Exchange Traded Fund (ETF)

Exchange-Traded Funds (ETFs) 

An ETF is called an exchange-traded fund because it’s traded on an exchange just like stocks are. The price of an ETF’s shares will change throughout the trading day as the shares are bought and sold on the market. This is unlike mutual funds, which are not traded on an exchange, and which trade only once per day after the markets close. Additionally, ETFs tend to be more cost-effective and more liquid compared to mutual funds.

An ETF is a type of fund that holds multiple underlying assets, rather than only one like a stock does. Because there are multiple assets within an ETF, they can be a popular choice for diversification. ETFs can thus contain many types of investments, including stocks, commodities, bonds, or a mixture of investment types.

An ETF can own hundreds or thousands of stocks across various industries, or it could be isolated to one particular industry or sector. Some funds focus on only U.S. offerings, while others have a global outlook. For example, banking-focused ETFs would contain stocks of various banks across the industry.

An ETF is a marketable security, meaning it has a share price that allows it to be easily bought and sold on exchanges throughout the day, and it can be sold short. In the United States, most ETFs are set up as open-ended funds and are subject to the regulatory requirements.

Types of ETFs

Various types of ETFs are available to investors that can be used for income generation, speculation, and price increases, and to hedge or partly offset risk in an investor’s portfolio. Here is a brief description of some of the ETFs available on the market today.

Passive and Active ETFs

ETFs are generally characterized as either passive or actively managed. Passive ETFs aim to replicate the performance of a broader index—either a diversified index such as the NSE IT or a more specific targeted sector or trend. 

Actively managed ETFs typically do not target an index of securities, but rather have portfolio managers making decisions about which securities to include in the portfolio. These funds have benefits over passive ETFs but tend to be more expensive to investors. We explore actively managed ETFs below.

Bond ETFs

Bond ETFs are used to provide regular income to investors. Their income distribution depends on the performance of underlying bonds. They might include government bonds, corporate bonds, and state and local bonds—called municipal bonds. Unlike their underlying instruments, bond ETFs do not have a maturity date. They generally trade at a premium or discount from the actual bond price.

Stock ETFs

Stock (equity) ETFs comprise a basket of stocks to track a single industry or sector. For example, a stock ETF might track automotive or foreign stocks. The aim is to provide diversified exposure to a single industry, one that includes high performers and new entrants with potential for growth. Unlike stock mutual funds, stock ETFs have lower fees and do not involve actual ownership of securities.

Industry/Sector ETFs

Industry or sector ETFs are funds that focus on a specific sector or industry. For example, an energy sector ETF will include companies operating in that sector. The idea behind industry ETFs is to gain exposure to the upside of that industry by tracking the performance of companies operating in that sector.

One example is the technology sector, which has witnessed an influx of funds in recent years. At the same time, the downside of volatile stock performance is also 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.

Commodity ETFs

As their name indicates, commodity ETFs invest in commodities, including crude oil or gold. Commodity ETFs provide several benefits. First, they diversify a portfolio, making it easier to hedge downturns.

For example, commodity ETFs can provide a cushion during a slump in the stock market. Second, holding shares in a commodity ETF is cheaper than physical possession of the commodity. This is because the former does not involve insurance and storage costs.

Currency ETFs

Currency ETFs are pooled investment vehicles that track the performance of currency pairs, consisting of domestic and foreign currencies. Currency ETFs serve multiple purposes. They can be used to speculate on the prices of currencies based on political and economic developments for a country. They are also used to diversify a portfolio or as a hedge against volatility in forex markets by importers and exporters. Some of them are also used to hedge against the threat of inflation. There’s even an ETF option for bitcoin.

Inverse ETFs

Inverse ETFs attempt to earn gains from stock declines by shorting stocks. Shorting is selling a stock, expecting a decline in value, and repurchasing it at a lower price. An inverse ETF uses derivatives to short a stock. Essentially, they are bets that the market will decline.

When the market declines, an inverse ETF increases by a proportionate amount. Investors should be aware that many inverse ETFs are exchange-traded notes (ETNs) and not true ETFs. An ETN is a bond but trades like a stock and is backed by an issuer such as a bank. Be sure to check with your broker to determine if an ETN is a good fit for your portfolio.

Leveraged ETFs

A leveraged ETF seeks to return some multiples (e.g., 2× or 3×) on the return of the underlying investments. For instance, if the S&P 500 rises 1%, a 2× leveraged S&P 500 ETF will return 2% (and if the index falls by 1%, the ETF would lose 2%). These products use derivatives such as options or futures contracts to leverage their returns. There are also leveraged inverse ETFs, which seek an inverse multiplied return.

How to Buy ETFs

With a multiplicity of platforms available to traders, investing in ETFs has become fairly easy. Follow the steps outlined below to begin investing in ETFs.

Find an Investing Platform

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

However, a commission-free purchase or sale does not mean that the ETF provider will also provide access to their product without associated costs. Some areas in which platform services can distinguish their services from others are convenience, services, and product variety.

For example, smartphone investing apps enable ETF share purchasing at the tap of a button. This may not be the case for all brokerages, which may ask investors for paperwork or a more complicated situation. Some well-known brokerages, however, offer extensive educational content that helps new investors become familiar with and research ETFs.

Research ETFs

The second and most important step in ETF investing involves researching them. There is a wide variety of ETFs available in the markets today. One thing to remember during the research process is that ETFs are unlike individual securities such as stocks or bonds.

