What are Exchange-Traded Funds (ETFs) & How Do They Work?

What is an Exchange-Traded Fund (ETF)?

An ETF is a type of fund that invests in a portfolio of assets, such as a stock market index, sector, or commodity. Shares that represent ownership of the portfolio are traded on stock exchanges so that investors can buy and sell them in the same way as individual stocks.

How Do ETFs Work?

Exchange-traded funds pool investors’ money to purchase a diversified portfolio of underlying assets. These assets are held in a trust, and the ETF shares represent ownership in that trust.

At the core of how ETFs work is the creation and redemption process, which keeps a fund’s ETF’s market price in line with its net asset value (NAV).

Large financial institutions, often called authorized participants (APs), create new ETF shares by assembling baskets of securities that match the composition of the benchmark index. APs exchange this basket of securities with the ETF issuer, typically an ETF management company, in exchange for a specified number of shares.

APs can also redeem ETF shares by returning them to the issuer in exchange for the underlying securities. This helps maintain the ETF’s NAV and ensures that its market price stays close to the NAV.

ETF market prices fluctuate throughout the trading day based on supply and demand, investor sentiment, and trading activity. When a price deviates from its NAV, APs step in to buy or sell shares and the underlying basket of securities to bring the market price back in line with the NAV.

Most ETFs are designed to track the performance of an underlying index or benchmark, such as the S&P 500 or a bond index.

The management company constructs a portfolio of assets (stocks, bonds, or other securities) that closely mirrors the composition of the chosen index and rebalances the portfolio periodically to reflect changes in the index, such as by adding or removing securities.

The extent to which an ETF’s performance deviates from the performance of the underlying index is known as a tracking error. This is influenced by factors such as expenses, trading costs, and portfolio management decisions.

ETFs that generate dividends and other income from the underlying securities pass the returns on to shareholders in the form of cash distributions or reinvestment into the fund.

What is the Difference Between ETFs, Mutual Funds, and Stocks?

Aspect	Exchange Traded Funds (ETFs)	Mutual Funds	Individual Stocks
Structure	An open-end investment company with shares that represent ownership in a portfolio of assets.	An open-end investment company that pools money from multiple investors to invest in a diversified portfolio of assets.	Ownership in a specific company with shares representing a stake in that company.
Trading	Traded on stock exchanges throughout the trading day at market prices.	Priced and traded at the end of the trading day at the net asset value (NAV).	Traded on stock exchanges throughout the trading day at market prices.
Diversification	Provides instant diversification by holding a basket of assets within a single security.	Offers diversification through a portfolio of assets, but investors may need to buy multiple funds for broader diversification.	Represents ownership in a single company, so diversification depends on owning multiple company stocks.
Liquidity	High liquidity, allowing intraday trading and quick access to funds.	Typically less liquid owing to end-of-day pricing, limiting intraday trading.	High liquidity, facilitating intraday trading and easy access to funds.
Expense Ratios	Typically lower expense ratios compared to mutual funds.	Expense ratios can vary but may be higher than those of ETFs.	No expense ratios, but may have brokerage commissions and fees.
Tax Efficiency	Tax-efficient due to in-kind creation and redemption process, potentially resulting in fewer capital gains distributions.	Capital gains distributions can be more frequent, leading to potential tax consequences.	Tax treatment depends on the holding period and individual tax circumstances.
Management Style	Primarily passive management, aiming to replicate the performance of an underlying index. Some actively managed ETFs are also available.	Offers both passive and actively managed options.	Passive ownership with no active management by the investor.
Flexibility	Suitable for various investment strategies, including passive, active, sector-specific, and thematic.	Offers various strategies but may require investors to buy/sell shares at NAV.	Allows investors to choose specific companies and sectors for their portfolios.
Minimum Investment	No minimum investment is required, making ETFs accessible to investors of all sizes.	Minimum investment amounts may vary by fund, potentially limiting accessibility for some investors.	No minimum investment.
Transparency	High transparency with daily disclosure of holdings allows investors to see exactly what assets are held.	Holdings are disclosed quarterly.	Transparency depends on the company’s reporting practices.
Risk Exposure	Provides exposure to specific asset classes, sectors, or themes, allowing for precise risk management.	Offers exposure to asset classes and sectors, but not as granular as ETFs in terms of thematic or sector-specific strategies.	Direct exposure to the performance and risks associated with a single company.
Dividends and Income	May offer automatic dividend reinvestment or cash distribution options.	Typically offer automatic dividend reinvestment or cash distribution options.	Receive dividends directly from the individual company.
Investment Goals	Suitable for various investment goals, including income generation, growth, and risk mitigation.	Cater to diverse investment goals, including income, growth, and preservation.	May align with long-term capital appreciation, income, or speculative objectives.

