Introduction to Exchange-Traded Funds (ETFs)

Exchange-traded funds (ETFs) are relatively new, having only been on the market since the 1990s. Despite their short history, these investment vehicles have become very popular with investors. An ETF is a type of financial instrument whose unique advantages over mutual funds have caught the eye of many an investor. If you find the tasks of analyzing and picking stocks a little daunting, ETFs may be right for you. Let's take a look at some of the basics of ETFs and how to invest in them.

What Is an Exchange-Traded Fund (ETF)?

The best way to describe an exchange-traded fund is a mutual fund that trades like a stock. Just like a mutual fund, an ETF represents a basket of securities like stocks that reflect an index such as the S&P 500 or the Barclays Capital U.S. Aggregate Bond Index.

But an ETF isn't a mutual fund. Rather, it trades just like any other company on a stock exchange. Unlike a mutual fund that has its net asset value (NAV) calculated at the end of each trading day, an ETF's price changes throughout the day, fluctuating with supply and demand.

Keep in mind that while ETFs attempt to replicate the return on indexes, there is no guarantee that they will do so exactly. That being said, it isn't uncommon to see a small difference between the actual index's year-end return and that of an ETF.

By owning an ETF, you get the diversification of a mutual fund plus the flexibility of a stock. Because ETFs trade like stocks, you can short-sell them and buy them on margin. Another advantage is that the expense ratios of most ETFs are lower than that of the average mutual fund. For example, the SPDR S&P 500 ETF (SPY) has a low expense ratio of 0.0945% as of 2022. When buying and selling ETFs, you pay your broker the same commission that you'd pay on any regular trade.

Types of ETFs

The first ETF that traded in the United States. was the SPY. It began trading on the American Stock Exchange (AMEX) in 1993.

There are thousands of ETFs that trade in the U.S. and globally. These vehicles track a wide variety of sector-specific, asset-type-specific, country-specific, and broad-market indexes. You can find an ETF for just about any kind of sector of the market. For example, if you were interested in getting exposure to some European stocks through the Austrian market, you might take a look at the iShares MSCI Austrian Index fund (EWO).

Some of the more popular ETFs have nicknames like cubes and diamonds. Many are passively managed, meaning investors save big on management fees.

Below, we've highlighted some of the most common types of ETFs available on the market.

Invesco QQQ Trust Series 1 (QQQ)

The Invesco QQQ Trust Series 1 (QQQ) ETF tracks the Nasdaq 100, an index that consists of the 100 largest and most actively traded non-financial domestic and international companies on the Nasdaq. It offers investors broad exposure to the tech sector. Because QQQ curbs the risk that comes with investing in individual stocks, it is a great way to invest in the long-term prospects of the technology industry.

The diversification it offers can be a big advantage when there's volatility in the markets. If one tech company falls short of projected earnings, it will likely be hit hard, but owning a piece of a hundred other companies can cushion that blow.

 Standard & Poor's Depository Receipts (SPDRs)

Standard & Poor's depository receipts (SPDRs) are commonly known as spiders. These investment instruments bundle the benchmark S&P 500 and give you ownership of the index. Imagine the trouble and expenses involved in trying to buy all 500 stocks in the S&P 500. SPDRs allow individual investors to own the index's stocks in a cost-effective manner.

Another nice feature of SPDRs is that they divide various sectors of the S&P 500 stocks and sell them as separate ETFs. There are literally dozens of these types of ETFs.

For instance, the technology select sector index contains around 70 different holdings covering products developed by companies such as defense manufacturers, telecommunications equipment, hardware, software, and semiconductors. corresponding ETF, the SPDR Select Sector Fund - Technology (XLK), trades on the NYSE ARCA.

iShares and Vanguard

iShares is BlackRock's brand of ETFs. The firm offers more than 800 ETFs globally with $1.9 trillion dollars under management. BlackRock has a number of iShares that follow many of the major indexes around the world including the Nasdaq, New York Stock Exchange (NYSE), Dow Jones, and Standard & Poor's. All of these trade on the major exchanges in the U.S. just like normal stocks.

Vanguard also has its own series of ETFs. The firm has its own branded ETFs, including hundreds of ETFs for many different areas of the market including the financial, healthcare, and utility sectors.

Diamonds ETF

Contrary to what you may think, this ETF has nothing to do with diamonds. Rather, it's a nickname for the SPDR Dow Jones Industrial Average (DIA) ETF. This fund tracks the Dow Jones Industrial Average and is structured as a unit investment trust. DIA trades on the NYSE ARCA.

ETF Investment Styles

Whether you're a novice investor or experienced one, there are ETFs that cater to different investment needs and styles. If you're interested in specific sectors, putting your money in one of these funds can alleviate the pressure of having to invest in individual companies and/or securities. The following are just a few of the categories you may find when investing in ETFs.

Targeting Resources

Funds can also provide a way to invest in natural resources. For instance, if you're interested in natural gas, you may want to consider a fund like the United States Natural Gas Fund (UNG).

An ETF like this one can give you a replication of natural gas prices after expenses. It can also try to follow the prices of natural gas by buying futures contracts on natural gas in the coming months.

As with all the funds, you need to keep an eye on the total expense ratio before investing.

Emerging Market Focus

Investing in ETFs that focus on emerging markets attempts to mimic the returns seen in funds like the iShares MSCI Emerging Markets Index (EEM). This ETF was created as an equity benchmark for international security performance. If you would like to gain some international exposure, specifically to emerging markets, an ETF like this one may be for you.

Inverse/Opposite Movers

Not all ETFs are designed to move in the same direction or even in the same amount as the index they track. The prices of inverse ETFs go up when the markets go down and vice-versa.

For example, the Direxion Daily Financial Bear 3x Shares (FAZ) is a triple bear fund. It attempts to perform 300% in the opposite direction of the Russell 1000 Financial Services Index using derivatives and other types of leverage to boost performance returns of the underlying index. This fund became popular when the financial crisis placed downward pressure on financial stocks.

Low Fees

One of the benefits of investing in ETFs is the fact that they come with low fees. The average expense ratio for an index ETF was 0.16% in 2022. Compare that to the average cost of a mutual fund, which was 0.66% for an active fund and 0.05% for a passive one.

Although the fee that you pay may not be much outright, there may be other charges depending on what you trade and how you do so. For instance, your trading app or platform may charge buy and sell fees or commissions and you may have to pay for other costs like bid-ask spreads.

The Bottom Line

A great reason to consider ETFs is that they simplify index and sector investing in a way that is easy to understand. If you feel a turnaround is around the corner, go long. If, however, you think ominous clouds will be over the market for some time, you have the option of going short.

The combination of the instant diversification, low cost, and the flexibility that ETFs offer, makes these instruments one of the most useful innovations and attractive pieces of financial engineering to date. There are a number of brokers who provide ETF investments.