What Are Exchange-Traded Funds (ETFs)?

Definition & Examples of an Exchange-Traded Fund (ETF)

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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.

Learn more about ETFs, their pros and cons, and if they're the right investment choice for your portfolio.

What Is an ETF?

ETFs are baskets of securities with multiple assets like stocks, bonds, and gold, which makes 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. ETFs' versatility makes them good tools for investing either in broad market indices like the S&P 500 or in sectors, such as technology or health, and sub-sectors, such as social media or robotics.

How ETFs Work

Buying and selling ETFs can be as easy as buying a stock; you can do it through regular brokerage accounts during normal trading hours. When you place an ETF trade, you'll have to choose a certain number of shares to buy or sell, just like you would 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.

Some common ETFs include:

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

Pros and Cons of ETFs

ETFs can be smart investment tools for all types of investors. However, they are not 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. ETF expense ratios, on average, are significantly lower than 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 within the fund, 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, investors can place market orders, such as stop-loss orders and limit orders. An investor can put in a stop-loss order to automatically sell their ETF when it reaches a certain price.

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, the costs 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 so 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

  • ETFs are baskets of different assets grouped together and sold as one.
  • ETFs have cheaper expense ratios than mutual funds because they are passively-managed.
  • Investors can gain access to hundreds of assets with a single ETF.
  • Many ETFs track a specific sector.
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Article Sources

  1. Investment Company Institute. "Trends in the Expenses and Fees of Funds, 2018," Page 1. Accessed August 20, 2020.