Exchange-Traded Fund (ETF)

What is an Exchange-Traded Fund (ETF)?

The definition of an exchange-traded fund (ETF) is a type of fund that invests in a portfolio of assets, such as a stock market index, sector, or commodity. Shares that represent ownership of the portfolio are traded on stock exchanges so that investors can buy and sell them in the same way as individual stocks.

Techopedia Explains the Meaning of Exchange-Traded Fund

Exchange-traded funds pool investors’ money to purchase a diversified portfolio of underlying assets. These assets are held in a trust, and the ETF shares represent ownership in that trust.

At the core of how ETFs work is the creation and redemption process, which keeps a fund’s ETF’s market price in line with its net asset value (NAV).

Most ETFs are designed to track the performance of an underlying index or benchmark, such as the S&P 500 or a bond index.

The management company constructs a portfolio of assets (stocks, bonds, or other securities) that closely mirrors the composition of the chosen index and rebalances the portfolio periodically to reflect changes in the index, such as by adding or removing securities.

The extent to which an ETF’s performance deviates from the performance of the underlying index is known as a tracking error. This is influenced by factors such as expenses, trading costs, and portfolio management decisions.

ETFs that generate dividends and other income from the underlying securities pass the returns on to shareholders in the form of cash distributions or reinvestment into the fund.

History of ETFs

ETFs emerged in the early 1990s when the SPDR S&P 500 ETF Trust (SPY) was introduced. The SPY ETF, launched by State Street Global Advisors in January 1993, is often considered to be the industry pioneer.

It tracks the performance of the S&P 500 US stock market index, one of the most widely followed equity benchmarks in the world, and remains one of the most actively traded ETFs.

Since then, the ETF industry has expanded to offer a wide range of investment options.

Historic.

For #Bitcoin and for ETFs. pic.twitter.com/ppKpanSCXb

— Binance (@binance) January 11, 2024

In the early years, ETFs gained traction slowly as investors and financial institutions took time to understand how to use this new form of investment vehicle. One of the main advantages was the ability to offer investors exposure to a broad market or specific sectors with low expense ratios compared to traditional mutual funds.

As ETFs gained popularity, fund managers began launching a variety of new ETFs with different objectives, such as sector and industry, commodity, and fixed-income ETFs.

The industry continued to grow into the early 2000s, and innovations in ETFs expanded their scope to include different types of investments, such as actively managed ETFs that allow fund managers to make investment decisions rather than simply implementing passive index-tracking strategies.

Leveraged and inverse ETFs became popular tools for traders looking to profit from short-term market volatility.

The 2008 financial crisis highlighted the benefits of ETFs, such as liquidity and transparency, which became more attractive to institutional and retail investors seeking safer and more efficient investment options.

The ETF industry continued to gain mainstream acceptance, and rapid growth saw assets under management (AUM) reach trillions of dollars.

ETF providers regularly launch new products, such as socially responsible ETFs and cryptocurrency ETFs, and actively manage thematic funds to meet evolving investor preferences and market trends.

How Do ETFs Work?

ETFs work through a unique creation and redemption mechanism that allows them to maintain a close alignment between the fund’s market price and the net asset value (NAV) of the underlying securities they hold. This mechanism ensures that ETF shares trade efficiently on the stock exchange.

The creation process works as follows:

Portfolio creation

An ETF sponsor, typically an asset management company, creates a portfolio of underlying securities that closely mirrors the composition of the target index or investment strategy the fund aims to track. The ETF sponsor works with authorized participants (APs), typically large institutional investors or market makers.

Creation of ETF shares

To create new ETF shares, an AP assembles a basket of the underlying securities that match the composition of the ETF’s portfolio. The AP delivers this basket of securities to the ETF issuer in exchange for newly created ETF shares.

Exchange listing

Once created, the ETF shares are listed on a stock exchange, where investors can buy and sell them throughout the trading day at market prices.

Here is how the redemption process works:

Portfolio rebalancing

Over time, the composition of the ETF’s underlying securities may change because of factors such as corporate actions, changes in index components, or adjustments made by the ETF manager to maintain the fund’s alignment with the target index.

Redemption request

If the ETF’s market price deviates significantly from its NAV, authorized participants can initiate a redemption process, by exchanging ETF shares for the underlying securities held by the ETF issuer.

Redemption of ETF shares

In response to a redemption request, the ETF issuer delivers the underlying securities to the authorized participant in exchange for the ETF shares being redeemed. This process helps arbitrage away any discrepancies between the ETF’s market price and its NAV.

Market making and liquidity

In addition to the creation and redemption process, market makers play a crucial role in maintaining liquidity in the ETF market. They continuously quote bid and ask prices for ETF shares, ensuring that there is a ready supply of shares available for investors to buy or sell on the secondary market.

Arbitrage mechanism

The creation and redemption mechanism of ETFs, combined with the active participation of authorized participants and market makers, creates an arbitrage opportunity. If the ETF’s market price deviates from its NAV, arbitrageurs can step in to buy or sell the underlying securities and ETF shares, bringing the two prices back into equilibrium.

