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Burned by the recent meme stock craze? Had a few "to the moon" stock picks come crashing down? Sick of being charged high fees by a financial advisor for mutual funds? Well, there's a simple solution to all of that via investing in exchange-traded funds (ETFs).
Exchange-traded funds (ETFs) currently make up nearly one-third of all U.S. trading by dollar value and nearly a quarter of all share volume. That’s pretty amazing for a product that has only been around since the 1980s and didn’t really “show up” until the middle-to-end of the last decade.
These versatile investment instruments offer beginners a straightforward, transparent and low-cost introduction to investing. If you're looking to revamp your portfolio by investing in ETFs, then this guide is for you.
- ETFs at a Glance
- Types of ETFs
- Index ETFs
- See All 32 Items
ETFs at a Glance
ETFs are mutual funds that can be bought and sold during the trading day at the current market price, while mutual fund shares are redeemed at the end of the day based on the net asset value (the worth of the fund’s portfolio at closing prices).
Other key ETF factors include:
- ETFs must disclose holdings daily while active mutual funds do it quarterly or semi-annually.
- Unlike mutual funds, ETFs are less likely to have taxable events, making them more tax efficient.
- ETFs come with stock transaction costs whereas mutual funds may or may not have any transaction costs.
- ETFs are generally based on indexes rather than active management or complex strategies.
Typically, you’ll see ETFs cover sectors like healthcare and technology or commodities like gold and crude oil, or simply track an overall index (like the popular NYSEARCA: SPY on the S&P 500). However, there are some exotic ETFs that use leverage or track the inverse of an index.
Types of ETFs
The different types of ETFs can be broadly distinguished by their asset class, geography and strategy. Asset class refers to whether the ETF tracks stocks, bonds, commodities, currencies or derivatives. Geography refers to which country the ETF's assets originate from. Strategy refers to the management style of the ETF, which is usually passive versus active. These categories are not mutually exclusive, with many ETFs having characteristics of each one. Here are some common types of ETFs.
Index ETFs
Index ETFs are passive investments that try to replicate and track the performance of a stock market index, such as the S&P 500, Nasdaq 100 or the Dow Jones Industrial Average. They can also track proprietary indexes created by various organizations like S&P Global, FTSE or MCSI. Indexes can target stocks, bonds, commodities or currencies from around the world. Because of their low turnover and automated nature, index ETFs tend to charge lower fees.
Active ETFs
Active ETFs do not track an index. Rather, they use their own quantitative or qualitative strategies with the objective of outperforming a benchmark or fulfilling a specific objective. Examples include ETFs that target potentially undervalued stocks based on a quantitative screener or ETFs that use options strategies to try to provide higher-than-average yields. These ETFs generally have higher expense ratios than their index counterparts.
Leveraged/Inverse ETFs
Leveraged ETFs (or inverse ETFs) are special types of active ETFs that provide enhanced exposure to an underlying asset. For example, a 2x leveraged S&P 500 ETF might target a daily return double that of the S&P 500, while an inverse S&P 500 ETF might target a daily return opposite that of the S&P 500. Both leveraged and inverse ETFs are considered advanced tools best suited for short-term traders. These ETFs can behave unpredictably when held long term and are highly volatile. They also tend to have high expense ratios.
Country ETFs
Country ETFs provide investors with exposure to stocks and bonds listed on the exchanges of a specific country. For example, a total U.S. stock market and total U.S. bond market ETF would provide investors with exposure to U.S. stocks and U.S. bonds respectively. These ETFs can be combined in various proportions to provide global market exposure.
Equity ETFs
Equity ETFs only hold stocks. The actual selection of the stock depends on both the strategy of the ETF and its geography. For example, a passive U.S. index ETF might have substantially different holdings that an active U.S. low-volatility ETF. Equity ETFs can further be distinguished by the sector of their holdings, such as technology, consumer staples and healthcare to name a few.
Bond ETFs
Bond ETFs only hold fixed-income assets. Like stocks, they can be sorted based on their strategy and geography. An example would be a passive U.S. bond index ETF versus an active Canadian unconstrained bond ETF. Bond ETFs can further be categorized by the types of bonds they hold. Just like how stocks can come from different sectors, bonds can come from different issuers (government vs. corporate), credit quality (investment grade vs. junk) and maturities (short, intermediate or long durations).
Commodities ETFs
Some ETFs track commodities, which include resources like gold, silver, copper, oil, natural gas, soybeans, corn and wheat. Commodities ETFs can come in passive index and actively managed variants. They can either be physically backed by holding the commodity directly in storage (usually gold or silver) or gain synthetic exposure via commodity futures. Commodity ETFs are usually used to speculate on commodity prices or hedge against inflation. They tend to be volatile and charge high fees.
