Exchange Traded Funds 101: What They Are and How They Work
Exchange-traded funds (ETFs) have been around since the early 1990s. Today, they are one of the most popular investment vehicles among institutional and individual investors.
So what are ETFs and what’s all the hype about? Read on to find out. We’ll go over what ETFs are, how they work, and how you can start investing in them today.
Let’s get started!
What Is an Exchange-Traded Fund?
An exchange-traded fund (ETF) is a basket of investments like stocks or bonds. It usually tracks a certain index, sector, commodity, or other asset. One ETF can comprise hundreds or even thousands of stocks across various industries. In that way, ETFs are like mutual funds.
But unlike mutual funds, ETFs can be bought and sold on the stock market just like an individual stock. They are traded at regular market hours and extended hours, not just at the end of the trading day after markets close.
The first ETF in the US was the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index. It was established in 1993 and is still actively traded today.
Since then, there are nearly 3,000 ETFs listed in the US that cover a wide range of assets, sectors, and indexes.
Types of Exchange-Traded Funds
Here are some different types of ETFs you can invest in:
- Stock ETFs track a certain stock index, like the S&P 500 or the Dow Jones Industrial Average (DJIA).
- Commodity ETFs track the price of a certain commodity, such as gold or oil.
- Bond ETFs provide exposure to a wide selection of fixed income instruments, like government bonds, corporate bonds, and state and local bonds.
- International ETFs follow foreign markets like individual countries or country blocs to provide global diversification.
- Sector ETFs track one of the 11 main economic industries, like healthcare, finance, or technology.
- Currency ETFs track the performance of different currency pairs to help you speculate on currency prices or hedge against volatility or inflation.
- Inverse ETFs are based on making gains from shorting stocks, which means selling with the expectation of repurchasing at a lower price later.
- Leveraged ETFs yield multiples of the underlying investment’s return or loss. For example, if the underlying asset increases in value by 1%, a leveraged ETF will return 2%. But if the underlying asset decreases in value by 1%, your losses will increase by 2% as well. With more potential for reward comes more risk.
- Alternative ETFs provide exposure to alternative asset classes like real estate, private equity, and hedge funds.
- Actively managed ETFs have a portfolio manager unlike most ETFs that follow an index.
How Does an Exchange-Traded Fund Work?
Now that you know what an ETF is, here’s how it works:
An asset owner creates a fund based on a basket of assets (like stocks or bonds). They then sell shares of that fund to investors who can trade their shares like stocks on the stock market.
Shareholders don’t own the ETF fund’s underlying assets themselves; rather, they are invested in the fund and get to share in its gains and losses.
That said, ETF shareholders are still eligible for dividend payments, reinvestments, an other benefits that come with the ETF’s underlying assets.
The Benefits of Exchange-Traded Funds
So what are the benefits of investing in exchange-traded funds over regular stocks or mutual funds?
An ETF is like a mix between a mutual fund and a stock that gives you the best of both worlds. On the one hand, ETFs hold more than one asset, which means it’s good for investment diversification. On the other hand, you can trade ETFs like stocks, which means they are relatively liquid.
Other benefits of ETFs include low management fees, few broker commissions (if any), price transparency, and tax efficiency—Because ETFs involve less transactions than a mutual fund, you’re less exposed to capital gains taxes.
How to Invest in Exchange-Traded Funds
To take advantage of this great investment vehicle, here’s what you need to do:
First, you need to open a brokerage account if you don’t already have one. You can opt for a traditional broker-dealer or an online brokerage like Vanguard or Fidelity.
Next, research different ETFs. Consider what each one tracks, the current market, and your own interests. Financial advisors and robo-advisors can help you choose what to invest in with the help of stock market APIs that track the performance of different ETFs.
Lastly, settle on a trading strategy. Do you want to invest long-term and let the ETF appreciate while you collect dividends? Or do you prefer to buy and sell quickly as a day trader?
For most investors, staying invested for the long term is the better choice. It lets you take advantage of compound interest, dollar cost averaging, and value appreciation.
The Bottom Line
ETFs are a great investment vehicle. They give you broad market exposure, are highly liquid, and are tax efficient. Start comparing different ETFs listed on your brokerage account today. Investing in the right one will help set you up for your financial future.