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What Is an ETF (Exchange Traded Fund) – Definition, Types, Pros & Cons

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You hear it all the time: “Diversify your investments!” But if you only have $100 to invest, you can’t exactly go out and buy 500 individual shares in large-cap corporations, each of whose stock prices could cost hundreds or even thousands of dollars.

You can, however, buy a share of an exchange-traded fund (ETF) that owns shares in 500 different companies.

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As useful as ETFs are, you should never invest in anything you don’t understand. Fortunately, ETFs aren’t as confusing as their finance-nerd name suggests, so with a quick overview you can invest confidently in no time at all.

What Is an ETF?

An exchange-traded fund is a type of security that serves as a basket fund that owns a variety of other securities.

For example, an ETF can mimic the S&P 500 by owning shares in all 500 companies represented by that index. If you buy one share of that ETF, you indirectly buy a small stake in all 500 companies.

Sound similar to a mutual fund? Although ETFs and mutual funds are both funds that own multiple other securities, they also feature several key differences.

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The Original Pooled Fund: Mutual Funds 101

While ETFs emerged relatively recently in the 1990s, mutual funds date back to the 1920s.

A mutual fund is an arrangement in which investors pool their money and hire a portfolio manager to buy and sell securities on their behalf. With traditional open-end mutual funds, investors can buy or sell shares of the fund directly from the fund company itself. Investors buy or sell shares of the fund at its combined net asset value (NAV) as of the market close at the end of the day. If you buy shares of an open-end mutual fund after markets open, you get the fund’s closing price for that business day. If you buy them after markets close for the day, you get the price as of the close of the next business day.

Closed-end fund shares, in contrast, are traded over exchanges just like a stock, and are typically purchased from other shareholders, also like stocks. You can buy and sell shares at whatever price you can find a willing buyer or seller. Unless the fund company is buying back shares or selling founding shares to its initial subscribers, the fund company itself is not involved with secondary market transactions.

However, just as with open-end mutual funds, the fund still employs a manager or a team of managers who buy and sell securities on shareholders’ behalf. This active management comes with a price tag in the form of generally high expense ratios. But mutual funds can also come with a range of other fees, each more odious than the last (more on them shortly).

How ETFs Differ

Exchange-traded funds are close cousins to closed-end funds. Like closed-end fund shares, investors can buy ETF shares over stock exchanges just like a stock.

There are a few differences worth noting, however. In most — but not all — cases, closed-end funds are actively managed by the fund manager, while most ETFs are not actively managed but passively replicate an index. That constitutes the greatest difference in practice, even though exceptions exist for both types of funds. Other practical differences include lower expense ratios and fees for ETFs, along with greater transparency about the securities owned by the fund.

From a technical standpoint, other differences separate the two types of funds. Exchange-traded funds cannot borrow money; they simply represent a fund that owns shares of many companies. Closed-end funds, being privately managed, can leverage debt to multiply gains (and losses). This closed capital structure means prices can stray further from the underlying net asset value (NAV) of the fund’s holdings.


Advantages of ETFs

There are plenty of reasons to love ETFs. In fact, they make up the backbone of my stock portfolio.

As you create and adjust your investing strategy and retirement strategy, consider the following perks to ETFs as a primary investment.

1. Cost

Because ETF shareholders don’t need to pay a manager or a team of analysts and brokers to buy and sell funds on their behalf or to manage fund inflows and outflows, exchange-traded funds typically charge much lower expense ratios than traditional mutual funds. Their expense ratios also tend to be lower than open-end index funds, because even open-end index funds have to keep enough staff on hand to process constant purchases and redemptions.

For example, many large-cap mutual funds charge expense ratios of 80 basis points (0.8%) per year or more. Investor shares of open-end mutual funds typically feature an expense ratio of 18 to 50 basis points, depending on the index. Investor shares of large-cap index funds, such as S&P 500 index funds, will typically charge 18 to 20 basis points.

But large-cap ETFs often charge only 6 to 15 basis points each year.

The high fees on mutual funds don’t end at the annual expense ratio. Other potential fees include:

  • A sales charge or commission (an upfront fee to purchase)
  • A redemption fee (a fee to sell)
  • A short-term trading fee (a penalty for selling shares within an initial waiting period)
  • Servicing or marketing fees

That said, you can also buy shares in a “no-load” mutual fund directly from the fund company without paying a sales charge.

