Your Quick Guide: What Is An ETF?

The investing world has no shortage of acronyms. It pays to know what they mean. Whether you’re an aspiring solo trader or you work closely with a brokerage, you’ve probably come across the acronym “ETF,” short for exchange-traded funds. ETFs are essentially a basket of securities put together by an investment company. The underlying assets in these bundles target specific investment strategies.

Here’s your quick primer to ETFs and why investing in them could make sense for you.

Why People Invest In ETFs

People invest in ETFs for many reasons. Unlike mutual funds, they are typically low-cost funds traded on the stock exchange. That makes them a more accessible investment option. ETFs are generally less risky than single securities due to the diversification of the fund.

There are also many different ETFs that focus on certain investment strategies, like tracking a stock index. Another common strategy is for ETFs to contain multiple asset classes to assure a diversified portfolio. By tracking a stock index, an ETF focuses on the rate of return against the growth of the market, whereas an ETF with an extremely diverse portfolio is focused on mitigating risk.

What You Should Know About Exchange-Traded Funds

Since ETFs come in a variety of forms – from specific index funds to real estate ETFs – it pays to know more about the details of how ETFs trade. Before purchasing ETF shares, consider how much different ETFs cost, how returns are taxed and how they differ from mutual funds.

How Much ETFs Cost

ETFs come with their own fees. The first to consider is brokerage commissions. If you buy an ETF through a brokerage, they could charge you a fee per transaction. This could be a flat fee of, say $5 – $20, or a percentage. Many brokerages also offer no-commission ETFs.

You’ll also pay a management fee to the investment company that manages the fund. This fee is often referred to as annual expense ratio, or AER. This is the cost to run the fund and it comes out of your return. Say a fund has an AER of 0.70% and you’ve got $10,000 in it. That means, for your $10,000, you’ll pay $70 in an annual fee. If the fund sees no growth, you’re losing money.

Despite the costs, the performance of ETFs makes them part of a solid investment strategy.

How ETFs Are Taxed When Redeemed

ETFs are notoriously tax-efficient due to their structure, which allows people to transact with other investors on the exchange without triggering a tax event. However, some ETFs have underlying assets that can cause taxation. For instance, if one ETF has a lot of securities that pay annual dividends, you’ll need to pay capital gains tax on them. The same goes for an ETF that has bonds that pay out monthly.

Also, if you sell your shares in your ETF for more than what you paid for them, you’ll be required to pay capital gains tax. This tax varies depending on your taxable income level and how long the asset was held. Assets held less than a year have short-term capital gains treated at the same rate as income tax. Those held longer than a year are subject to long-term capital gains taxes of 0%, 15% or 20%, depending on income level.

How ETFs Are Different From Mutual Funds And Index Funds

ETFs gained steam in the early 1990s as a response to the popularity of index funds. One of the first ETFs was the S&P 500 Trust ETF, also known as the SPDR (pronounced as “spider”). This is still an actively traded fund on the market, over 30 years later. While ETFs often track a specific index, when people refer to an investment as an index fund, they’re usually talking about an index mutual fund.

There are many differences between ETFs and mutual funds. One main difference is that ETFs trade on the open market with intraday trading and regular pricing updates. Mutual funds, on the other hand, are only bought and sold at the end of the day, which is also when their net asset value (NAV) is determined.

Types Of ETFs

There are over 8,700 ETFs traded globally, with each one being unique. Some ETFs focus on a particular industry, like health care. Others trade on specific stock exchanges, try to protect against volatility or supply investors with a fixed income. Here are some common ETF types:

• Equity ETFs
• Bond ETFs
• High-dividend ETFs
• Inverse ETFs
• Commodity ETFs
• Market-Cap Index ETFs
• ESG ETFs
• Currency ETFs
• International ETFs
• Leveraged ETFs

How To Choose An ETF

With all of these ETF offerings, it can be tough to know how to make the right investment decisions. However, there are few key things you can do to pick the right ETF to invest in.

• Narrow the scope: Pick an ETF that follows a specific strategy. If you want one that tracks a specific index, look first at ETFs that track the S&P 500. Or you could narrow it down by a specific industry, such as tech, real estate or health care.
• See how active they are: You want to invest in actively managed ETFs that are trading in volume daily. Frequently traded ETFs lead to slightly greater liquidity, where as low-volume ETFs are traded less often and are less liquid.
• Research how much they cost: Look at each ETF’s expense ratio (or how much it costs to own the fund) to see how much is being charged to manage them.
• Consider their history: Dig into the past performance before making the ETF investment.

How To Start Investing In ETFs

Many investors start by using an app or an AI advisor. These can be great tools for investing in a wide range of investment products, from ETFs to individual stocks. Most major brokerages require little to set up an account for you to get started. All you will need to give is some personal and financial information and you’ll be able to buy and sell ETFs in no time.

ETF Pros And Cons

ETFs can be a great investment for both beginners and seasoned investors. However, they’re not without their cons. Let’s put the pros and cons side by side to easily compare.

FAQs: How ETFs Work

While this quick guide has already answered several questions, there are still so many more. Here is a selection of what else people want to know when investing in ETFs.

Is an ETF better than a stock?

ETFs are no better or worse than individual stocks. It depends on the market and the performance of the ETF and the stock. If an ETF has high operating costs and isn’t performing well, shares of a specific stock at a thriving company could easily be a better investment. However, a diversified ETF in a tough economy is typically a lot less risky than a single stock.

Are ETFs a good investment?

It depends on the ETF. In general, ETFs that track the S&P 500 are seen as a good investment for passive investors. However, you should always research the underlying assets of an ETF and look at its past performance before investing in it. It’s also wise to work with a financial professional before making any decisions.

What is an example of an ETF?

The quintessential ETF is the Standard & Poors Depository Receipts – or SPDR (SPY) – ETF that was created in 1993. This ETF tracks the performance of the S&P 500. Since its introduction, several other similar funds have been created, such as Blackrock’s iShares Core S&P 500 ETF (IVV) and the Vanguard S&P 500 ETF (VOO).

How are ETFs priced?

ETFs have two prices: the price an investor pays (known as an “ask”) and the price they get when an ETF is sold (known as a “bid”). The difference between the ask and the bid is what’s known as a spread. If the spread is high, that means the market price of shares of the ETF is more costly than the intraday value of the underlying assets. A high spread is a poor time to do business with that ETF because you’ll lose money.

Do ETFs trade like stocks?

Yes, ETFs are funds traded on the stock exchange just like stocks. Their liquidity and flexibility for intraday trading is a big part of what differentiates them from mutual funds.

What are examples of popular ETFs?

There are many ways to measure the size and popularity of an ETF. One way is through the amount of assets under management (AUM). Here are the top 10 ETFs with high AUM according to ETF.com.

1. SPDR S&P 500 ETF Trust (SPY)     

2. iShares Core S&P 500 ETF (IVV)     

3. Vanguard Total Stock Market ETF (VTI)

4. Vanguard S&P 500 ETF (VOO)        

5. Invesco QQQ Trust (QQQ)

6. Vanguard FTSE Developed Markets ETF (VEA)

7. Vanguard Value ETF (VTV)  

8. iShares Core MSCI EAFE ETF (IEFA)         

9. Vanguard Total Bond Market ETF (BND)     

10. iShares Core U.S. Aggregate Bond ETF (AGG)

The Bottom Line: ETFs Offer Diversification For Your Portfolio

ETFs are a great option for investors, especially passive investors. They allow you to take advantage of fund manager expertise and generate a rate of return that matches market performance. They’re tax efficient and can help you mitigate risk through diversification.

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