What Are Exchange-Traded Funds (ETFs)?

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DEFINITION

An exchange-traded fund (ETF) is a type of investment security that groups assets together and passively tracks an underlying benchmark index, such as the S&P 500.

Definition and Examples of Exchange Traded Funds

ETFs are baskets of securities with multiple assets like stocks, bonds, and gold, making them similar to mutual funds, especially index funds. However, unlike mutual funds, ETFs trade like stocks, meaning that investors can buy and sell shares on an exchange. The versatility of ETFs makes them valuable tools for investing either in broad market indices like the S&P 500 or in sectors, such as technology or health, and even sub-sectors, such as social media or robotics.

One popular ETF is the Vanguard S&P 500 ETF (VOO), which invests in the stocks of the 500 companies listed on the S&P 500 index. The ETF is a passively managed fund, meaning that there is no active trading in and out of stocks. Instead, the VOO mirrors the S&P 500 by owning all of its holdings at the same percentage weighting as the index. For instance, the financial sector made up 11.50% of the S&P 500, and so too did it make up 11.50% of the VOO ETF, as of February 2022.

Other examples of ETFs include the following:

  • Schwab U.S. Large-Cap ETF (SCHX)
  • Global X Robotics & Artificial Intelligence ETF (BOTZ)
  • iShares Global Clean Energy ETF (ICLN)

How ETFs Work

Buying and selling ETFs can be as easy as buying a stock and can be done through a brokerage account during normal trading hours. When placing an ETF trade, you'll have to choose a certain number of shares to buy or sell, just like with a stock. For example, if you want to buy $1,000 of a particular ETF and it trades at $100 per share, you'll need to place a buy order for 10 shares, using the ETF's ticker symbol.

While ETFs trade on an exchange like stocks, they have a unique process of share creation and redemption. A third party, known as authorized participants (APs), handles the buying and selling of the ETF's underlying securities, generally in large chunks of shares known as creation units. That way, the ETF doesn't absorb those trading costs, and the price of the fund stays closely tied to that of the underlying index, regardless of supply and demand.

Pros and Cons of ETFs

ETFs can be smart investment tools for all types of investors. However, they might not be ideal for everyone. Before investing in ETFs, it’s wise to know the pros and cons.

Pros
  • Diversification

  • Low cost

  • Tax efficiency

  • Market orders

Cons
  • Trading costs can add up

  • May be narrowly focused

  • Temptation to trade

Pros Explained

  • Diversification: Investors can gain access to dozens, or even hundreds, of stocks or bonds in one ETF. Holding multiple investment securities in one fund reduces volatility, compared to buying just one or a few individual securities.
  • Low cost: Most ETFs are passively managed, so there is no need for costly research or analysis, which reduces management costs. ETFs' expense ratios, on average, are significantly lower than those of mutual funds. Many ETFs have expenses below 0.25% ($25 for every $10,000 invested). By contrast, the expense ratio for the average mutual fund is about 0.76%.
  • Tax efficiency: Actively managed mutual funds trade their holdings, which creates capital gains distribution that is often taxable to the shareholder. While ETF gains are also taxable, their structure generally makes them more tax-efficient than mutual funds.
  • Market orders: Since ETFs trade throughout the day on exchanges, an investor can place market orders, such as stop-loss orders and limit orders.

Cons Explained

  • Trading costs can add up: ETFs sometimes generate a small trading commission every time an investor buys or sells shares. Although the commission fees are low, they add up quickly if you’re making frequent trades.
  • May be too narrowly focused: Many ETFs track a particular sector benchmark or similar niche area of the market, such as technology. Those types of ETFs tend to have wider swings in price than a broader market index, such as the S&P 500.
  • Temptation to trade: The ability to buy and sell quickly can make it tempting to dabble in market-timing, which can be more harmful than good. It causes people to speculate on price changes instead of investing for the longer term.

Key Takeaways

  • An exchange traded fund (ETF) is an investment that groups assets together and passively tracks an underlying index, such as the S&P 500.
  • ETFs have cheaper expense ratios than mutual funds have, because they are passively managed.
  • An ETF provides investors with access to hundreds of stocks, thus helping with diversification.
  • ETFs are a convenient way to invest in a broad group of stocks, such as an index, or to track a specific sector.
  • However, ETFs can be too narrowly focused, and the ease of trading can lead investors to try to time the market by trading in and out of them.

Article Sources

  1. Vanguard Group Inc. "Vanguard S&P 500 ETF (VOO)."

  2. Charles Schwab Investment Management Inc. "Schwab U.S. Large-Cap ETF."

  3. Global X Management Company. "BOTZ Robotics & Artificial Intelligence ETF."

  4. BlackRock Inc. "ICLN iShares Global Clean Energy ETF."

  5. Investment Company Institute. "Trends in the Expenses and Fees of Funds, 2018," Page 1.