2. Liquidity

When you buy an open-end mutual fund, you can only buy fund shares once per day, at their net asset value as of the last market close. You can’t buy or sell shares during the day, making mutual funds impractical for day trading. If you own an open-end fund in the evening off-hours, then you hear disastrous news the next morning after the markets open, you cannot sell until after 4pm Eastern time. Likewise, you cannot buy on good news. Purchase orders don’t get logged until after 4pm the following day.

In contrast, you can buy and sell ETFs and closed-end mutual funds throughout the trading day using your brokerage account. Bear in mind that some funds trade more frequently than others, making it easier to find a willing buyer or seller in a hurry.

3. Short Selling

With open-end funds, you can’t engage in short selling, the practice of borrowing shares and selling them in the expectation that share prices will fall. If prices fall, the short seller buys back the shares at the new price and returns them to the original owner, keeping the difference.

Investors can, however, short sell indexes, industries, countries, and entire markets using ETFs. Although it’s worth mentioning that only experienced investors should consider short selling. If you’re wrong, and the shares rise instead of fall, there’s no limit to your losses. When you invest traditionally in a security, you only risk your initial investment amount.

4. Tax Considerations and Low Turnover

Index funds, including ETFs, tend to be tax efficient and ideal for holding in taxable accounts. This is because portfolio turnover in index funds is low, whereas managers of actively managed funds sell securities and buy new ones every time they feel like it. Index funds and ETFs, on the other hand, only sell shares when new securities get dropped from the index, and buy shares only when they are added to the index.

Every time a fund sells a share at a profit, the IRS assesses capital gains tax, which gets passed on to shareholders. Since index funds and ETFs don’t sell shares often, it is rare for them to generate a taxable distribution for their shareholders.

Exchange-traded funds also don’t suffer the complication of redemptions. Investors buy and sell shares to each other on the open market, rather than through a fund manager, so the fund never has to buy or sell shares to pay out a selling investor.

5. In-Kind Distributions

In an additional option in an ETF’s toolkit, the brokerage issuing ETFs can make “in-kind” distributions to shareholders. This means the fund can send securities from the portfolio directly to shareholders for individuals to sell themselves if they want the cash. This helps shelter the fund’s remaining shareholders from the tax consequences of the sale.

However, if the ETF’s portfolio generates dividend income, this income is taxable, just as it is with closed-end and open-end mutual funds.

6. No Cash Drag

Index fund ETFs try to replicate an index as closely as possible and don’t have to pay out redemptions themselves. As a result, they can afford to have almost no cash on hand. Most are 100% fully invested at all times, which works to their favor in rising markets.

In falling markets, however, a low cash position hurts the fund, with no safety net of cash held in reserve. The portfolio bears the full brunt of a market decline.


Disadvantages of ETFs

No asset type is without its downsides. As you compare ETFs to mutual funds, keep the following drawbacks in mind as well as the upsides listed above.

1. Small Discounts

When fund shares get traded in the open market as opposed to being redeemed directly from the fund company itself, investors directly determine share prices. This price can be higher or lower than the aggregated value of the shares in the portfolio. With closed-end funds, investors can frequently buy fund shares at a 5% to 15% discount to net asset value while still getting the full benefit of any dividends or interest payments from the fund and the potential for capital appreciation if the discounts narrow.

With ETFs, on the other hand, discounts are typically either extremely narrow or nonexistent. Investors seeking to benefit from buying fund shares at a discount should explore buying an actively managed closed-end fund rather than an ETF. This is particularly true for income-oriented investors.

2. DRIPs Not Necessarily Available

Many investors like to have dividends automatically reinvested in fund shares, in a DRIP, or dividend reinvestment plan. However, not all brokerages and funds allow this, as it can potentially require too much fund administration and drive up fund costs.

A big part of the logic of ETF investing is the low-cost structure of ETFs. When you buy shares in an ETF, double check whether you can reinvest dividends automatically. If not, expect to receive your dividends and interest payments directly, and to pay taxes on them if you don’t hold them in an IRA or other tax-advantaged account.

3. Market Average Returns

Although not all ETFs represent passive index funds, most do, and these by definition deliver a return that mirrors that stock index.

Index funds are as close as investors can get to “investing in the market itself.” If the S&P 500 jumps by 5%, so do index funds that track it. But that means that investors inherently earn market average returns, rather than beating the market like so many investors aim to do.

