ETF (Exchange Traded Fund)

What is an ETF?

An ETF (exchange-traded fund) is an investment fund that holds a basket of securities like stocks, bonds, or commodities while trading on an exchange like a stock. They replicate the performance of an underlying index, sector, asset class, or investment strategy.

Example:

The SPDR S&P 500 ETF (SPY) aims to replicate the returns of the S&P 500 index by holding the same underlying component stocks.

ETFs never hold one specific stock or asset within. Instead, they stand for diversification within a single traded security since they hold multiple stocks or assets in it. That can be in a specific market (only Nasdaq stocks), broad market (all U.S. stocks), selected industry (only Bitcoins), or focusing on the best-performing stocks that find their way to the ETF (e.g., top 10 stocks in the top 10 countries of the world).

How ETFs Work

ETFs are structured like mutual funds in that they represent a pool of securities, but they trade throughout the day on exchanges like stocks.

Authorized parties handle the management of new ETF shares to maintain trading close to the fund’s net asset value.

ETF prices fluctuate throughout the day based on supply and demand, just as regular stocks do, but in a 1:1 ratio relative to the assets it invested in.

For example, if someone simply buys S&P500 ETFs, he can not influence the price of the S&P500 because the index consists of many stocks.

That means while a trader, investor, or fund can influence the stock price with the trading activities, it can not directly influence the price per ETF.

ETF Advantages

Key advantages of ETFs include lower expenses than actively managed mutual funds, greater tax efficiency by avoiding capital gains distributions, transparency of holdings, and easy tradability and diversification.

They offer potential tax benefits by generating fewer capital gains events. Overall, ETFs provide investors with access to nearly any asset class or strategy at a relatively low cost.

Types of ETFs

While traditional index ETFs track a major index like the S&P 500, the ETF universe has quickly expanded to include funds based on factors, sectors, strategies, asset classes, and more niche areas like blockchain or cloud computing.

There are also inverse, leveraged, and active ETFs that don’t simply track an index but follow an active strategy. The sheer variety provides exposure opportunities across the investing landscape.

No matter what type of investment strategy you are looking for, chances are that you find the right ETF quickly.

Buying/Selling ETFs

Investors can buy and sell the chosen ETF in a similar way to a listed stock by using a brokerage account. The order will get executed during normal market hours based on their market price.

Investors can use various order types like market, limit, or stop orders. Trading costs include the ETF’s expense ratio and potential commission for the buy/sell trade.

Some brokers offer commission-free online ETF trades. Owning period, size of trade, and execution price determine capital gains taxes.

ETF Costs and Fees

One major advantage of ETFs is their lower expense ratios (the percentage of how much you pay per year to the ETF issuer relative to the price per ETF) compared to old-school actively managed mutual funds. The lower expense ratio is possible because ETFs passively track an index or strategy.

Average expense ratios range from 0.05% for plain index ETFs, over often 0.20%, to 0.50-0.75% for more complex or actively managed ETFs. Other costs include spreads between the bid-ask price when trading and brokerage commissions to buy/sell, though many brokers now offer commission-free ETF trades.

ETF Risks

Like any investment, ETFs carry certain risks:

  • Potential tracking error from deviating from the target index
  • Trading at a premium/discount to net asset value
  • Lack of liquidity in some funds
  • Closure risk if an ETF is terminated
  • Concentration risk if ETF funds are heavily weighted in certain sectors/securities.

However, for broad-based funds, ETF risks are generally lower than individual stocks.

Still, if you buy a Bitcoin ETF, you can expect high volatility, with chances of a 50% return in 1 year, but also with the risk of a 50% loss.

ETF History and Growth

The first ETF was the SPDR S&P 500 Trust ETF (SPY), which was launched in 1993 and designed to track the S&P 500 index.

From just a single fund, the global ETF industry has grown to over $10 trillion in assets under management across nearly 9,000 ETFs trading worldwide as of 2023.

ETFs have disrupted the investment management industry by providing easy access to nearly every asset class.

Alexander Voigt, CEO
Article by
Alexander Voigt is the founder of DayTradingZ, was a regular contributor to Benzinga and has been featured and quoted on leading financial websites such as Investors.com, Capital.com, Business Insider and Forbes.