What Is an ETF? An Overview for Beginner Investors
Everyone is talking about ETFs. Here's why — and what you need to know before investing in them.
7 min read
Whether you're taking your first steps into investing or looking to diversify your investment portfolio, Exchange-Traded Funds (ETFs) will surely have crossed your path. They’re increasingly popular, but you might still be wondering: what exactly are ETFs and how do they work? In this article, we’ll demystify ETFs and explain what they are and how they work. Plus, we’ll go over the pros and cons to keep in mind if you’re considering investing in ETFs.
What are Exchange-Traded Funds (ETFs)?
Exchange-Traded Funds (ETFs) are a type of investment fund. They track the performance of a specific index, commodity, bond, or basket of assets together, combining the benefits of a fund and a share in one security. You can trade them on stock exchanges, just like individual stocks.ETFs cover various asset classes, including equities, fixed-income securities, and commodities. Some ETFs passively track the performance of a specific index, such as the S&P 500, while others may be actively managed, allowing investors to speculate in hopes of boosting their profits.
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ETFs come in all shapes and sizes to match the different goals and risk profiles that investors might have. Here are some common types of ETFs:
Equity ETFs: The most common type of ETFs. They track the performance of a specific stock market index, sector, or industry. Examples include ETFs that follow the S&P 500, Nasdaq-100, or a particular industry like technology or healthcare.
Fixed-income or Bonds ETFs: These ETFs invest in bonds and other fixed-income securities. They focus on government bonds, corporate bonds, municipal bonds, or a mix of different fixed-income financial instruments.
Commodity ETFs: Commodity ETFs relate to physical commodities such as gold, silver, oil, or agricultural products. Some commodity ETFs own the physical commodities, while others use futures contracts to track their prices.
Currency ETFs: These track the performance of a specific currency or a basket of currencies. Investors use currency ETFs to gain exposure to foreign exchange markets without trading currencies directly.
Sector and industry ETFs: This type focuses on specific sectors or industries, allowing investors to target their investments in areas like technology, healthcare, energy, or finance.
Inverse ETFs: Also known as "short ETFs" or "bear ETFs," these funds aim to profit from the decline of an index value. They use various financial instruments to achieve the opposite performance of the tracked index.
Leveraged ETFs: These funds use financial derivatives to amplify the returns of the underlying index. For example, a 2x leveraged ETF seeks to double the daily performance of its track index. However, leverage also increases risk.
Smart Beta or Factor ETFs: These ETFs follow alternative indexing strategies, emphasizing factors like value, momentum, or low volatility rather than market capitalization. The goal is to outperform traditional market cap-weighted indices.
Multi-asset ETFs: These funds invest in a mix of different asset classes, such as stocks, bonds, and commodities. They provide diversified exposure within a single investment vehicle.
As you can see, there are tons of options if you're interested in investing in ETFs. Remember that it's important to understand the risks associated with each type of ETF before incorporating them into your portfolio. Check if your goals match the risks, and know that the ETF landscape continually evolves and new types of ETFs may emerge over time.
How do ETFs work?
ETFs provide a cost-effective way for investing in entire markets through a single security. For instance, by holding a single MSCI World ETF, you diversify your investment across approximately 1,600 companies worldwide. Beyond equities, ETFs offer access to other asset classes, making them versatile building blocks for private financial investments. These funds replicate market indices seamlessly and, similar to shares, are tradable on the stock exchange at any time.
How do ETFs differ from other types of investment?
Not all investments are created equal, and ETFs have their own special flavor. Understanding the differences between ETFs and other types of investment will empower you to make informed decisions based on your financial goals and risk tolerance. Here's what you need to know:
Accessible: ETFs typically have lower minimum investment requirements than mutual funds or other investment vehicles, making them more accessible.
Tax efficient: ETFs are known for their tax efficiency. That’s in large part because of a unique process called “creation and redemption” that minimizes capital gains with ETFs — which, in turn, minimizes capital gains taxation.
Diverse: ETFs often provide investors with a cost-effective way to diversify their investment portfolio. Since ETFs can track an index or a basket of assets, investors are able to spread their risk across various securities.
More liquidity: ETFs can be bought or sold on the stock exchange at any time during market hours, providing more liquidity. Mutual funds, on the other hand, only perform transactions at the end of the trading day.
Passive vs. active: Many ETFs follow a passive investment strategy, tracking the performance of a specific index. This contrasts with actively managed funds, where you might make investment decisions to outperform the market.
Compared to mutual funds, individual stocks, or other investment options, ETFs offer a unique blend of features that can be appealing. For brand-new investors wanting to get started with ETFs, the next big question is: how?
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Many different trading platforms and banks offer ETFs, so your journey into investing in these assets can be pretty straightforward. Consider taking the following steps:
Find an investing platform: Explore online investing platforms, retirement account provider sites, and investing apps. Look for platforms offering commission-free trading to avoid additional fees when buying or selling ETFs. And choose a platform that aligns with your priorities and goals — maybe convenience is important to you, or the variety of products.
Research: Do a deep dive on the ETFs you’re interested in and understand the sector or industry they represent. This might not sound like a whole lot of fun, but knowledge is power — you’ll thank yourself in the long run! Consider your investment time frame, financial goals, budget, and specific sectors that interest you to help narrow down your research project.
Create a trading strategy: For beginners, it’s crucial to craft a trading strategy for yourself. For example, you might want to spread your investment costs over time rather than investing a lot right away. As you become more comfortable with trading, you can explore more advanced strategies like swing trading or sector rotation.
While practical steps like these can be a good starting point for getting into ETF investing, don't forget that all investments come with advantages and disadvantages.
The advantages and disadvantages of ETFs
An investment portfolio can have one, several, or exclusively ETFs. For beginner investors, many exchange-traded funds offer budget-friendly access to a diversified range of securities. Those are two major advantages, but there are a few other reasons why some people choose to invest ETFs:
Access to diverse stocks: ETFs provide access to a broad range of stocks across various industries, allowing investors to diversify their portfolios with a single investment.
Low expense ratios and reduced commissions: ETFs generally incur lower average costs than buying individual stocks. With only one transaction to buy and one to sell, investors benefit from fewer broker commissions. Some brokers even offer no-commission trading on select low-cost ETFs.
Risk management through diversification: Diversification is often a hallmark of ETFs, which makes them generally considered less risky. With ETFs, investors can spread risk and mitigate the impact if some of their investments perform poorly.
Targeted industry focus: Some investors like to tailor their portfolios to their interests, and ETFs make that possible.
But, as with all types of investments, there are also disadvantages and risks to ETFs. For example, actively managed ETFs, where fund managers make investment decisions, may have higher fees than passively managed ETFs. If you choose to concentrate on a single industry, that makes your portfolio less diverse — and if your chosen sector runs into problems, so do your investments.As always, understanding the advantages and disadvantages of ETFs is key. This helps you to make informed decisions so that your investment journey aligns with your financial goals.
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