Investors try to beat the market in many ways, from trying to time the market to picking individual stocks to buying actively managed mutual funds. The strategy behind buying passive index funds and holding them long-term, however, dispenses with trying to get clever and simply rides the market higher.

After years of trying to prove my cleverness and beat the market, I stopped bothering. It took too much effort anyway. Still, for many investors, accepting market average returns takes some of the fun out of investing.


Types of ETFs

There’s an ETF for nearly every purpose. The most common types include the following:

  1. Long ETFs (Typical Index Funds). These take a “long position” on an underlying stock market index. They typically own shares of companies in a specific index in the same weighted proportions as the index. If the index rises, so do share prices in long ETFs, by about the same amount minus any expenses and trading costs.
  2. Inverse ETFs. The opposite of long ETFs, these take “short positions” on the underlying index. Share prices move in the opposite direction to ETF shares. Think of them as betting against the market: if the index loses money, you win. As outlined above, short selling comes with inherently more risk, because there’s no limit to your losses.
  3. Commodity and Precious Metal ETFs. These ETFs invest in certain commodities or precious metals, or a combination of many. For example, an ETF that invests in gold may hold gold stocks or claims on actual gold bullion held in trust by a custodian. You can also buy ETFs that offer broader exposure to multiple precious metals, or to commodities more generally. Shares in commodity ETFs typically move in rough tandem with the prices of the underlying commodity.
  4. Industry ETFs. These ETFs own a portfolio of stocks representing an industry, such as energy and oil, technology, mining, transportation, health care, and so on.
  5. Country or Region ETFs. These investments buy shares in companies that represent a cross-section of industry in a given country. For instance, they may own shares of the largest 50 publicly traded stocks in a specific country as measured by market capitalization. You can also buy regional ETFs as well, which focus on entire continents.
  6. Leveraged ETFs. Leveraged funds use borrowed money to “gear up” their portfolios, magnifying returns. This, of course, also magnifies risk as well. For instance, a leveraged S&P 500 ETF will seek to roughly double the returns of the index, less interest and expenses. But they will also double the size of losses as well. You can also buy leveraged inverse ETFs, but they come with even more risk given the lack of limits on losses.
  7. Currency ETFs. These securities seek to capture a return on foreign currency fluctuations and growth.
  8. Bond ETFs. Similar to stock ETFs, these funds own a portfolio of bonds instead of stocks.

Who Should Invest in ETFs?

I contend that ETFs should make up the core of every investor’s stock portfolio.

These funds offer broad or narrow market exposure to any region, industry, or commodity. You can buy large-cap funds, small-cap funds, and everything in between. And you don’t have to worry about researching specific stocks.

The wide selection and degree of precision lets you build a diverse asset allocation, stacking ETFs with a low correlation coefficient to each other. This means that when part of your portfolio “zigs,” your other investments tend to “zag.” That reduces the volatility of your portfolio as a whole, creating less downside risk.

Because they cost so little, ETFs also make excellent long-term investments, as your savings on fees and expense ratios compound over time.

In fact, ETFs form the foundation of most robo-advisor portfolios. You can use robo-advisor platforms like Acorns, SoFi Invest, or Schwab Intelligent Portfolios to automate your savings and investments entirely. When you first open an account, you complete a questionnaire, and the robo-advisor then proposes an asset allocation — mostly comprising ETFs with broad market exposure — as a rounded investment portfolio.


Final Word

Despite the many benefits to investing through ETFs, they still come with risk, like any other investment vehicle. Which means you need to understand that risk, along with historical returns.

Before investing your life savings, speak to a financial advisor or open an account with a robo-advisor and scope out their recommendations for your portfolio. And, of course, don’t be shy about doing your own due diligence on funds that interest you.

At a minimum, consider investing in at least three ETFs: one reflecting a wide range of U.S. large-cap stocks (such as a fund mirroring the S&P 500), one for small-cap stocks (such as one mirroring the Russell 2000), and one for international stocks. You can, of course, expand that to dig deeper, such as investing in both international developed countries and emerging markets. But in the beginning, keep it simple, and keep it diverse — two goals that ETFs can help you achieve.

Do you invest in ETFs? Why or why not?

G. Brian Davis
G. Brian Davis is a real estate investor, personal finance writer, and travel addict mildly obsessed with FIRE. He spends nine months of the year in Abu Dhabi, and splits the rest of the year between his hometown of Baltimore and traveling the world.

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