How ETFs Work: Investing in Exchange Traded Funds

Even if you don't own any ETFs, chances are you've heard of this popular investing vehicle. Although ETFs have been available for nearly three decades, and millions of investors hold them, they're still relatively new to the investment world.

Whether you're a beginning investor or an experienced portfolio manager, it pays to have a fundamental sense of how ETFs work, who should invest in them, and their advantage over other investment types.

ETF Definition and History

ETFs, short for Exchange-Traded Funds, are investment securities that are similar to index mutual funds, but which trade like stocks. An ETF is a basket of securities that trades on a stock exchange. It can track an index (such as the S&P 500, the NASDAQ 100, or the Russell 2000), as well as commodities like gold or oil.

ETFs first came into existence in 1992 when the American Stock Exchange (AMEX) petitioned the Securities and Exchange Commission (SEC) to create a new stand-alone security that would track the S&P 500 index. In 1993, the S&P Depository Receipt, also known as SPDR or "spider," began trading on the AMEX. Today this ETF is known as SPDR S&P 500 (SPY).

Today there are over 4,000 ETFs on the market with $3 trillion in assets.

ETFs vs Mutual Funds

ETFs are similar to mutual funds. For instance, shareholders of both mutual funds and ETFs do not directly own the underlying assets of the fund -- they own shares of the fund itself, which then buys shares of the underlying assets.

But there are also key differences:

  • ETFs trade intra-day, like stocks. By contrast, mutual funds trade at the end of the day, when the net asset value (NAV) of the underlying holdings can be determined.
  • ETFs typically have lower expense ratios compared to even the lowest-priced index mutual funds.
  • ETFs have no minimum initial investment amount, whereas mutual funds typically require an initial investment of $1,000 or more.

There are more differences between ETFs and mutual funds, but these are the most important to note for everyday investors.

Advantages and Disadvantages of ETFs

Understanding the basic advantages and disadvantages of ETFs can help investors determine if these investment vehicles are appropriate for their investment objectives:

  • As previously mentioned, ETFs have low expenses, which can be 0.10 percent, or $10 for every $10,000 invested, or they can be lower than that. In the long term, low expenses can result in higher returns relative to actively-managed mutual funds. This is the basic idea of increasing revenue by reducing expenses.
  • Because of their passive nature, ETFs have extremely low turnover, which means they don't frequently buy and sell the underlying holdings. Low turnover translates into less relative capital gains, which means ETFs are highly tax-efficient funds. Therefore investors with taxable brokerage accounts may want to use ETFs to minimize tax costs.
  • The ability to trade intra-day creates the opportunity to take advantage of short-term price fluctuations or to use hedging strategies. For example, investors can sell ETFs short or place limit orders. Although everyday investors aren't advised to sell securities short, limit orders can be used effectively. For example, if an investor wanted to protect against an extreme intra-day downturn, they could place a sell limit order to sell shares at a particular price.

    The primary disadvantage for investors to keep in mind is that, because ETFs trade like stocks, they commonly charge commissions or similar fees for trading. So even if an ETF has a $7 commission charged per trade, an investor wanting to dollar-cost average and buy shares once or twice per month may end up with more annual expenses than a comparable index mutual fund.

    Who Should Invest in ETFs?

    ETFs can be appropriate for almost any investor. However, since ETFs typically track a stock index, a bond index, or a commodity, they are most appropriate for investors with long-term investment objectives, which would include goals with time horizons of three years or more.

    An exception to the long-term investment objective is the retired investor who needs current income. This investor may be interested in buying an ETF that holds dividend stocks or an ETF that holds bonds. However, most retired investors are looking for long-term growth in addition to current income. As such, a balance of dividend-paying stocks and high-yielding bonds is appropriate for retirees, as this gives them the potential for maintaining or growing principal over time.

    Since ETFs are tax-efficient, they can be smart investment choices for investors with taxable brokerage accounts.

    Many ETFs focus on sectors, which means that investors who are looking for exposure to areas of the market like healthcare, technology, utilities, and energy have many low-cost ETFs to choose from.

    Examples of Top ETFs to Buy in the Market Today

    There are thousands of ETFs to choose from in the market, but it is smart for most investors to narrow their choices to the funds that are widely traded and have high assets under management. Narrowly traded ETFs tend to cover niche areas of the market that may not be appropriate for everyday investors because of their potential for higher relative market risk. In addition, narrowly traded ETFs can trade above or below (at a premium or discount) to the net asset value of the underlying holdings.

    With that backdrop, and in no particular order, here are 10 of the biggest ETFs to buy in the market today:

    1. S&P SPDR (SPY): The oldest ETF and the largest to track the S&P 500 index, SPY is a diversified stock ETF that represents over 500 of the largest U.S. stocks by market capitalization. Expenses are 0.09 percent.
    1. iShares Core S&P 500 (IVV): Another large ETF that tracks the S&P 500, IVV is a broadly traded ETF with high assets, which makes it just as compelling of a holding as SPY. Expenses are rock bottom at just 0.04 percent.
    2. iShares Russell 3000 (IWV): This ETF can be considered a "total stock market" index fund because it captures the entire U.S. stock market, which includes small-, mid- and large-cap stocks. The expense ratio for IWV is 0.20 percent.
    3. iShares MSCI EAFE (EFA): Investors looking for an ETF that invests in stocks outside the U.S. and Canada can consider adding EFA to their portfolio. The EAFE acronym stands for Europe, Australasia (Australia and Asia), and the Far East. The fund over 900 foreign stocks and the expense ratio is 0.33 percent.
    4. iShares Russell 2000 (IWM): Investors wanting exposure to small U.S. companies can buy an ETF like IWM and get a low-cost fund that tracks the Russell 2000 index, which includes over 2,000 small U.S. companies. The expense ratio for IWM is 0.20 percent.
    5. iShares Core U.S. Aggregate Bond (AGG): This ETF from iShares captures the "total" bond market by tracking the Barclay's Aggregate Bond Index, which covers thousands of U.S. bonds. Expenses are just 0.05 percent.
    6. Health Care Select Sector SPDR (XLV): ETFs can be smart tools to gain exposure to sectors of the market and XLV covers the health care sector, which includes stocks of companies involved in pharmaceuticals, hospital management, medical devices, biotechnology and more. Expenses are 0.14 percent.
    7. Technology Select Sector SPDR (XLK): This ETF provides exposure to the technology sector, which includes industries involved in computer hardware and software, IT services, social media, and telecommunications. Expenses for XLK are 0.14 percent.
    8. Energy Select Sector SPDR (XLE): Investors wanting exposure to the energy sector can consider buying shares of XLE, which tracks and index that includes stocks of companies involved in the oil, gas, and related industries. The expense ratio for XLE is 0.14 percent.
    9. Utilities Select Sector SPDR (XLU): Another area of the market that investors often want exposure to is the utilities sector, which tracks an index that includes stocks of companies involved in the gas and electric utilities industry, as well as power producers and telecommunications. Expenses for XLU are 0.14 percent.

    How to Buy ETFs

    To buy ETFs, investors need to open a brokerage account, which can be done most easily with an online discount brokerage firm, such as Schwab, TD Ameritrade, or Scottrade. Large mutual fund companies such as Vanguard and Fidelity also offer a wide variety of ETFs.

    The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.

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