ETFs are a type of shared investment property that works a lot like mutual funds. ETFs usually follow a certain market, industry, product, or other asset. However, unlike mutual funds, ETFs can be bought and sold on a stock exchange just like regular stocks. An ETF can be set up to track the price of anything from a single product to a big group of different stocks. ETFs can even be set up to follow certain financial plans.
The SPDR S&P 500 ETF (SPY) was the first ETF. It tracks the S&P 500 Index and is still widely traded today.
KEY TAKEAWAYS
A group of assets that trades on a market like a stock is called an exchange-traded fund (ETF).
ETF share prices change all day as the ETF is bought and sold. This is different from mutual funds, which only trade once a day after the market ends.
ETFs can hold any kind of investment, like stocks, commodities, or bonds. Some only hold U.S. investments, while others hold investments from all over the world.
ETFs have low-cost ratios and fewer trading fees than buying individual stocks.
Exchange-Traded Fund (ETF) is the Spanish word for this.
Exchange-Traded Fund (ETF) Definition
Understanding Exchange-Traded Funds (ETFs)
ETF stands for “exchange-traded fund.” Like stocks, ETFs are sold on a market. As ETF shares are bought and sold on the market, their prices change throughout the business day. Mutual funds, on the other hand, aren’t sold on an exchange and only trade once a day, after the markets stop. Also, compared to mutual funds, ETFs tend to be less expensive and more flexible.
ETFs are a type of fund that holds more than one base object, unlike stocks, which only hold one. ETFs can be a good choice for diversity because they hold many different investments. ETFs can therefore hold many different kinds of investments, such as stocks, commodities, bonds, or a mix of these.
An ETF can own hundreds or even thousands of stocks in many different businesses, or it can focus on just one. Some funds only invest in U.S. companies, while others look at the world as a whole. For example, ETFs that focus on the banking business would hold stocks from many different banks.
An ETF is a tradable asset, which means that it has a share price that makes it easy to buy and sell throughout the day on markets, and it can also be sold short. Most ETFs in the U.S. are set up as open-ended funds and are governed by the Investment Company Act of 1940, unless later rules have changed their rules.
There is no limit on how many people can put in an open-end fund.
Kinds of ETFs
There are different types of ETFs that buyers can use to make money, speculate, and raise prices, as well as to protect or partially offset risk in their portfolios. Here is a short explanation of some ETFs that are on the market right now.
ETFs can be passive or active.
Most of the time, ETFs are either passively or actively handled. Passive ETFs try to match the success of a wider index, like the S&P 500, or a more narrow industry or trend. Gold mining stocks are an example of the second group. As of February 18, 2022, there were about eight ETFs that focused on gold mining companies, not counting inverse, leveraged, or low-AUM funds.
Actively managed ETFs usually don’t try to match an average of stocks. Instead, portfolio managers decide which stocks to include in the portfolio. These funds are better than passive ETFs in some ways, but they tend to cost buyers more. Below, we talk about ETFs that are actively managed.
Bond ETFs
Bond ETFs are used to give buyers a steady stream of income. How they share their income relies on how well the bonds they own do. Bonds could be issued by the government, by a company, or by a state or local government. These bonds are called “municipal bonds.” Bond ETFs do not have an expiration date like the bonds they hold. Most of the time, they sell at a higher or lower price than the real price of the bond.
Stock ETFs
Stock ETFs are made up of a group of stocks that follow a single business or area. For example, a stock ETF might follow car stocks or stocks from other countries. The goal is to give investors exposure to a wide range of companies in a single industry, including companies that are doing well and new companies that have room to grow. Stock ETFs are different from stock mutual funds in that they have lower fees and do not involve owning shares.
Industry/Sector Exchange-Traded Funds
ETFs that focus on a certain business or sector are called industry or sector ETFs. For example, an ETF for the energy industry will have companies that work in that area. The idea behind industry ETFs is to get exposure to the upside of that industry by watching the success of companies in that area.
One example is the tech industry, which has seen a lot of money come into it in recent years. At the same time, an ETF limits the risk of wild stock performance because it doesn’t involve direct ownership of shares. Industry ETFs are also used to move in and out of different industries as the economy goes through changes.
ETFs for goods
Commodity ETFs deal in things like crude oil or gold, as their name suggests. There are many good things about commodity ETFs. First, they make a stock more diverse, which makes it easier to protect against bad times.
For example, metal ETFs can be a safety net when the stock market goes down. Second, buying shares in a commodity ETF is less expensive than buying the product itself. This is because the first one doesn’t have to pay for security or storage.
ETFs for currency
Currency ETFs are mutual funds that track the success of currency pairs, which are made up of both local and foreign currencies. Currency ETFs are used for more than one thing. They can be used to guess how the prices of currencies will change based on how a country’s government and economy change. Importers and exporters also use them to balance their portfolios or protect themselves from fluctuations in the foreign exchange market. Some of them can also be used to protect against inflation. Bitcoin can even be bought through an ETF.
Inverse ETFs
By shorting stocks, inverse ETFs try to make money when stock prices go down. When you short a stock, you sell it with the expectation that it will lose value and then buy it back at a lower price. Shorting a stock is what an opposite ETF does. They are really bets that the market will go down.
When the stock market goes down, an opposite ETF goes up by the same amount. Investors should know that many inverse ETFs are actually exchange-traded notes (ETNs) and not real ETFs. ETNs are like bonds, but they trade like stocks and are backed by an owner like a bank.
Leveraged ETFs
A leveraged ETF tries to make twice or three times as much money as the stocks it holds. For example, if the S&P 500 goes up by 1%, a 2-leveraged S&P 500 ETF will earn 2% (and lose 2% if the market goes down by 1%). These goods increase their returns by using derivatives like options or futures contracts. There are also leveraged inverse ETFs, which try to get a return that is the opposite of what it was.
