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What Is an ETF (Exchange Traded Fund) and How Does It Work?

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 be 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.

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 (Exchange Traded Fund)?

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

For example, ETFs such as the SPDR or SPY fund can mimic the S&P 500 by owning shares in all 500 companies represented by that index. If you buy one share of those ETFs, 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. 

You buy and sell shares of ETFs in real time on the open market, like stocks, from other investors. In contrast, you have to buy and sell shares of mutual funds directly from the fund itself. That adds a host of benefits to ETFs, such as not having to hold a reserve of cash, not requiring a minimum investment amount, not coming with load (purchase) fees, and not requiring expensive labor on the part of a fund manager (passed on to the investor in the form of high expense ratios). 

For more, read up on the differences between ETFs and mutual funds

Pro tip: You can earn a free share of stock (up to $200 value) when you open a new trading account from Robinhood. With Robinhood, you can customize your portfolio with stocks and ETFs, plus you can invest in fractional shares. Sign up for Robinhood.

How Do ETFs Work?

The ETF provider — such as Vanguard, Charles Schwab, iShares, or Fidelity — buys shares in all the underlying securities. In the example above, a fund mimicking the S&P 500 buys shares in all 500 companies, weighted similarly to the index itself. That way the fund reflects the benchmark index in a near-perfect mirror image. 

Investors then buy and sell shares in the fund on open stock exchanges. Continuing the example, if investors send share prices for individual companies in the S&P lower, the index’s value drops, and that same downward force leads investors to sell shares in the ETF holding those individual companies. 

Note that these funds aren’t directly tied to the index: a drop in the S&P 500 doesn’t directly cause ETFs mirroring it to fall in price by the same percentage. But the same market forces drive both, so even though they don’t move in exactly perfect lockstep, they move in tandem. 

Ultimately, these funds rise or fall in price based on what investors are willing to pay for shares. Which, in turn, depends on the value of the assets owned by the funds. 

Types of ETFs

There’s an ETF for nearly every purpose and asset class. The most common types include:

  1. Long ETFs (Typical Index Funds). These take a “long position” on an underlying stock market index. Index funds 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. Short selling comes with inherently more risk, for reasons we’ll discuss later.
  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 leverage 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.

Advantages of ETFs

There are plenty of reasons to love ETFs. In fact, they are the heart of many index investors’ portfolios, and the backbone of my stock portfolio as well.

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

​​1. Diversification

Because ETFs own many individual securities, you get the same diversification benefit by investing in the ETF. By buying a single share, you effectively invest in every stock or other security owned by that ETF. 

That means you don’t have to spend hours researching and trying to pick stocks. You can simply invest in “the market” broadly by investing in ETFs that own thousands of stocks representing the bulk of a region’s publicly traded companies. 

I own few individual stocks for foreign companies, for example. But by investing in international ETFs representing other countries and regions, I gain exposure to thousands of foreign stocks. Therefore a shock to one company, or one country, or even one region won’t collapse my entire portfolio.

2. Lower Cost

Investors save money on ETFs vs. mutual funds in two ways. 

First, you can buy shares in ETFs without a transaction fee by investing through a commission-free brokerage. Examples include Charles Schwab, Vanguard, and TD Ameritrade

Second, ETFs tend to charge much lower expense ratios. Most ETFs are passively managed — they don’t rely on a human fund manager to pick and choose investments. Instead, an algorithm manages the individual securities owned by the fund. As share prices rise and fall for companies in the S&P 500, for example, ETFs that mimic it simply adjust their weighting based on the same rules as the index. 

Because passive 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.

3. Liquidity

When you buy an open-end mutual fund, you can only buy fund shares once per day, at their net asset value (NAV) 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.

Note that liquidity varies among ETFs, just as it does among individual stocks. Thinly-traded ETFs often see a wide gap between buyers’ bid price and sellers’ asking price. In these cases, selling shares — particularly a large number of shares — can cause a downward swing in prices.

4. Transparency

Anyone with a brokerage account can look up an ETF’s price history, trading volume, and holdings. You can do this in real time, with no restrictions. 

However mutual funds typically disclose their holdings monthly or quarterly, so you don’t know their exact current holdings at the time when you buy or sell shares. 

5. Ability to Short Sell

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.

6. Tax Benefits

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 only sell shares when new securities get dropped from the index, and buy shares only when they are added to the index. Otherwise, they only tweak percentages as the weighting of shares shifts.

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.

The brokerage issuing ETFs can also avoid unnecessary taxes by making “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.

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

7. No Cash Drag

ETFs don’t have to pay out shareholders directly when they go to sell (known as redeeming shares). That’s because when you sell your shares of an ETF, you’re selling them to another buyer on the open market. 

Because these funds don’t have to let sellers cash out, ETFs can afford to have almost no cash on hand. Most keep 100% of their capital fully invested at all times, which helps them replicate an index as closely as possible and maximizes their gains in rising markets. 

And as history shows, markets rise more often than not, with an upward long-term average

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

So ETF shareholders benefit from the fund not holding part of their money in cash — at least during bull markets.

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. Potential Illiquidity

As outlined above, some ETFs boast higher liquidity than others. 

If an ETF doesn’t see much trading volume, then buy orders can push up the cost, and sell orders can drive down the price. You can still buy or sell quickly, but not necessarily at the price showing currently. 

2. Higher Cost for Actively Managed Funds

Not all ETFs represent passive index funds. Some ETFs are actively managed by fund managers aiming to beat the market. 

Given the human labor involved, these actively managed funds cost more. Specifically, they charge a higher expense ratio: the annual management fee charged to shareholders. 

3. Easy Way to Earn Market Average Returns

While not all ETFs are index funds, ETFs let you invest in a broad basket of equities. And index funds offer a particularly easy way to earn returns that closely mirror a given 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.

4. 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 market price can be higher or lower than the aggregated value of the shares in the portfolio.

With closed-end funds, investors can sometimes 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 mutual fund rather than an ETF. This is particularly true for income-oriented investors.

5. DRIPs Not Always Available

Many investors like to have dividends automatically reinvested in fund shares using 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.

Should You 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 U.S. 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.

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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