The choice between ETFs, mutual funds, and individual stocks depends on individual financial objectives, risk tolerance, and investment preferences.

Many investors choose to build diversified portfolios by combining these investment vehicles to achieve their specific goals.

Why Choose ETFs

ETFs offer flexibility and can serve various purposes:

Investment strategies: Investors can use ETFs for a wide range of investment strategies, including long-term investing, trading, income generation, and risk management.
Asset classes: ETFs cover various asset classes, including equities, fixed income, commodities, real estate, and alternative investments.
Specialized strategies: ETFs can cater to specialized strategies such as factor investing, thematic investing, and sustainable investing.
Risk management: ETFs can be used for risk management purposes, such as hedging against market downturns or specific risks.

Types of ETFs

There are various types of exchange-traded funds, each designed to cater to different investment objectives and asset classes.

ETF type and examples	Characteristics
Equity ETFs	Aim to replicate the returns of a portfolio of equities. Offer investors exposure to a broad market or specific industries and sectors within the market.
Index ETFs	Track the performance of indices such as the S&P 500, Dow Jones Industrial Average, or NASDAQ.
Sector ETFs	Focus on specific industries or sectors of the economy, such as technology, healthcare, financials, or energy.
Strategy ETFs	Emphasize stocks with specific characteristics.
Dividend ETFs	Focus on companies that pay high and/or growing dividends.
Equal Weighted ETFs	Gives each holding in the portfolio equal weighting to provide balanced exposure.
Growth ETFs	Invest in companies with strong earnings growth potential.
Low Volatility/Risk Weighted ETFs	Invest in stocks with low volatility characteristics, which typically have relatively stable share prices and above-average yields.
Value ETFs	Target undervalued stocks with lower price-to-earnings ratios.
Fixed Income ETFs	Invest in various types of bonds and other debt securities, providing income and stability to investors.
Treasury Bond ETFs	Invest in US government-issued Treasury bonds for regular income.
Corporate Bond ETFs	Hold bonds issued by corporations, offering potentially higher yields than government bonds but with higher credit risk.
Municipal Bond ETF	Invest in bonds issued by state and local governments, providing tax advantages for some investors.
Commodity ETFs	Provide exposure to physical commodities such as gold, silver, oil, and agricultural products to investors to speculate on commodity prices or hedge against inflation.
Gold ETFs	Hold physical gold bullion, allowing investors to track the price of gold without owning the physical metal.
Oil ETFs	Track the price of crude oil for speculative purposes and hedging against energy price fluctuations.
Agricultural ETFs	Invest in agricultural commodities like wheat, corn, or soybeans, offering exposure to the agricultural sector.
International ETFs	Offer exposure to foreign markets and assets, allowing investors to diversify their portfolios globally and capitalize on international growth opportunities.
Global ETFs	Invest in companies from various countries worldwide, providing broad international exposure.
Country ETFs	Focus on a single country’s stock market.
Region ETFs	Cover specific geographical regions, such as Europe, Asia-Pacific, or emerging markets.
Currency ETFs	Offer investors exposure to foreign exchange markets for a single currency or a basket of currencies.
Specialty and Thematic ETFs	Target specific themes, trends, or niche markets. They are designed for investors who want to align their portfolios with particular ideas or developments.
Artificial Intelligence ETFs	Provide exposure to companies developing AI technologies and applications.
Blockchain/Cryptocurrency ETFs	Offer investors exposure to blockchain miners and developers or cryptocurrencies without having to own coins or tokens.
Cloud Technology ETFs	Target companies that are active in developing or providing cloud technology.
Cybersecurity ETFs	Invest in companies engaged in protecting digital data and networks from cyberthreats.
Robotics and Automation ETFs	Focus on companies developing technology in the fields of automation and robotics.

How to Trade ETFs

Buying and selling ETFs involves several steps, from choosing an account provider to executing orders.

Step 1. Choose a brokerage account

Before you can trade ETFs, you need access to a brokerage account that offers the ETFs you want to invest in. Different brokerages may offer varying selections of ETFs. Consider fees such as commissions and account maintenance charges. Some brokerages offer commission-free ETF trades, which can save you money.

