Exchange-Traded Fund (ETF) What It Is and how to Invest

An exchange-traded fund (ETF) is a basket of securities that tracks or seeks to outperform an underlying index. ETFs can contain investments such as stocks and bonds.

What Is an Exchange-Traded Fund (ETF)?

An exchange-traded fund (ETF) is a pooled investment security that can be bought and sold like an individual stock. ETFs can be structured to track anything from the price of a commodity to a large and diverse collection of securities.

ETFs can even be designed to track specific investment strategies. Various types of ETFs are available to investors for income generation, speculation, and price increases, and to hedge or partly offset risk in an investor’s portfolio. The first ETF was the SPDR SandP 500 ETF (SPY), which tracks the SandP 500 Index.

KEY TAKEAWAYS

  • An exchange-traded fund (ETF) is a basket of securities that trades on an exchange just like a stock does.
  • ETF share prices fluctuate all day as the ETF is bought and sold; this is different from mutual funds, which only trade once a day after the market closes.
  • ETFs offer low expense ratios and fewer broker commissions than buying the stocks individually.

Googlawi / Zoe Hansen

How ETFs Work

An ETF must be registered with the Securities and Exchange Commission. In the United States, most ETFs are set up as open-ended funds and are subject to the Investment Company Act of 1940, except where subsequent rules have modified their regulatory requirements. Open-end funds do not limit the number of investors involved in the product.

Vanguard's Consumer Staples ETF (VDC) tracks the MSCI US Investable Market Consumer Staples 25/50 Index and has a minimum investment of $1.00. The fund holds shares of all 104 companies on the index, some familiar to most because they produce or sell consumer items. A few of the companies held by VDC are Proctor and Gamble, Costco, Coca-Cola, Walmart, and PepsiCo. Investors who buy $1.00 in VDC own $1.00 shares representing 104 companies.

There is no transfer of ownership because investors buy a share of the fund, which owns the shares of the underlying companies. Unlike mutual funds, ETF share prices are determined throughout the day. A mutual fund trades only once a day after market close.

Volatile stock performance is curtailed in an ETF because they do not involve direct ownership of securities. Industry ETFs are also used to rotate in and out of sectors during economic cycles.

Types of ETFs

  • Passive ETF: Passive ETFs aim to replicate the performance of a broader index—either a diversified index such as the SandP 500 or a more specific targeted sector or trend.
  • Actively managed ETF: Do not target an index of securities, but rather have portfolio managers making decisions about which securities to include in the portfolio. Actively managed ETFs have benefits over passive ETFs but can be more expensive to investors.
  • Bond ETF: Used to provide regular income to investors and distribution depends on the performance of underlying bonds which may include government, corporate, and state and local bonds, usually called municipal bonds. Unlike their underlying instruments, bond ETFs do not have a maturity date.
  • Stock ETF: A basket of stocks that track a single industry or sector like automotive or foreign stocks. The aim is to provide diversified exposure to a single industry, one that includes high performers and new entrants with growth potential. Unlike stock mutual funds, stock ETFs have lower fees and do not involve actual ownership of securities.
  • Industry or sector ETF: Funds that focus on a specific sector or industry. An energy sector ETF will include companies operating in that sector. Blackrock's iShares U.S. Technology ETF (IYW) mirrors the performance of the Russell 1000 Technology RIC 22.5/45 Capped Index and holds 1374 stocks of technology sector companies.
  • Commodity ETF: Invest in commodities like crude oil or gold. Commodity ETFs can diversify a portfolio, making it easier to hedge market downturns. Holding shares in a commodity ETF is cheaper than physical possession of the commodity.
  • Currency ETF: Track the performance of currency pairs consisting of domestic and foreign currencies. Currency ETFs can be used to speculate on the prices of currencies based on political and economic developments in a country. They are also used to diversify a portfolio or as a hedge against volatility in forex markets by importers and exporters.
  • Bitcoin ETF: The spot Bitcoin ETF was approved by the SEC in 2024. These ETFs expose investors to bitcoin's price moves in their regular brokerage accounts by purchasing and holding bitcoins as the underlying asset and allowing them to buy shares of the fund. Bitcoin futures ETFs, approved in 2021, use futures contracts traded on the Chicago Mercantile Exchange and mimic the price movements of bitcoin futures contracts.
  • Inverse ETF: Earn gains from stock declines by shorting stocks. Shorting is borrowing a stock, selling it while expecting a decline in value, and repurchasing it at a lower price. An inverse ETF uses derivatives to short a stock. Inverse ETFs are exchange-traded notes (ETNs) and not true ETFs. An ETN is a bond that trades like a stock and is backed by an issuer such as a bank.
  • Leveraged ETF: A leveraged ETF seeks to return some multiples (e.g., 2× or 3×) on the return of the underlying investments. If the SandP 500 rises 1%, a 2× leveraged SandP 500 ETF will return 2% (and if the index falls by 1%, the ETF would lose 2%). These products use debt and derivatives, such as options or futures contracts, to leverage their returns.