Why Should You Invest in ETFs?
Exchange-Traded Funds (ETFs) are popular among investors. They are accessible, flexible, and cost-effective. ETFs provide diversification like mutual funds but can be traded like individual stocks. They are a good choice for both new and experienced investors. You can use ETFs to build a long-term portfolio or target specific sectors. They offer a variety of options to fit your financial goals. ETFs are easy to buy and sell on major stock exchanges. They also usually have lower expense ratios than traditional mutual funds. In the next sections, we will discuss why investing in ETFs can benefit your investment strategy.
Diversification
ETFs are an easy way to diversify your investment portfolio. A single ETF gives you access to various assets, likestocks, bonds, or commodities. This helps reduce risks linked to individual investments. If one stock or sector performs poorly, gains in others can balance it out. For example, instead of buying individual tech companies, you can invest in a tech-focused ETF. This lowers your risk related to any one company. By holding diverse assets, investors can better handle market fluctuations and seek steady long-term growth.
Low Costs
ETFs are cost-effective investment options. They usually have lower expense ratios compared to mutual funds. This means fewer fees take away from your investment each year. Many ETFs are passively managed, tracking a specific index instead of selecting stocks. This reduces the need for expensive research and management. ETFs also tend to have lower trading costs because they are traded less frequently than mutual funds. Over time, these savings can enhance an investor’s returns. Lower costs make ETFs a good choice for smaller investors who might struggle with the higher fees of actively managed funds.
Liquidity
ETFs have high liquidity. They are traded on major stock exchanges like individual stocks. This means investors can buy and sell them throughout the trading day at market prices. In contrast, mutual funds can only be bought or sold at the end of the day at the fund’s closing price. This flexibility allows investors to react quickly to market changes. Whether adjusting strategies or exiting positions, ETFs enable real-time trading. They are especially appealing to active investors who want more control over their trades.
Tax Efficiency
ETFs are more tax-efficient than many other investment options, especially mutual funds. This is mainly because of their "in-kind" creation and redemption process. This structure limits capital gains within the fund, meaning ETFs usually distribute fewer capital gains to investors. As a result, tax liabilities are minimized. In contrast, mutual funds often buy and sell assets, which can trigger taxable capital gains for shareholders. For long-term investors, this tax efficiency lowers the overall tax burden and improves after-tax returns. This is especially important for those in higher tax brackets looking to reduce their annual tax bills.
Transparency
ETFs provide transparency that many investors find appealing. They disclose their holdings daily, allowing investors to view every asset at any time. This helps investors align their choices with their goals and values. For instance, someone who wants to avoid certain industries, like tobacco or fossil fuels, can find ETFs that do not include these sectors and check the holdings easily. In contrast, mutual funds report their holdings quarterly. This means limited insight into the current portfolio. For those who want control and informed decisions, daily transparency is a significant advantage.
Considerations Before Investing in ETFs
Investing in Exchange-Traded Funds (ETFs) can diversify your portfolio. However, it's important to consider a few key factors before investing. First, understand the assets within the fund. Next, look at the trading and management costs. Also, check the liquidity of the ETF. Consider the tax implications of your investments. Finally, clarify your financial goals and risk tolerance. Ensuring your chosen ETFs align with your strategy is crucial. This evaluation helps you make informed decisions and benefit from ETFs in your financial plans.
Expense Ratios
ETFs are known for being cost-efficient. However, not all ETFs have the same fees. Expense ratios show the annual management fees as a percentage of assets. These ratios can differ between funds. Even small differences can impact long-term returns. This is especially true with large investments or over long time periods. It is important to compare expense ratios across different ETFs in the same asset class. Doing so helps ensure you receive the best value for your money.
Liquidity
Liquidity refers to how easily an ETF can be bought or sold without impacting its price. Not all ETFs have high liquidity. This is especially true for those that track niche or less popular market segments. ETFs with low trading volumes usually have wider bid-ask spreads. This means there is a larger difference between your buying price and the selling price. Wider spreads can increase the cost of buying or selling shares. This can reduce overall profitability. Before you invest, check the trading volume and liquidity. This will help ensure the ETF is easy to trade without significant costs.
Underlying Assets
It is important to understand the underlying assets in an ETF. These assets should align with your investment goals. Decide if you want exposure to specific sectors, regions, commodities, or asset classes like equities or bonds. Choosing the right ETF is crucial for achieving your financial objectives. Ensure that the ETF's strategy matches your risk tolerance and investment timeframe. For example, sector-specific ETFs may have higher risks but offer targeted growth. In contrast, broad market ETFs generally provide more stable and diversified exposure.
