How ETFs Work: Investing in Exchange Traded Funds

ETFs Definition, History, Advantages and How to Invest

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Learn how ETFs work and if they are a smart investment vehicle for you. Getty Images

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, a fundamental sense of how ETFs work, who should invest in them, and how they are advantageous relative to other investment types is an integral aspect of successful investing in today's capital markets.

ETF Definition and History

A simple definition of ETF, short for Exchange-Traded Fund, is that they are investment securities that are similar to index mutual funds but they trade like stocks. Like an index mutual fund, an ETF is a basket of securities that trades on a stock exchange and the fund will track an index, such as the S&P 500, the NASDAQ 100, or the Russell 2000. ETFs can also track 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

Since ETFs are similar to mutual funds, it's helpful for investors to begin and build upon their knowledge with a basic comparison of the two types of funds:

  • ETFs trade intra-day like stocks; Mutual funds trade at the end of the day, when the net asset value (NAV) of the underlying holdings can be determined.
  • Like mutual funds, shareholders of 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.
  • 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 similarities and 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 since 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 and a balance of dividend-paying stocks and high-yielding bonds is appropriate for retirees because they want to have 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.
  2. 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.
  3. 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.
  4. 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.
  5. 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.
  6. 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.
  7. 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.
  8. 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.
  9. 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.
  10. 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.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.