Types of ETFs

Equity ETFsStrategy ETFsFixed Income ETFsCommodity ETFsInternational ETFsCurrency ETFsSpecialty and Thematic ETFs

Aim to replicate the returns of a portfolio of equities. Offer investors exposure to a broad market or specific industries and sectors within the market.

Index ETFs: Track the performance of indices such as the S&P 500, Dow Jones Industrial Average, or NASDAQ.
Sector ETFs: Focus on specific industries or sectors of the economy, such as technology, healthcare, financials, or energy.

Emphasize stocks with specific characteristics.

Dividend ETFs: Focus on companies that pay high and/or growing dividends.
Equal Weighted ETFs: Gives each holding in the portfolio equal weighting to provide balanced exposure.
Growth ETFs: Invest in companies with strong earnings growth potential.
Low Volatility/Risk Weighted ETFs: Invest in stocks with low volatility characteristics, which typically have relatively stable share prices and above-average yields.
Value ETFs: Target undervalued stocks with lower price-to-earnings ratios.

Invest in various types of bonds and other debt securities, providing income and stability to investors.

Treasury Bond ETFs: Invest in US government-issued Treasury bonds for regular income.
Corporate Bond ETFs: Hold bonds issued by corporations, offering potentially higher yields than government bonds but with higher credit risk.
Municipal Bond ETF: Invest in bonds issued by state and local governments, providing tax advantages for some investors.

Provide exposure to physical commodities such as gold, silver, oil, and agricultural products to investors to speculate on commodity prices or hedge against inflation.

Gold ETFs: Hold physical gold bullion, allowing investors to track the price of gold without owning the physical metal.
Oil ETFs: Track the price of crude oil for speculative purposes and hedging against energy price fluctuations.
Agricultural ETFs: Invest in agricultural commodities like wheat, corn, or soybeans, offering exposure to the agricultural sector.

Offer exposure to foreign markets and assets, allowing investors to diversify their portfolios globally and capitalize on international growth opportunities.

Global ETFs: Invest in companies from various countries worldwide, providing broad international exposure.
Country ETFs: Focus on a single country’s stock market.
Region ETFs: Cover specific geographical regions, such as Europe, Asia-Pacific, or emerging markets.

Offer investors exposure to foreign exchange markets for a single currency or a basket of currencies.

Target specific themes, trends, or niche markets. They are designed for investors who want to align their portfolios with particular ideas or developments.

Artificial Intelligence ETFs: Provide exposure to companies developing AI technologies and applications.
Blockchain/Cryptocurrency ETFs: Offer investors exposure to blockchain miners and developers or cryptocurrencies without having to own coins or tokens.
Cloud Technology ETFs: Target companies that are active in developing or providing cloud technology.
Cybersecurity ETFs: Invest in companies engaged in protecting digital data and networks from cyberthreats.
Robotics and Automation ETFs: Focus on companies developing technology in the fields of automation and robotics.

What is the Difference Between ETFs, Mutual Funds, and Stocks?

Aspect	Exchange Traded Funds (ETFs)	Mutual Funds	Individual Stocks
Structure	An open-end investment company with shares that represent ownership in a portfolio of assets.	An open-end investment company that pools money from multiple investors to invest in a diversified portfolio of assets.	Ownership in a specific company with shares representing a stake in that company.
Trading	Traded on stock exchanges throughout the trading day at market prices.	Priced and traded at the end of the trading day at the net asset value (NAV).	Traded on stock exchanges throughout the trading day at market prices.
Diversification	Provides instant diversification by holding a basket of assets within a single security.	Offers diversification through a portfolio of assets, but investors may need to buy multiple funds for broader diversification.	Represents ownership in a single company, so diversification depends on owning multiple company stocks.
Liquidity	High liquidity, allowing intraday trading and quick access to funds.	Typically less liquid owing to end-of-day pricing, limiting intraday trading.	High liquidity, facilitating intraday trading and easy access to funds.
Expense Ratios	Typically lower expense ratios compared to mutual funds.	Expense ratios can vary but may be higher than those of ETFs.	No expense ratios, but may have brokerage commissions and fees.
Tax Efficiency	Tax-efficient due to in-kind creation and redemption process, potentially resulting in fewer capital gains distributions.	Capital gains distributions can be more frequent, leading to potential tax consequences.	Tax treatment depends on the holding period and individual tax circumstances.
Management Style	Primarily passive management, aiming to replicate the performance of an underlying index. Some actively managed ETFs are also available.	Offers both passive and actively managed options.	Passive ownership with no active management by the investor.
Flexibility	Suitable for various investment strategies, including passive, active, sector-specific, and thematic.	Offers various strategies but may require investors to buy/sell shares at NAV.	Allows investors to choose specific companies and sectors for their portfolios.
Minimum Investment	No minimum investment is required, making ETFs accessible to investors of all sizes.	Minimum investment amounts may vary by fund, potentially limiting accessibility for some investors.	No minimum investment.
Transparency	High transparency with daily disclosure of holdings allows investors to see exactly what assets are held.	Holdings are disclosed quarterly.	Transparency depends on the company’s reporting practices.
Risk Exposure	Provides exposure to specific asset classes, sectors, or themes, allowing for precise risk management.	Offers exposure to asset classes and sectors, but not as granular as ETFs in terms of thematic or sector-specific strategies.	Direct exposure to the performance and risks associated with a single company.
Dividends and Income	May offer automatic dividend reinvestment or cash distribution options.	Typically offer automatic dividend reinvestment or cash distribution options.	Receive dividends directly from the individual company.
Investment Goals	Suitable for various investment goals, including income generation, growth, and risk mitigation.	Cater to diverse investment goals, including income, growth, and preservation.	May align with long-term capital appreciation, income, or speculative objectives.

