An exchange-traded fund (ETF) is a pooled investment security that can be bought and sold like an individual stock. ETFs can be structured to track anything from the price of a commodity to a large and diverse collection of securities.
ETFs can even be designed to track specific investment strategies. Various types of ETFs are available to investors for income generation, speculation, and price increases, and to hedge or partly offset risk in an investor’s portfolio. The first ETF was the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index.
An ETF must be registered with the Securities and Exchange Commission. In the United States, most ETFs are set up as open-ended funds and are subject to the Investment Company Act of 1940, except where subsequent rules have modified their regulatory requirements.2 Open-end funds do not limit the number of investors involved in the product.
Vanguard’s Consumer Staples ETF (VDC) tracks the MSCI US Investable Market Consumer Staples 25/50 Index and has a minimum investment of $1.00. The fund holds shares of all 104 companies on the index, some familiar to most because they produce or sell consumer items. A few of the companies held by VDC are Proctor & Gamble, Costco, Coca-Cola, Walmart, and PepsiCo.34Investors who buy $1.00 in VDC own $1.00 shares representing 104 companies.
There is no transfer of ownership because investors buy a share of the fund, which owns the shares of the underlying companies. Unlike mutual funds, ETF share prices are determined throughout the day. A mutual fund trades only once a day after market close.
Volatile stock performance is curtailed in an ETF because they do not involve direct ownership of securities. Industry ETFs are also used to rotate in and out of sectors during economic cycles.
Access to many stocks across various industries
Low expense ratios and fewer broker commissions
Risk management through diversification
ETFs exist that focus on targeted industries
Actively managed ETFs have higher fees
Single-industry-focused ETFs limit diversification
Lack of liquidity hinders transactions
ETFs trade through online brokers and traditional broker-dealers. Many sources provide pre-screened brokers in the ETF industry. Individuals can also purchase ETFs in their retirement accounts. An alternative to standard brokers is a robo-advisor like Betterment and Wealthfront.
An ETF’s expense ratio is the cost to operate and manage the fund. ETFs typically have low expenses because they track an index.
ETFs are available on most online investing platforms, retirement account provider sites, and investing apps like Robinhood. Most of these platforms offer commission-free trading, meaning that investors don’t have to pay fees to the platform providers to buy or sell ETFs.
After creating and funding a brokerage account, investors can search for ETFs and make their chosen buys and sells. One of the best ways to narrow ETF options is to utilize an ETF screening tool with criteria such as trading volume, expense ratio, past performance, holdings, and commission costs.
Below are examples of popular ETFs on the market. Some ETFs track an index of stocks, thus creating a broad portfolio, while others target specific industries.
Most stocks, ETFs, and mutual funds can be bought and sold without a commission. Funds and ETFs differ from stocks because of the management fees that most of them carry, though they have been trending lower for many years. In general, ETFs tend to have lower average fees than mutual funds.
| Exchange-Traded Funds | Mutual Funds | Stocks |
|---|---|---|
| Exchange-traded funds (ETFs) are a type of index funds that track a basket of securities. | Mutual funds are pooled investments into bonds, securities, and other instruments. | Stocks are securities that provide returns based on performance. |
| ETF prices can trade at a premium or at a loss to the net asset value (NAV) of the fund. | Mutual fund prices trade at the net asset value of the overall fund. | Stock returns are based on their actual performance in the markets. |
| ETFs are traded in the markets during regular hours, just like stocks are. | Mutual funds can be redeemed only at the end of a trading day. | Stocks are traded during regular market hours. |
| Some ETFs can be purchased commission-free and are cheaper than mutual funds because they do not charge marketing fees. | Some mutual funds do not charge load fees, but most are more expensive than ETFs because they charge administrative and marketing fees. | Stocks can be purchased commission-free on some platforms and generally do not have charges associated with them after purchase. |
| ETFs do not involve actual ownership of securities. | Mutual funds own the securities in their basket. | Stocks involve physical ownership of the security. |
| ETFs diversify risk by creating a portfolio that can span multiple asset classes, sectors, industries, and security instruments. | Mutual funds diversify risk by creating a portfolio that can span multiple asset classes, sectors, industries, and security instruments. | Risk is concentrated in a stock’s performance. |
| ETF trading generally occurs in-kind, meaning they are not redeemed for cash. | Mutual fund shares can be redeemed for money at the fund’s net asset value for that day. | Stocks are bought and sold using cash. |
| Because ETF share exchanges are usually treated as in-kind distributions, ETFs are the most tax-efficient among all three types of financial instruments. | Mutual funds offer tax benefits when they return capital or include certain types of tax-exempt bonds in their portfolio. | Stocks are taxed at either ordinary income tax rates or capital gains rates. |
Though ETFs allow investors to gain as stock prices rise and fall, they also benefit from companies that pay dividends. Dividends are a portion of earnings allocated or paid by companies to investors for holding their stock. ETF shareholders are entitled to a proportion of the profits, such as earned interestor dividends paid, and may get a residual value if the fund is liquidated.