How to Purchase ETFs
Traders can buy in ETFs pretty easily now that there are a lot of sites to choose from. Follow the steps below to start putting money into ETFs.
Find a place to put your money.
ETFs can be bought on most online investment sites, sites that offer savings accounts, and apps like Robinhood. Most of these platforms let you buy and sell ETFs without having to pay fees to the platform makers.
But just because you don’t have to pay a fee to buy or sell an ETF doesn’t mean that you can get access to it for free. Some ways that platform services can set themselves apart from others are through ease, services, and a wide range of products.
For example, trading apps for smartphones make it easy to buy ETF shares with the tap of a button. This may not be true for all brokerages, which may ask buyers for records or a more complex situation. Some well-known brokerages, on the other hand, have a lot of information for new buyers that helps them learn about ETFs and do research on them.
Look into ETFs.
Researching ETFs is the second and most important step in buying in them. There are many different ETFs on the market right now. One thing to keep in mind as you do your study is that ETFs are not like individual stocks or bonds.
When you buy an ETF, you’ll need to look at the whole picture, in terms of the field or business. Here are a few questions you might want to think about as you do your research:
How long do you plan to invest?
Do you want to make money or grow your money?
Are there certain industries or financial tools that get you excited?
Think about a trading plan.
Dollar-cost averaging, or spreading out your financial costs over time, is a good way to trade if you are just starting out with ETFs. This is because it evens out results over time and makes sure that spending is done in a controlled way instead of in a random or volatile way.
It also helps people who are new to trading learn more about how ETFs work. When buyers get better at trading, they can try more advanced tactics like swing trading and sector rotation.
Traditional Brokers vs. Online Brokers
Both internet traders and standard broker-dealers let people buy and sell ETFs. As an option to traditional agents, you can use a robo-advisor like Betterment or Wealthfront, which use ETFs a lot in their financial goods.
With a trading account, buyers can buy and sell ETF shares just like they would trade stocks. Investors who want to be more hands-on can choose a standard trading account, while investors who want to be less hands-on can choose a robo-advisor. Robo-advisors often have ETFs in their portfolios, but it may not be up to the user to choose whether to focus on ETFs or individual stocks.
How to Find the Right ETF
Before putting money into ETFs, buyers will need to put money into their trading accounts. How you put money into your trading account will depend on the broker you choose. Once you have money in your account, you can look for ETFs and buy and sell them just like you would with shares of stock. Using an ETF screening tool is one of the best ways to cut down your ETF choices. These tools are offered by many companies as a way to look through the thousands of ETFs. Most of the time, you can look for ETFs based on some of the following:
Volume: Trading volume over a certain time period lets you compare how popular different funds are. The more traffic a fund has, the easier it may be to trade it.
Expenses: The smaller the price ratio, the less of your investment goes to overhead costs. Even though it might be tempting to always look for funds with the lowest expense ratios, sometimes more expensive funds (like actively managed ETFs) do well enough to make up for the higher fees.
Success: Even though past success isn’t a good predictor of future results, it is still a popular way to compare ETFs.
positions: The stocks of different funds are often also taken into account by screener tools. This lets customers compare the different positions of each possible ETF purchase.
Commissions: Many ETFs are commission-free, which means that you don’t have to pay anything to buy or sell them. But you should check to see if this could be a deal-breaker.
Making an ETF
When an ETF wants to make more shares available, the AP gets shares of the stocks in the fund’s index, such as the S&P 500, and sells or trades them to the ETF for new shares of the same value. In turn, the AP makes money by selling the ETF shares on the market. When an AP sells stocks to the ETF provider in exchange for ETF shares, the block of shares used in the deal is called a “creation unit.”
When shares sell for more than their cost
Imagine an ETF that invests in S&P 500 stocks and has a share price of $101 when the market closes. If the stocks that the ETF owns are only worth $100 per share, then the fund’s current price of $101 is higher than its net asset value (NAV). The NAV is a way to figure out how much the assets or stocks in an ETF are worth as a whole.
An AP has a reason to try to get the ETF share price back in line with the NAV of the fund. To do this, the AP buys shares of the stocks that the ETF wants to hold in its portfolio from the market and sells them to the fund in exchange for shares of the ETF.
In this case, the AP buys shares of stock on the open market that are worth $100 each and gets shares of an ETF that are worth $101 each on the open market. This is called creation, and it makes more ETF shares available on the market. If everything else stays the same, putting more shares on the market will lower the price of the ETF and make the price of each share equal to the fund’s NAV.
Redeeming an ETF
On the other hand, an AP also buys ETF shares on the open market. The AP then sells these shares back to the ETF provider in return for individual stock shares that it can sell on the open market. Because of this, the number of ETF shares goes down. This is called “redemption.”
Demand on the market and whether or not the ETF is selling at a cost or premium to the value of the fund’s assets affect the amount of withdrawal and creation activity.
When shares sell at a discount, they can be bought back.
Imagine an ETF that holds the stocks in the Russell 2000 small-cap index and is currently selling at $99 per share. If the stocks held by the ETF are worth $100 per share, then the ETF is selling at a discount to its NAV.
An AP will buy shares of the ETF on the open market and sell them back to the ETF in exchange for shares of the underlying stock portfolio. This will bring the share price of the ETF back to its NAV. In this case, the AP can trade $100 worth of ETF shares it got for $99 for $100 worth of stock. This is called withdrawal, and it makes fewer ETF shares available on the market. When the number of ETF shares goes down, the price should go up and move closer to the NAV.
