What Are ETFs?

Exchange-traded funds (ETFs) are baskets where you can invest your money. Here's what you should know about ETFs.

Exchange-traded funds (ETFs), explained

An ETF is an exchange-listed security that typically tracks an index comprised of individual securities. Such as the S&P 500 or the Nasdaq. When you purchase a share of an ETF, you’re not picking out the securities you wish to buy. Instead, you decide which asset class(es), sector(s), or indices you’d like to invest. Some ETFs also follow particular strategies by choosing a sampling of an index to follow and some are even actively managed

ETFs can own thousands of stocks in a single fund. Or they can limit to a few dozen within a given sector or industry. In the United States, most ETFs are open-end funds. This means that they don't limit investors.

The main difference between an ETF and a mutual fund, which we will cover next, is that ETFs list on exchanges and trade intraday, like stocks. This can be both a blessing and a curse for many investors.

For instance, incredibly risk-adverse investors who notice shares of their ETF slipping with a market crash can sell before the day’s close. However, the ability to access the market at any time leads to trading on impulse and emotion, rather than attempting to weather the storm.

Furthermore, ETFs tend to be more cost-effective and liquid than many other funds on the market due to different capital gains regulations. Typically, they cost less tax-wise in a given year than many mutual funds, and they often carry a smaller expense ratio, as well. This is the result of many passively ETFs, which leads to fewer management fees.

However, there are a few actively managed ETFs in which the portfolio managers handpick securities to buy and sell throughout the day. These ETFs tend to cost more overall. And it's no guarantee that you'll generate gains over passive ETFs. This is partially the result of higher expense ratios as well as the fact that they are more susceptible to human judgment and impulse.

Main Types of ETFs

There are several types of ETFs on the market with each based around different goals. Some intend to turn a profit through capital gains, while others are based around supplying dividends to investors. Still others hedge against various risks in investors’ portfolios.

A few of the most common ETFs include:

  • Bond ETFs focus on investing in various types of bonds across or within certain sectors
  • Industry ETFs track a stated industry – financial, technology, etc.
  • Currency ETFs put their funds into foreign (non-USD, for our purposes) currencies
  • Commodity ETFs invest in various physical commodities, such as gold or oil

What this means for you

Overall, ETFs offer more choices to their investors when it comes to trading shares. This is because investors do not have to buy or sell  in a set time in the trading day. They also have smaller or no investment minimums than many types of funds.

Furthermore, it’s possible to profit on an ETF when the market plunges, as some ETFs (called inverse ETFs) trade on principle of shorting the stocks in their portfolio.

However, just as with mutual funds, not every ETF is profitable. Because they can list on exchanges, they have to meet certain standards – but management fees and high expense ratios can eat into an investor’s profits, just as with any fund.

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