An ETF is more tax-efficient than a mutual fund because most buying and selling occur through an exchange, and the ETF sponsor does not need to redeem shares each time an investor wishes to sell or issue new shares each time an investor wishes to buy.
Redeeming shares of a fund can trigger a tax liability, so listing the shares on an exchange can keep tax costs lower. In the case of a mutual fund, each time an investor sells their shares, they sell it back to the fund and incur a tax liability that must be paid by the shareholders of the fund.
The supply of ETF shares is regulated through creation and redemption, which involves large specialized investors called authorized participants (APs). When an ETF wants to issue additional shares, the AP buys shares of the stocks from the index—such as the S&P 500 tracked by the fund—and sells or exchanges them to the ETF for new ETF shares at an equal value. In turn, the AP sells the ETF shares in the market for a profit.
When an AP sells stocks to the ETF sponsor in return for shares in the ETF, the block of shares used in the transaction is called a creation unit. If an ETF closes with a share price of $101 and the value of the stocks that the ETF owns is only worth $100 on a per-share basis, then the fund’s price of $101 was traded at a premium to the fund’s net asset value (NAV). The NAV is an accounting mechanism that determines the overall value of the assets or stocks in an ETF.
Conversely, an AP also buys shares of the ETF on the open market. The AP then sells these shares back to the ETF sponsor in exchange for individual stock shares that the AP can sell on the open market. As a result, the number of ETF shares is reduced through the process called redemption. The amount of redemption and creation activity is a function of demand in the market and whether the ETF is trading at a discount or premium to the value of the fund’s assets.
The distinction of being the first exchange-traded fund (ETF) is often given to the SPDR S&P 500 ETF (SPY) launched by State Street Global Advisors on Jan. 22, 1993. There were, however, some precursors to the SPY, notably securities called Index Participation Units listed on the Toronto Stock Exchange (TSX) that tracked the Toronto 35 Index that appeared in 1990.
An index fund usually refers to a mutual fund that tracks an index. An index ETF is constructed in much the same way and will hold the stocks of an index, tracking it. However, the difference between an index fund and an ETF is that an ETF tends to be more cost-effective and liquid than an index mutual fund. You can also buy an ETF from a broker who will execute the trade throughout the trading day, while a mutual fund trades via a broker only at the close of each trading day.
Nearly all ETFs provide diversification benefits relative to an individual stock purchase. Still, some ETFs are highly concentrated—either in the number of different securities they hold or in the weighting of those securities. For example, a fund that concentrates half of its assets in two or three positions may offer less diversification than a fund with fewer total portfolio constituents but broader asset distribution.
Exchange-traded funds represent a cost-effective way to gain exposure to a broad basket of securities with a limited budget. Investors can build a portfolio that holds one, many, or only ETFs. Instead of buying individual stocks, investors buy shares of a fund that targets a representative cross-section of the wider market. However, there are some additional expenses to keep in mind when investing in an ETF.
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