Exchange-traded funds, ETFs for short, are securities that trade on major stock exchanges. There are many different types of ETFs, some of which track various indexes, commodities, industries, stocks, bonds and more.
Diversifying your portfolio with ETFs can be cheaper and easier than buying the individual stocks, bonds or other securities that make up the funds. If you're thinking about investing in ETFs, here's what you should know.
How ETFs Work
ETFs are securities that pool money from investors to buy a variety of securities. ETFs can be made up of stocks, bonds, commodities and other assets, and some may track specific indexes, industries and specialty securities.
Because ETFs are made up of a variety of securities, they're often used to diversify a portfolio. With a stock ETF, for instance, the fund may invest in dozens or even hundreds of stocks, which can help mitigate some of the risks of owning a handful of individual stocks.
Investors can strategically invest in different types of ETFs to further diversify their portfolios across several asset classes.
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Types of ETFs
There are several different types of ETFs. Each one has its advantages and disadvantages, and investing across multiple ETF types can help mitigate some of the risks associated with individual funds.
ETFs are either passively or actively managed. Passive ETFs typically track a specific index, sector or investment trend, so there's no fund manager who's actively picking which securities to include in the fund. In contrast, active ETFs are managed by a team of portfolio managers who decide which securities to invest in. Active ETFs tend to be more expensive than passive ETFs but can have the potential to beat benchmark returns.
Here are some of the more common types of exchange-traded funds, all of which may be actively or passively managed:
- Equity ETFs: These funds invest in a variety of stocks, either domestic or foreign, and may specialize in certain indexes, stocks with high dividend yields and more.
- Bond ETFs: These might invest in government bonds, corporate bonds, municipal bonds, international bonds or a mix. They typically provide lower returns but can offer income payments to their shareholders.
- Sector ETFs: These funds focus on a specific sector or industry, such as technology, utilities, automotive or telecommunications.
- Commodity ETFs: These ETFs specialize in commodities, such as gold, silver, oil, agricultural goods and more.
- Currency ETFs: These funds invest in a variety of currencies, both domestic and foreign.
- Inverse ETFs: These ETFs function much like shorting a stock—a strategy that some investors use to profit off of securities that are decreasing in value.
As you research different types of ETFs, it's important to choose the funds you want to invest in based on your investment goals and risk tolerance.
Common ETF Fees
ETFs are attractive to investors because they tend to charge lower fees than mutual funds. Here are some of the fees you may come across when investing in ETFs:
- Trade commission: Most brokers no longer charge commissions when you buy and sell ETFs, but some may still charge a fee of up to $25 per trade, especially if you want to make trades in person or over the phone.
- Operating expense ratio: This fee is charged by the fund to cover administration, portfolio management and other expenses. It's calculated as a percentage of your investment and is charged at an annual rate. The average expense ratio for all U.S. ETFs and open-end mutual funds was 0.45% in 2019, according to investment research company Morningstar.
- Bid-ask spreads: When trading ETFs, the bid price is the price at which the fund can be sold, and the ask price is the price at which the same fund can be bought. The difference between the two is called the bid-ask spread. This cost can vary based on the liquidity of assets in the fund, inventory management costs and competition.
- Discounts and premiums to net asset value (NAV): The NAV of an ETF is the value of the fund's assets minus its liabilities, divided by the total number of fund's outstanding shares. ETFs typically trade at a premium or a discount of their NAV, and the change to the premium or discount while you hold the fund could be a potential cost.
Pros and Cons of ETFs
There are both benefits and drawbacks to using ETFs in your portfolio. Here's what to consider before you invest.
- Investing in ETFs can make it easier to diversify your portfolio.
- Most ETFs charge lower expense ratios than mutual funds.
- ETFs can be traded on major exchanges throughout trading hours.
- They provide more tax efficiency than mutual funds.
- Some brokers may charge trading commissions.
- Options for equities may be limited in some types of sectors.
- Some ETFs may not provide enough diversification.
How to Invest in ETFs
You can invest in exchange-traded funds through a brokerage account. Set up an account if you don't already have one and fund it with enough money to buy fractional or full shares of the ETFs you want. Note, however, that some brokers may not offer fractional ETF shares.
Once your account is funded, research your options and find the ticker symbol for the ETF you want to buy, then submit your trade request.
Remember, you can trade ETFs anytime during trading hours. In comparison, mutual fund purchase requests are executed once a day after the market closes, giving you less liquidity.
Take your time to compare ETFs and determine which ones will best serve your investment goals and risk tolerance. It may even be worth consulting with a financial advisor who can provide you with objective advice on your investment strategy.