As of January 2024, nine ETFs focus on companies engaged in gold mining, excluding inverse, leveraged, and funds with low assets under management (AUM).

Pros and Cons of ETFs

  • Access to many stocks across various industries

Access to many stocks across various industries

  • Low expense ratios and fewer broker commissions

Low expense ratios and fewer broker commissions

  • Risk management through diversification

Risk management through diversification

  • ETFs exist that focus on targeted industries

ETFs exist that focus on targeted industries

Buying ETFs

ETFs trade through online brokers and traditional broker-dealers. Many sources provide pre-screened brokers in the ETF industry. Individuals can also purchase ETFs in their retirement accounts. An alternative to standard brokers is a robo-advisor like Betterment and Wealthfront.An ETF’s expense ratio is the cost to operate and manage the fund. ETFs typically have low expenses because they track an index.

ETFs are available on most online investing platforms, retirement account provider sites, and investing apps like Robinhood. Most of these platforms offer commission-free trading, meaning that investors don’t have to pay fees to the platform providers to buy or sell ETFs.

After creating and funding a brokerage account, investors can search for ETFs and make their chosen buys and sells. One of the best ways to narrow ETF options is to utilize an ETF screening tool with criteria such as trading volume, expense ratio, past performance, holdings, and commission costs.

Order a copy of Googlawi's What To Do With $10,000 for more wealth-building advice.

Popular ETFs

Below are examples of popular ETFs on the market. Some ETFs track an index of stocks, thus creating a broad portfolio, while others target specific industries.

  • SPDR SandP 500 (SPY): The oldest surviving and most widely known ETF that tracks the SandP 500 Index.
  • iShares Russell 2000 (IWM): An ETF that tracks the Russell 2000 small-cap index.
  • Invesco QQQ (QQQ) (“cubes”): An ETF that tracks the Nasdaq 100 Index, which typically contains technology stocks.
  • SPDR Dow Jones Industrial Average (DIA) (“diamonds”): An ETF that represents the 30 stocks of the Dow Jones Industrial Average.
  • Sector ETFs: ETFs that track individual industries and sectors such as oil (OIH), energy (XLE), financial services (XLF), real estate investment trusts (IYR), and biotechnology (BBH).
  • Commodity ETFs: These ETFs represent commodity markets, including gold (GLD), silver (SLV), crude oil (USO), and natural gas (UNG).
  • Country ETFs: Funds that track the primary stock indexes in foreign countries, but they are traded in the United States and denominated in U.S. dollars. Examples include China (MCHI), Brazil (EWZ), Japan (EWJ), and Israel (EIS). Others track a wide breadth of foreign markets, such as ones that track emerging market economies (EEM) and developed market economies (EFA).

ETFs vs. Mutual Funds vs. Stocks

Most stocks, ETFs, and mutual funds can be bought and sold without a commission. Funds and ETFs differ from stocks because of the management fees that most of them carry, though they have been trending lower for many years. In general, ETFs tend to have lower average fees than mutual funds.