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What is an ETF?

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A type of security, an exchange-traded fund (ETF), involves a set of shares, such as stocks, which mostly follow an underlying index, even though they can invest in or use different strategies in any number of industry sectors. Across several aspects, ETFs are similar to mutual funds; hence they are listed during the day on exchanges and ETF shares, much like ordinary stocks.

The SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index, is a well-known example. Many forms of investments may be included in ETFs, including stocks, commodities, shares, or a mixture of investment types. As Marketable security, an ETF has an associated price that allows it to be quickly acquired and sold.

Why is an ETF, ETF?

Since it’s exchanged on an exchange just like stocks, an ETF is called an exchange-traded fund. During the entire trading day, an ETF’s stock’s price will adjust as the shares are purchased and sold on the market. This is unlike mutual funds that are not traded on an exchange and are only traded once a day after closing the markets. Also, as compared to mutual funds, ETFs tend to be more cost-effective and more liquid.

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Holds Multiple Underlying Assets

Unlike a stock that holds just one asset, an ETF is a type of fund with several underlying assets. Thus, ETFs are practical for portfolio diversification since there are several assets within an ETF.

An ETF is capable of owning hundreds or thousands of stocks across different industries or may be isolated from one specific sector or market. Some funds concentrate on U.S. or China offers only, while others have a global view. Banking-focused ETFs, for instance, will include stocks of different banks across the industry.

Diverse ETFs

Different forms of ETFs are available to investors that can be used in an investor’s portfolio for revenue generation, speculation, price rises, and hedge or partially offset risk.

  • Bond ETFs – Include government bonds, corporate bonds, and state and municipal bonds
  • Industry ETFs – Tracks a particular industry such as technology, banking, or the oil and gas sector. 
  • Commodity ETFs – Commodities like crude oil or gold. 
  • Currency ETFs – Foreign currencies like the Singapore and United States dollar. 
  • Inverse ETFs – Profit from stock declines by shorting stocks. Just like selling a stock, short when you expect a decrease a value, and repurchase at a lower price.
  • Crypto ETFs – A cryptocurrency ETF that tracks one or more digital tokens

On a separate note, it is crucial to understand that exchange-traded notes (ETN) are not real ETFs, though they consist of many inverse ETFs. Instead, an ETN is a bond that is traded like a portfolio and backed like a bank.

Examples

There are plenty of ETFs in the market, but here are some popular traditional ETFs that have proven to be stable in the charts:

SPDR S&P 500 (SPY)

The SPDR S&P 500 (SPY) is an ETF that tracks the Standard & Poor’s 500 (S&P 500) index by holding a portfolio of stocks in companies included in the S&P 500 index.

Invesco QQQ (QQQ)

Similar to Invesco QQQ (QQQ), Indexes the Nasdaq 100 is an ETF that consists of 100 of the largest nonfinancial companies listed on the Nasdaq Stock Market based on market capitalization. And, mainly contain technology stocks.

Commodity ETFs

Commodity ETFs represents commodity markets that include crude oil (USO) and natural gas (UNG)

iShares Russell 2000 (IWM)

The iShares Russell 2000 ETF tracks investment results of an index composed of small-capitalization U.S. Equities.

SPDR Dow Jones Industrial Average (DIA)

DIA is an ETF that represents the 30 stocks of the Dow Jones Industrial Average5.

Physically-Backed ETFs

The SPDR Gold Shares (GLD) and iShares Silver Trust (SLV) hold physical gold and silver bullion in the fund.

Sector ETFs

Sector ETFs is a sector-based ETF that tracks individual industries such as oil (OIH), energy (XLE), financial services (XLF), REITs (IYR), Biotech (BBH)

ETF Pros and Cons 

The main expenditure for ETF would be the operation and management costs of the fund although ETFs generally have lower average costs as investors would only have to perform one transaction to buy and to sell for a multitude of assets. We can trade ETFs through online or offline brokers, even Robo-advisors. For each trade, brokers usually charge a fee, although there are brokers that offer non-commission trading service for low-cost ETFs. 

Pros

  • Entry to a variety of stocks spanning different industries 
  • Low percentages of costs and less fees for brokers. 
  • Management of risks by diversification 
  • There are ETFs based on targeted markets

Cons

  • Higher fees for actively managed ETFs 
  • Single-industry ETFs restrict diversification 
  • Lack of liquidity impedes transactions

ETF Summarized

  • An ETF is a basket of assets (stocks, commodities, U.S only or international holdings etc) that trade on an exchange, similar to a stock
  • ETF share prices fluctuates as transactions occur throughout the day
  • ETFs incur less broker commission fee as compared to purchasing individual stocks, offering an overall lower expense ratio
Photo by Tetiana SHYSHKINA on Unsplash

Closing Thoughts

Thanks to their many advantages such as low expense ratios, ample liquidity, selection of investment options, diversification, low investment threshold, and so forth, ETFs are perfect for beginners. These features also render ETFs ideal platforms for new traders and investors to employ different trading and investment strategies.

For related articles, read DigiFinex Academy.

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