The choice between ETFs, mutual funds, and individual stocks depends on individual financial objectives, risk tolerance, and investment preferences.

Many investors choose to build diversified portfolios by combining these investment vehicles to achieve their specific goals.

Why Choose ETFs

ETFs offer flexibility and can serve various purposes:

Investment Strategies

nvestors can use ETFs for a wide range of investment strategies, including long-term investing, trading, income generation, and risk management.

Asset Classes

ETFs cover various asset classes, including equities, fixed income, commodities, real estate, and alternative investments.

Specialized Strategies

ETFs can cater to specialized strategies such as factor investing, thematic investing, and sustainable investing.

Risk Management

ETFs can be used for risk management purposes, such as hedging against market downturns or specific risks.

How to Trade ETFs

Buying and selling ETFs involves several steps, from choosing an account provider to executing orders.

Choose a brokerage account
Before you can trade ETFs, you need access to a brokerage account that offers the ETFs you want to invest in. Different brokerages may offer varying selections of ETFs. Consider fees such as commissions and account maintenance charges. Some brokerages offer commission-free ETF trades, which can save you money.
Research and select ETFs
Conduct research to identify suitable ETFs that align with your investment goals and risk tolerance. Compare the expense ratios of different ETFs, as lower expenses can result in higher returns over time. Your brokerage should offer research tools and resources to help you analyze ETFs and make informed decisions.
Place an order
Buy or sell ETF shares through your brokerage account.
Asset allocation
Build a diversified portfolio by selecting ETFs from different asset classes, such as equity, fixed income, commodities, and countries/regions.
Monitor and manage your investments
Review your portfolio periodically to ensure it remains aligned with your investment goals and risk tolerance. Rebalance, if necessary, to maintain your preferred asset allocation.
Stay Informed
Keep up with news and events that may impact the ETFs you hold. Market conditions, economic data, and geopolitical events can all influence investment performance.
Income reinvestment
Decide whether you want to reinvest the dividends and income your ETFs generate or receive them as cash. Many brokerage accounts provide an option to automatically reinvest dividends.
Tax considerations
Be aware of the tax implications of buying and selling ETFs. Capital gains and losses can have tax consequences, and tax-efficient trading strategies can help minimize taxes. Remember that investing in ETFs carries risk, and is essential to conduct thorough research based on your individual financial circumstances before making any investment decisions.

Evaluating ETFs

When considering investing in ETFs, it’s essential to conduct thorough research to choose funds that align with your investment objectives and risk tolerance.

Here are some key factors to consider when evaluating ETFs:

Expense RatiosTracking ErrorLiquidityUnderlying HoldingsProvider Reputation

Represent the annual operating expenses of an ETF expressed as a percentage of its total assets. As these expenses are deducted from the fund’s returns, higher expense ratios can significantly reduce long-term returns, so it’s essential to compare the expense ratios for similar ETFs.

Measures the deviation of an ETF’s performance from its underlying index. Lower tracking error indicates that the ETF closely mirrors the performance of its benchmark index, making it a more reliable investment vehicle for tracking specific market segments.

The ease with which ETF shares can be bought or sold on the secondary market without significantly affecting their market price. High liquidity enables efficient trading and ensures that investors can enter or exit positions at fair market prices. Higher trading volumes typically indicate higher liquidity and tighter bid-ask spreads, reducing transaction costs.

Understanding the underlying holdings of an ETF is crucial for assessing its exposure to specific sectors, industries, or asset classes. Different ETFs may track the same market segment but use different index methodologies. You should review the ETF’s prospectus and holdings disclosure to ensure it aligns and meets your investing needs.

The reputation and credibility of the ETF provider are important considerations when evaluating ETFs. Established and reputable providers typically offer greater transparency, investor support, and adherence to best practices in fund management.

By carefully evaluating these factors and conducting comprehensive due diligence, investors can make informed decisions when selecting ETFs.

Examples of ETFs

Well-known and frequently traded ETFs include:

SPDR S&P 500 ETF (SPY): Tracks the performance of the S&P 500 index.
Invesco QQQ Trust (QQQ): Tracks the performance of the NASDAQ-100 index.
Vanguard Total Stock Market ETF (VTI): Provides exposure to the entire US stock market.