You will need to consider the whole picture in terms of sector or industry when you commit to an ETF. Here are some questions you might want to consider during the research process:

• What is your time frame for investing?
• Are you investing for income or growth?
• Are there particular sectors or financial instruments that excite you?

Consider a Trading Strategy

If you are a beginning investor in ETFs, cost averaging or spreading out your investment costs over a period of time is a good trading strategy. This is because it smooths out returns over a period of time and ensures a disciplined approach to investing.

It also helps beginning investors learn more about the ETF investing. When they become more comfortable with trading, investors can move out to more sophisticated strategies like swing trading and sector rotation.

Online Brokers vs. Traditional Brokers

ETFs trade through both online brokers and traditional broker-dealers. You can view some of the top brokers in the industry for ETFs with Investopedia’s list of the best brokers for ETFs. You can also typically purchase ETFs in your retirement account.

A brokerage account allows investors to trade shares of ETFs just as they would trade shares of stocks. Hands-on investors may opt for a traditional brokerage account, while investors looking to take a more passive approach may opt for a robo-advisor. Robo-advisors often include ETFs in their portfolios, although they choice of whether to focus on ETFs or individual stocks may not be up to the investor.

What to Look in an ETF

After creating a brokerage account, investors will need to fund that account before investing in ETFs. The exact ways to fund your brokerage account will be depend on the broker. After funding your account, you can search for ETFs and make buys and sells in the same way that you would shares of stocks. One of the best ways to narrow your ETF options is to utilize an ETF screening tool. Many brokers offer these tools as a way to sort through the thousands of ETF offerings. You can typically search for ETFs according to some of the following criteria:

• Volume: Trading volume over a particular period of time allows you to compare the popularity of different funds; the higher the trading volume, the easier it may be to trade that fund.
• Expenses: The lower the expense ratio, the less of your investment that is given over to administrative costs. While it may be tempting to always search for funds with the lowest expense ratios, sometimes costlier funds (such as actively managed ETFs) have strong enough performance that it more than makes up for the higher fees.
• Performance: While past performance is not an indication of future returns, this is nonetheless a common metric for comparing ETFs.
• Holdings: The portfolios of different funds often factor into screener tools as well, allowing customers to compare the different holdings of each possible ETF investment.
• Commissions: Many ETFs are commission-free, meaning that they can be traded without any fees to complete the trade. However, it is worth checking if this is a potential dealbreaker.

ETFs vs. Mutual Funds vs. Stocks

Comparing features for ETFs, mutual funds, and stocks can be a challenge in a world of ever-changing broker fees and policies. 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.1 In general, ETFs tend to have lower average fees than mutual funds.5 Here is a comparison of other similarities and differences.

Exchange-Traded Funds	Mutual Funds	Stocks
Exchange-traded funds (ETFs) are a type of index funds that track a basket of securities.	Mutual funds are pooled investments into bonds, securities, and other instruments that provide returns.	Stocks are securities that provide returns based on performance.
ETF prices can trade at a premium or at a loss to the net asset value (NAV) of the fund.	Mutual fund prices trade at the net asset value of the overall fund.	Stock returns are based on their actual performance in the markets.
ETFs are traded in the markets during regular hours just like stocks are.	Mutual funds can be redeemed only at the end of a trading day.	Stocks are traded during regular market hours.
Some ETFs can be purchased commission-free and are cheaper than mutual funds because they do not charge marketing fees.	Some mutual funds do not charge load fees, but most are more expensive than ETFs because they charge administrative and marketing fees.	Stocks can be purchased commission-free on some platforms and generally do not have charges associated with them after purchase.
ETFs do not involve actual ownership of securities.	Mutual funds own the securities in their basket.	Stocks involve physical ownership of the security.
ETFs diversify risk by tracking different companies in a sector or industry in a single fund.	Mutual funds diversify risk by creating a portfolio that spans multiple asset classes and security instruments.	Risk is concentrated in a stock’s performance.
ETF trading occurs in-kind, meaning they cannot be redeemed for cash.	Mutual fund shares can be redeemed for money at the fund’s net asset value for that day.	Stocks are bought and sold using cash.
Because ETF share exchanges are treated as in-kind distributions, ETFs are the most tax-efficient among all three types of financial instruments.	Mutual funds offer tax benefits when they return capital or include certain types of tax-exempt bonds in their portfolio.	Stocks are taxed at either ordinary income tax rates or capital gains rates.

Evaluating ETFs

The ETF space has grown at a tremendous pace in recent years, reaching $4 trillion in invested assets by 2019.6 The dramatic increase in options available to ETF investors has complicated the process of evaluating which funds may be best for you. Below are a few considerations you may wish to keep in mind when comparing ETFs.

Expenses

The expense ratio of an ETF reflects how much you will pay toward the fund's operation and management. Although passive funds tend to have lower expense ratios than actively managed ETFs, there is still a wide range of expense ratios even within these categories. Comparing expense ratios is a key consideration in the overall investment potential of an ETF.

Diversification

Nearly all ETFs provide diversification benefits relative to an individual stock purchase. Still, some ETFs are highly concentrated—either in the number of different securities they hold or in the weighting of those securities. A fund that concentrates half of its assets in two or three positions may offer less diversification than a fund with fewer total portfolio constituents but broader asset distribution, for example.

Liquidity

ETFs with very low AUM or low daily trading averages tend to incur higher trading costs due to liquidity barriers. This is an important factor to consider when comparing funds that may otherwise be similar in strategy or portfolio content.