Tracking Error
ETFs aim to replicate the performance of an underlying index. However, this replication may not be perfect. Tracking error measures how closely an ETF's performance matches its benchmark index. Factors such as management fees, portfolio turnover, and market inefficiencies can lead to deviations. A higher tracking error indicates that the ETF is not accurately following its index. This could result in lower-than-expected returns. It is important to review the ETF’s historical tracking error before making an investment. This ensures it is performing as closely to the index as possible.
Market Risks
ETFs, like any investment, face market risks. Their value can change with market fluctuations. The level of risk depends on the assets or sectors the ETF tracks. For instance, ETFs focused on volatile sectors, such as technology or emerging markets, may see significant price swings. It is important to understand the risks associated with the market, region, or sector the ETF follows. This is especially true for niche or specialized ETFs, which may experience greater volatility or sector-specific downturns. Investors should assess their own risk tolerance before investing.
How to Invest in ETFs
Investing in exchange-traded funds (ETFs) is popular among both new and experienced investors. ETFs are funds that trade on stock exchanges like stocks. They allow you to invest in a variety of assets such as stocks, bonds, or commodities without needing a lot of money. To invest in ETFs, you need to follow key steps. First, choose the right fund that fits your investment goals and risk levels. Next, understand the different types of ETFs available in the market. Knowing the basics of ETF investing helps you use this flexible option to grow your finances while managing risks. In the next sections, we will outline the important steps and considerations for making informed ETF investment decisions.
Step 1: Fees and Management
It’s worth understanding management fees, expected fees associated with buying and selling the ETF as well as the fees an ETF incurs to track its index.
Step 2: Pick a Broker
Most major brokers in the U.S. provide access to any ETF that is openly traded. Many brokerage accounts offer their own ETFs or partner with a company to provide ETFs that don’t have any trading commissions associated with them but may require a certain holding period.
Step 3: Decide How Much to Invest
Once you understand what an ETF tracks as well as what it holds, you can decide how much you want to invest in an ETF. Keep in mind that if you already own Apple shares and you purchase an ETF that tracks the S&P 500, you’ll get additional exposure to Apple through that ETF.
Step 4: Purchase the ETF
You can buy the ETF you’ve chosen during normal trading hours as you would any stock.
Check out Benzinga's picks for the Best Brokerages for ETF Investing.
ETFs vs. ETNs
Exchange-Traded Funds (ETFs) and Exchange-Traded Notes (ETNs) are important investment options. Both trade on major stock exchanges like stocks. However, they have different purposes and risks. ETFs are funds that hold various assets, like stocks or bonds. They offer broad market exposure or target specific sectors without buying individual securities. ETNs are unsecured debt securities from financial institutions. They promise returns based on the performance of a specific index or asset class. This difference impacts risk, taxes, and liquidity. Investors should understand how each works before deciding. We will explore the features, benefits, and drawbacks of ETFs and ETNs. This will help determine which option suits different investment strategies and goals.
Fund vs. Debt Note
ETFs are actually funds that own the underlying assets. ETNs are debt notes issued by an institution, essentially unsecured bond guarantees to the index or asset they’re trying to track.
Tracking Error
Over time, an ETF will not match the underlying index or asset it’s tracking due to a combination of management fees and transactional fees. Example: oil ETFs lose value over time due to the cost of rolling futures contracts plus management fees. ETNs have no tracking errors other than their management fee and tax fees.
Because of these two major differences, the tradeoff between the two is risk. ETNs accept the risk of the underlying product plus that of the issuing institution. ETFs only accept the underlying product risk, but you also get tracking error.
The risk is high with ETNs, though. To date, there are no known ETFs that have closed and weren’t able to be redeemed at their net asset value. However, there are examples of leveraged crude oil products to a recent ETN issued by Credit Suisse (XIV) that crashed 80% in one day.
Best Brokerage Accounts for ETF Investing
To begin investing in ETFs you'll need to open a brokerage account with a qualified broker. Below you'll find Benzinga's favorite trading platforms.
- Best For:Active and Global TradersVIEW PROS & CONS:Securely through Interactive Brokers’ website
Future Outlook for ETFs
The outlook for ETFs is optimistic. They continue to lead the global investment market. As of 2023, ETFs have over $10 trillion in assets under management. The U.S. market makes up more than $7 trillion of this total. The growth is driven by demand for cost-effective and diversified investment options. This demand is particularly strong during volatile market conditions. Both retail and institutional investors are contributing to this trend. Retail investors benefit from advancements like fractional shares and robo-advisors, which make ETF investing easier. Thematic ETFs are also gaining attention. These focus on areas like clean energy, artificial intelligence, and ESG (Environmental, Social, and Governance) investing. They provide exposure to high-growth industries. By mid-2023, thematic ETFs received record inflows, totaling $85 billion.
