Exchange traded funds (ETFs) are a type of security that combines the flexibility of stocks with the diversification of mutual funds. The exchange traded part of the name refers to how these securities are bought and sold on the market like stocks. The fund part refers to how an ETF provides easy access to diversification and exposure to a wide variety of asset classes.
What Is an ETF? How Do They Work?
An ETF is designed to track as closely as possible the price of an index or a collection of underlying assets. Here’s how it works: A financial services firm purchases a basket of assets—stocks or bonds, currencies or commodity futures contracts—that comprise the fund. The firm then sells shares that track the value of the fund, via broker-dealers. The shares can be traded on markets just like stocks.
When you buy shares in an ETF, you don’t actually end up owning a portion of the underlying assets, as would be the case with shares of stock in a company. The financial services firm that runs the ETF owns the assets, and adjusts the number of ETF shares outstanding as it attempts to keep their price in sync with the value of the underlying assets or index (more on that below).
There Are ETFs for Every Kind of Asset
There are ETFs based on almost any kind of security or asset available in financial markets. Stock ETFs track shares of companies in one industry or one sector. Bond ETFs may invest in treasuries of a certain maturity, high-grade debt or junk bonds. Foreign exchange ETFs buy currencies of one nation or even an entire region. Hybrid ETFs mix and match multiple asset types.
ETFs can be ultra-wide in focus, attempting to track a broad market index like the S&P 500, or even the performance of an entire country’s economy. They can also be ultra-narrow in focus, specializing on a small group of companies in one subsector.
ETFs Charge Fees
When you hold shares of an ETF, you generally pay an annual management fee. This takes the form of an expense ratio (sometimes called an operating expense ratio), equal to a percentage of the value of your ETF shares on an annualized basis.
The good news is that ETF fees are relatively low. For example, passive index ETFs had fees as low as 0.10% in 2018, according to Morningstar. There are actively managed ETFs (they’re less common), which have higher costs than index ETFs, which simply track designated market indexes.
You may also be charged brokerage commissions to trade ETFs, depending on which broker you use to buy and sell shares. Many brokers charge zero commissions on certain ETFs. Before deciding to buy an ETF, check to see what fees might be involved.
ETFs and Taxes
Gains from ETFs are taxed the same way their underlying assets are taxed. If you own a stock ETF and you sell the investment, any gain would be treated the same way as if you sold a stock. Hold the ETF for a year or less, and you’re subject to short-term capital gains taxes at your regular marginal tax rate. Hold the ETF for more than a year, and your taxes would be at the long-term capital gains rate.
Gains from an ETF holding precious metals would be taxed at the collectibles rate, while energy commodity ETFs are structured as limited partnerships, so you get a K-1 form every year at tax time. Some equity dividend ETFs collect dividends from the underlying assets and either distribute them to shareholders or reinvest them, with differing tax implications.
When investing in ETFs, do your due diligence in order to understand the tax implications. If you’d like to hold ETFs in a tax-advantaged retirement account, be sure to check with your custodian to see what types of ETFs might be allowed in your account.
ETFs vs. Mutual Funds: What’s the Difference?
ETFs and mutual funds share some similarities, but there are important differences between these two fund types, especially when it comes to taxes. When you invest in a mutual fund, you own a share of the underlying assets, which is not the case with ETFs. Shares of ETFs trade on exchanges throughout the day, while mutual funds may only be bought or sold at the end of the trading day.
You could have less control over the taxes you end up paying with mutual funds, especially when it comes to actively traded mutual funds. Trades made by mutual fund managers are subject to the holding requirements associated with long-term and short-term capital gains.
If a mutual fund manager buys and sells assets frequently, you could be on the hook for short-term capital gains taxes. Mutual fund taxes are factored at the end of the year, so there’s the potential that you could end up with a hefty tax bill, depending on how the fund was managed.
How ETFs Track Their Underlying Assets
Financial services companies sell blocks of ETF shares (called “creation units”) to broker-dealers to ensure the share prices of ETFs remain mostly in line with the underlying index or the prices of the assets held by the fund. Brokers buy these blocks of shares for cash, or trade in-kind for the sorts of assets held by the fund.