Step 2. Research and select ETFs

Conduct research to identify suitable ETFs that align with your investment goals and risk tolerance. Compare the expense ratios of different ETFs, as lower expenses can result in higher returns over time. Your brokerage should offer research tools and resources to help you analyze ETFs and make informed decisions.

Step 3. Place an order

Buy or sell ETF shares through your brokerage account.

Step 4. Asset allocation

Build a diversified portfolio by selecting ETFs from different asset classes, such as equity, fixed income, commodities, and countries/regions.

Step 5. Monitor and manage your investments

Review your portfolio periodically to ensure it remains aligned with your investment goals and risk tolerance. Rebalance, if necessary, to maintain your preferred asset allocation.

Step 6. Stay informed

Keep up with news and events that may impact the ETFs you hold. Market conditions, economic data, and geopolitical events can all influence investment performance.

Step 7. Income reinvestment

Decide whether you want to reinvest the dividends and income your ETFs generate or receive them as cash. Many brokerage accounts provide an option to automatically reinvest dividends.

Step 8. Tax considerations

Be aware of the tax implications of buying and selling ETFs. Capital gains and losses can have tax consequences, and tax-efficient trading strategies can help minimize taxes.

Remember that investing in ETFs carries risk, and is essential to conduct thorough research based on your individual financial circumstances before making any investment decisions.

Advantages of ETF Investments

Pros	Description
Diversification	ETFs offer instant portfolio diversification by holding a basket of assets such as stocks, bonds, currencies, or commodities and carry less risk than trading individual stocks
Liquidity	ETFs trade on stock exchanges throughout the trading day, providing high liquidity and flexibility for buying and selling.
Lower costs	ETFs typically offer lower expense ratios than traditional mutual funds, reducing the impact of fees on returns.
Transparency	ETFs disclose their holdings daily, allowing investors to see exactly what assets they own within the fund.
Flexibility	ETFs can be used for various investment strategies, including trading, long-term investing, or income generation.
Intraday trading	ETFs can be bought or sold during market hours at market prices, providing opportunities for intraday trading strategies.
Dividend reinvestment	Many ETFs offer automatic dividend reinvestment, helping investors grow their holdings over time.

Disadvantages of ETF Investments

Cons	Description
Market risk	ETF prices are subject to market fluctuations, and investors may experience losses.
Tracking error	Some ETFs may not perfectly replicate the performance of their underlying index, leading to tracking errors.
Tax considerations	Gains from trading ETFs may have tax implications, and investors should be aware of potential tax consequences.
Costs and Fees	While generally cost-efficient, some ETFs have high expense ratios and trading commissions that can accumulate over time.
Liquidity risks	ETFs with lower trading volumes may have wider bid-ask spreads, potentially affecting execution prices.
Complexity	Some specialized or leveraged ETFs can be complex and may not be suitable for all investors.
Market timing	Investors who trade ETFs frequently may be prone to market-timing errors and overtrading.

History of ETFs

ETFs emerged in the early 1990s when the SPDR S&P 500 ETF Trust (SPY) was introduced. The SPY ETF, launched by State Street Global Advisors in January 1993, is often considered to be the industry pioneer.

It tracks the performance of the S&P 500 US stock market index, one of the most widely followed equity benchmarks in the world, and remains one of the most actively traded ETFs.

Since then, the ETF industry has expanded to offer a wide range of investment options.

In the early years, ETFs gained traction slowly as investors and financial institutions took time to understand how to use this new form of investment vehicle. One of the main advantages was the ability to offer investors exposure to a broad market or specific sectors with low expense ratios compared to traditional mutual funds.

As ETFs gained popularity, fund managers began launching a variety of new ETFs with different objectives, such as sector and industry, commodity, and fixed-income ETFs.

The industry continued to grow into the early 2000s, and innovations in ETFs expanded their scope to include different types of investments, such as actively managed ETFs that allow fund managers to make investment decisions rather than simply implementing passive index-tracking strategies.

Leveraged and inverse ETFs became popular tools for traders looking to profit from short-term market volatility.

The 2008 financial crisis highlighted the benefits of ETFs, such as liquidity and transparency, which became more attractive to institutional and retail investors seeking safer and more efficient investment options.

The ETF industry continued to gain mainstream acceptance, and rapid growth saw assets under management (AUM) reach trillions of dollars.

ETF providers regularly launch new products, such as socially responsible ETFs and cryptocurrency ETFs, and actively manage thematic funds to meet evolving investor preferences and market trends.