The ETF industry is set for continued growth. Global assets are projected to reach $15 trillion by 2028. Fixed-income ETFs are gaining popularity. Investors are looking for stable returns in a low-interest-rate environment. In 2023, bond ETFs exceeded $1.6 trillion in assets under management, showing significant growth. Actively managed ETFs are also rising. By the end of 2023, they accounted for nearly 15% of total ETF inflows. This trend is changing the industry as investors seek higher returns within the ETF structure. Increased regulation and a focus on transparency are expected to attract more investors. This will solidify ETFs as a core part of global investment strategies.
Frequently Asked Questions
How to invest in an ETF for beginners?
To invest in ETFs, open a brokerage account and choose an ETF that matches your financial goals. Research its expense ratio and performance before purchasing shares.
Are ETFs a good investment?
Yes, ETFs are a good investment due to their diversification, low costs, and liquidity, making them suitable for various investment strategies.
Do ETFs pay dividends?
Yes, many ETFs pay dividends, usually distributed quarterly, depending on the underlying securities.
About Jay and Julie Hawk
About Julie:
Julie Hawk earned her honors undergraduate degree from the University of Michigan before pursuing post-graduate scientific research at Cambridge University. She then started work in the private sector as a business systems analyst for a major investment bank, where she qualified as a Series 7 Registered Representative and received comprehensive training in various financial products. Further honing her skills, she attended the prestigious O’Connell and Piper options training course in Chicago, mastering professional option risk management techniques.
Julie then transitioned into the role of a professional Interbank forex trader, currency derivative risk manager and technical analyst, ascending to the position of vice president over a 12-year career in the financial markets. Julie’s illustrious banking career spanned working for major international banks in New York City, London, and San Francisco, where she served as an Interbank dealer, technical analyst, derivative specialist and risk manager. Her responsibilities included educating, devising customized foreign exchange hedging and risk-taking strategies, and overseeing large-scale transactions for esteemed banking clients, including corporations, fund managers and high-net-worth individuals. As part of her responsibilities, Julie managed substantial portfolios of forex options, spot, and futures positions as a currency options risk manager, earning recognition for executing innovative and highly profitable forex derivative transactions. Julie also spearheaded educational conferences on currency derivatives.
During her banking career, Julie attained world-class expertise in technical analysis, including Elliott Wave Theory, and pioneered research into automated trading and trading signal systems. An active member of the San Francisco Writers’ Guild, Julie also authored trade strategies, educational material, market commentary, newsletters, reports, articles, and press releases. She became a sought-after market expert who was frequently interviewed by financial magazines and news wires such as REUTERS.
Following her retirement from the banking sector, she dedicated 15 years to online forex trading, mentoring and freelance writing for TheFXperts, which she co-founded with her husband Jay. Julie is the co-author of “Forex Trading: A Beginner’s Guide” and “Technical Analysis for Financial Markets Traders,” in addition to five other books on financial markets trading and personal finance. She now focuses on writing articles on financial markets for platforms like Benzinga, although she continues to trade forex online and mentor fellow traders as part of TheFXperts’ financial team.
About Jay:
Jay Hawk grew up in Chicago and Mexico City where he became bilingual in English and Spanish. After taking formal training as a classical guitarist at prestigious music conservatories in Europe, Jay then embarked on a remarkable journey into the financial markets, cultivating his notable expertise through hands-on experience that began on the Midwest Stock Exchange.
His financial career progressed as he started actively participating in various exchange floor trading activities in the Chicago futures and options pits, where he worked his way up the ladder, serving as a clerk, trader, broker, investor and fund manager. Jay then ran a retail stock brokerage desk and managed funds for large institutional investors, leveraging his discretionary trading skills to yield profitable results for clients.
This ultimately led to Jay holding exchange seats and operating as a market maker on options exchanges in Chicago and San Francisco, initially on the Chicago Board Options Exchange. Jay also played a significant role in the Chicago Mercantile Exchange’s evolution, where he contributed to launching and actively trading the first listed currency futures options. After transitioning to the West Coast, Jay then held a seat and ventured into trading stock options and their underlying stocks on the Pacific Options Exchange.
Jay’s comprehensive understanding of fundamental economic and corporate analysis continues to inform his trading and investment activities and has led to his subsequent success as an expert financial writer. Together with his wife Julie, he co-authored “Stock Trading: A Beginner’s Guide”, “Commodity Trading: A Beginner’s Guide” and “Fundamental Analysis for Financial Markets Traders,” among their published books focusing on financial markets trading, market analysis, and personal finance.
As an integral member of TheFXperts’ team, Jay now excels in trading forex online for his personal account, mentoring aspiring traders and writing for financial platforms like Benzinga where he specializes in covering topics related to the stock and commodity markets, as well as investing, trading and reviewing online brokers.