of the benchmark index.

When a fund simply tracks an index, it’s called a passively managed fund because all the manager does is build a portfolio to mimic the index’s holdings and asset allocation. The manager will only buy and sell holdings or rebalance the portfolio to keep the asset allocation in line with the fund’s benchmark index.

Actively managed ETFs

Goal: to outperform the benchmark index.

With actively managed funds, the fund manager and researchers make active investment decisions with the goal of generating higher returns than the benchmark index. The fund’s asset allocation may not consistently stay in line with its benchmark index in its pursuit of higher returns.

Passively managed funds typically have lower management fees than those that are actively managed. Why? It comes down to costs and labor. Passively managed funds will generally have minimal trading costs and fewer day-to-day management demands compared to one where the fund manager actively trades and strategizes in pursuit of higher returns.

ETF fees

While exchange-traded funds are known for being one of the lowest-cost investment vehicles, they aren’t without their fees. These costs can vary widely from fund to fund based on management style and how much it costs the fund provider to track a benchmark.

Common fees include:

  • Expense ratio. Also called the operating expense ratio (OER), this is the fee the manager charges to cover the cost of running the fund, usually expressed as a percentage of the money you invest.
  • Trading commissions. You may pay commissions each time you buy or sell ETF shares — which could be $0, as many online brokers offer commission-free trades.
  • Bid/ask spread. This spread is the difference between the highest price a buyer is willing to pay for a security (the bid) and the lowest price a seller is willing to accept for it (the ask), which acts like a markup on each trade you place. A wider spread is common in volatile markets or securities with low trading volumes (more on this soon).

Types of ETFs

Just as there are many different breeds of horses, exchange-traded funds come in all shapes and sizes.

Index ETFs

Index funds passively track a broader market index, like the S&P 500 or Russell 2000, and generate comparable returns. While index ETFs don’t totally mimic the underlying index, their returns should be comparable to the index’s annual return.

Stock ETFs

Stock funds hold baskets of stocks, typically focused on a single sector or industry — like energy or health care. These funds can offer investors exposure to a market segment with near-instant diversification. Many index funds are also stock ETFs.

Bond ETFs

Bond funds hold baskets of bonds and seek to generate income, just like individual bonds. These funds can focus on specific bond types, like corporate or municipal bonds, or be bond index funds. And unlike individual bonds, bond funds don’t have maturity dates, as the fund manager will buy and sell bonds as necessary to keep the fund’s strategy on track.

Sector/industry ETFs

Sector and industry funds will focus on a specific market sector or industry and hold only related securities. In turbulent market times like bear markets or when hints of a recession loom, investors can use sector and industry ETFs to increase or decrease their exposure and risk.

Currency ETFs

Currency funds track the relative value of domestic and foreign currencies. These funds give investors a simple way to gain exposure to and trade currency without engaging in foreign exchange (Forex or FX) trading. Currency funds can help investors bet for or against anticipated movements in a foreign country’s currency or cryptocurrency assets like Bitcoin.

Commodity ETFs

Commodity funds follow the price of a particular commodity like agricultural goods or precious metals. These funds typically focus either on a single physical commodity (like wheat) or the future performance of a commodity (like wheat futures). However, commodity funds can track commodity indexes like the Bloomberg Commodity Index or the S&P GSCI index.

Investors often use commodities to hedge against market downturns, and commodity ETFs offer investors a low-cost way to invest in commodities without having to trade futures.

Specialty ETFs

Fund managers sometimes create exchange-traded funds to capitalize on specific market behaviors. While returns can be high, risks are high as well. Funds included in the specialty category include:

  • Inverse ETFs. Inverse funds aim to profit from a decline in an index or market.
  • Leveraged ETFs. Leveraged funds use derivatives like options and futures contracts to amplify the returns of an underlying index — which means declines are also amplified.

Sustainable ETFs

Sustainable funds — also known as environmental, social and governance (ESG) funds or ethical investment funds — help investors align their values with their investments. These funds often focus on exclusionary investing (omitting certain investment types), companies with high ESG ratings and even funds that seek to hold large companies accountable.

ETF vs. mutual fund: What’s the difference?

Exchange-traded funds and mutual funds are like the fraternal twins of the investing world — they have similar internal structures but different external ways of expressing their styles.

Let’s compare ETFs and mutual funds side-by-side so you can see the similarities and differences clearly and concisely.

ETFs vs. mutual funds

ETFsMutual funds
Who owns the underlying assets?The fundThe fund
What do investors own?Shares of the ETFShares of the mutual fund
How do you buy shares?Must buy whole sharesCan buy fractional shares
When do shares trade?Anytime during the regular or extended trading dayOnce per day at the market close
What are the average management costs?
  • 0.16% for equity index ETFs
  • 0.12% for bond index ETFs
  • 0.47% for equity mutual funds
  • 0.39% for bond mutual funds

How to compare exchange-traded funds

With so many exchange-traded funds on the market, you’ll want to research and compare your options before you click that “buy” button. Keep these criteria in mind as you research and select the best ETFs for your investing goals:

  • Trading volume. Ideally, you’re looking for funds with trading volumes above 1 million shares per day.
  • Expense ratios. Lower is better — especially with index funds — but expect to pay more for actively managed funds.
  • Performance. If you’re buying index ETFs, compare the fund’s performance to its benchmark index, as not all funds are equal.
  • Tracking errors. A low tracking error is most favorable for index ETFs, as it means the fund closely mirrors the fund’s benchmark index.

Getting started: How to buy ETFs

Ready to learn how to buy ETFs? MagnifyMoney is here to walk you through the steps.

  1. Choose how you’ll buy. You can work directly with a financial advisor, buy ETFs through a robo-advisor or open an online brokerage account. If using an online broker, ensure the broker offers access to the specific funds you want to own.
  2. Locate the ticker and enter your order. Once you fund your account, search for the fund’s ticker. From the ETF’s profile page, you can begin an order for the number of shares you want to buy and submit your order.
  3. Track your investment. Congrats! You now own shares of an ETF. Keep an eye on your investments with a check-in schedule that makes sense for your investment strategy.

Frequently asked questions

Yes, ETFs holding dividend-paying stocks will pass those dividends to investors. You can take the dividends as cash or reinvest them into the fund with a dividend reinvestment plan, also called a DRIP.

A leveraged ETF uses complex trading strategies to amplify the returns of an underlying benchmark. For example, a 2x leveraged S&P 500 exchange-traded fund aims to generate twice the return of the S&P 500.

ETFs can be good investments if you’re looking for an asset with the liquidity of stocks but with the built-in diversification of a mutual fund. For investors concerned about capital gains taxes, exchange-traded funds also tend to have lower capital gains exposure — especially passively managed funds.

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