Each ETF discloses its net asset value (NAV) at the end of the trading day, much like a mutual fund, and then managers sell or trade creation units to bring the ETF back in line with the value of the underlying assets when the market price strays too far from the NAV. ETFs are extremely transparent, with all of the asset holdings publicly listed each day, making it simple to understand exactly what is held by the fund.
When investing in some types of ETFs, like commodity ETFs, it’s important to be aware of a situation called contango. The underlying assets held by commodity ETFs are futures contracts, and in certain cases the expiring near-term contracts are less expensive than the front-month contracts. As the futures held by the fund roll over, there can be moments when the ETF sees steep, sudden losses.
Diversification: A Core Benefit of ETFs
One of the most important concepts of sound investing is diversification. You shouldn’t invest in too narrow a range of securities or only one asset class, rather you should aim to build a diversified portfolio with a wide variety of securities and assets. This protects your wealth: When some assets are losing ground, others should be outperforming.
ETFs make it easy to diversify your investment portfolio. Commodity, precious metal and currency ETFs make it possible for investors to easily add exposure to alternative asset classes simply by buying ETF shares.
Keep in mind that investing in a commodity ETF isn’t the same as owning the commodity. Additionally, make sure your ETF portfolio construction uses principles of diversity and asset allocation to meet your goals, rather than focusing too heavily on simply buying something a little more exotic.
The Many Kinds of ETFs
At the end of 2019, there were 7,927 exchange-traded products worldwide, according to industry researcher ETFGI, valued at approximately $6.35 trillion. As of February 2020, there were 2,086 ETFs in the United States, according to data from the Investment Company Institute.
Some of the common ETF types include:
- Index ETFs: These are meant to follow specific U.S. indexes. One of the most popular is the SPDR S&P 500 ETF Trust (SPY), which tracks the S&P 500 index.
- Foreign market/country ETFs: Overseas market exposure is easy with these ETFs. One example is the iShares MSCI Japan ETF (EWJ), which focuses on the Japanese equity market.
- Industry or sector ETFs: These ETF focus narrowly on one sector, such as pharmaceuticals, utilities or technology. For example, the KranseShares MSCI All China Health Care Index ETF (KURE) focuses on the Chinese health care sector.
- Bond ETFs: These ETFs track different baskets of bonds. The iShares Core U.S. Aggregate Bond ETF (AGG) is one of the largest ETFs in the world, offering exposure to a wide variety of investment-grade bonds in the United States.
- Commodity ETFs: Get exposure to commodities, like crude oil or precious metals. The iShares Commodities Select Strategy ETF (COMT) is a broad-based ETF that includes energy, metals and agriculture. There are other commodity ETFs that focus exclusively on one type of commodity or group of commodities.
- Currency ETFs: You can find ETFs focused on the performance of individual currencies, like the U.S. dollar or the euro, against a basket of other currencies. It’s also possible to find ETFs like the WisdomTree Emergency Currency Strategy Fund (CEW), which focuses on currency appreciation related to emerging markets.
There are also ETFs that focus on different investing strategies, such as dividend growth, alpha or smart beta. There are ETFs that short the market and earn when the underlying assets lose value. Leveraged ETFs provide double or triple the gain (or loss) on the underlying assets or index.
How Do I Invest in ETFs?
You can use just about any broker to buy and sell shares of ETFs. It’s as easy as knowing the ticker symbol for the ETF you want, and placing an order like you would with any regular stock.
Additionally, many robo-advisors use ETFs in their portfolio construction process. If you open an account with a robo-advisor, they will likely invest in ETFs on your behalf using basic portfolio theories to put together an investing plan for you based on your goals and risk tolerance.
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Advantages and Disadvantages of ETFs
ETF Pros
- Low-cost, low-fee investments
- Instant diversification
- Easy to trade on an exchange
- High levels of transparency on assets and holdings
- Exposure to alternative assets
- Tax efficient
ETF Cons
- Some ETFs may experience lower liquidity, making them harder to sell
- ETFs can close, forcing you to sell an investment earlier than expected
- Some ETFs have tracking error: Share prices may diverge excessively from the prices of underlying assets or indexes
- While you can trade throughout the day, some trades may require extended periods to settle
