The Complete Guide to ETFs

ETFs vs. mutual funds: Which investment works for you?

Alt Hed: Here Is Your Complete Guide to Exchange-Traded Fund (ETF) Investing

There are so many financial products and services available to investors today that it can be difficult to familiarize yourself with all the various types of securities you can invest in. Should you consider individual stocksShould you buy bonds? It’s hard to be sure.

Fortunately, exchange-traded funds allow you to invest in both stocks and bonds and in many other kinds of investments as well. An ETF is a collection of securities, most often stocks, that are traded on stock exchanges.

Exchange-Traded Fund Definition

Exchange-traded funds (ETFs) are pooled investments that invest the fund’s capital in stocks, bonds or almost any other kind of security you can imagine. [1] The characteristics of exchange-traded funds are very similar to those of mutual funds.

  • Similarities:
    • Mutual funds and ETFs are SEC-registered investment companies. [2]
  • Differences:
    • Shares of exchange-traded funds (ETFs) are traded all day every business day, just like shares of stock. Mutual funds, on the other hand, are priced and traded only once a day at the close of business
    •  ETFs can be bought and held for many years or used as short-term trading vehicles that might be purchased and sold several times during a trading day.

How Do Exchange-Traded Funds Work?

An ETF is formed when investors pool investment funds together and register the fund with the Securities & Exchange Commission (SEC). Every ETF has its own investment objective, and each one invests in a specialized and well-defined category of securities. Most are invested in various types of stocks or bonds, but others invest in commodities, futures, precious metals, oil, preferred stocks and almost anything else that trades on major exchanges.  [3]

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Shares of ETFs trade on the major stock exchanges. Their performance depends on the performance of the underlying investment. An ETF that invests in stocks of transportation companies, for instance, will go up or down based on how the transportation industry is doing. Energy ETFs will rise and fall with the fortunes of the oil and natural gas markets.

Some ETFs are actively managed. This means that a portfolio manager picks the underlying investments and buys and sells them at their discretion. Other ETFs are passively managed. They are invested in one set of securities and don’t change their allocation over their lifetimes.

The most popular kind of passively-managed ETFs is index ETFs. They are designed to mirror the performance of an investor index such as the Dow Jones Industrial Index or the S&P 500 Index. There are as many index ETFs as there are indexes. [4]

Types of Exchange-Traded Funds

Some of the most popular exchange-traded funds examples are highlighted below:

Stock ETFs

Also known as “equity ETFs.” They invest exclusively in the stock (equity) of publicly traded companies. Stock ETFs can specialize in large-cap, mid-cap or small-cap stocks or a mixture of all three. Similarly, they might invest in “value,” or low PE, stocks or “growth” stocks.

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Some stock ETFs invest domestically in US-based companies. Others, called international funds, invest all over the world.

Because there are dozens of ways to invest in stocks, you will find dozens of stock ETF offerings on the market.

Bond ETFs

Bond ETFs are restricted to investments in corporate and government bonds. 

The most prominent bond ETFs are invested in investment-grade corporate bonds, high-yield (junk) corporate bonds and US Government bonds.

Bond ETFs tend to pay a regular income in the form of exchange-traded funds dividends. Some investors buy them as income investments, while others are hoping they will go up in value if the bond market goes up.

Index ETFs

An index ETF can be either a stock ETF or a bond ETF, as long as the investment has a prominent index to track.

Index ETFs invest in the securities that make up their target index. For example, a Dow Jones Industrial index ETF would invest its assets in the 30 stocks that make up the Dow. No more. No less.

The ETF would then perform almost precisely as the index performs. These are examples of the passively managed ETFs mentioned in the exchange-traded funds definition above. Index ETF investments are very popular because they allow even small investors to take advantage of movements in large indexes that represent the market as a whole.

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Inverse ETFs

An inverse ETF is designed to trade in the opposite direction from a target index or sector. There are S&P 500 inverse ETF shares that go down when the S&P goes up.

The portfolio manages to accomplish this feat by either being “short” the target index or by using complex options and futures contracts.

Inverse ETFs generally use leverage to accomplish their goals. This means that they borrow money on the margin to implement their strategy. This makes inverse ETF investing highly speculative. They tend to go up and down much faster than the broader market.

How is an ETF Different From Other Investments?

What makes an ETF different from other investments is that ETFs have more dimensions to them than standard mutual funds or other pooled investments.

  • ETF
    • Trades throughout the day. The price of an ETF can be driven by supply and demand factors as well as the value of the underlying investments.
    • Investing is more diversified than investing in individual stocks. If you buy a stock ETF, you can own a piece of hundreds of companies.
  • Mutual Fund
    • Priced only once a day and is always priced at exactly the value of the stocks, bonds or other assets it holds. The supply and demand for mutual fund shares do not come into play, whereas it plays a big part in ETF trading.

It is important to note the difference between exchange-traded fund shares and shares of exchange-traded notes or ETNs.

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  •  ETN
    • A debt security issued by a bank. They are always based on a fixed income index and, once issued, are not actively managed to enhance performance.
    • ETNs are not nearly as popular with individual investors as ETFs are. They are generally used by institutional investors.  [5]

Are ETFs a Good Investment?

ETFs are popular with large and small investors for good reason. They allow people access to large, powerful investment indexes that they wouldn’t normally have. They offer professional management and real diversification.

Here are some pros and cons of investing in ETFs: 

  • Pros
    • Professional management
    • Diversification
    • Access to index investing
    • Large selection to choose from
  • Cons
    • The sheer number of choices can become overwhelming
    • Research required before investing
    • Can sometimes be volatile
    • Internal fees can be hard to discover

Which Exchange-Traded Fund Is Best?

The best ETF for each investor will depend on an analysis of how much money they have and what their investing goals are. You will also want to be honest about your investing temperament; are you a conservative or an aggressive investor?

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  • Conservative investors should avoid risky ETFs, such as inverse ETFs.
  • Aggressive investors would not be happy in a government bond ETF that might pay a decent income but won’t hit any home runs.

To begin ETF investing, it’s first necessary to open a brokerage account with a broker or investment company. You can fund the account by wire transfer or by mailing in a check. Once the account is open and funded, you’re ready to get started.

Do your research and identify an ETF or two that you’re interested in. You may want to watch it for a few days so you can see how it reacts in various up or down markets. Once you’re ready to buy, placing an order is simple.

You can check the performance of your ETF investments several times during a trading day, or you can buy and hold for the long run.

[1] https://www.investor.gov/introduction-investing/investing-basics/glossary/exchange-traded-fund-etf

[2] https://www.sec.gov/fast-answers/answersmfinvcohtm.html

[3] https://www.sec.gov/reportspubs/investor-publications/investorpubsinwsmfhtm.html

[4] https://www.sec.gov/oiea/investor-alerts-and-bulletins/ib_indexfunds

[5] https://www.sec.gov/oiea/investor-alerts-bulletins/ib_etn.html

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    About the Author

    Sean Dennison

    Sean joined the GOBankingRates team in 2018, bringing with him several years of experience with both military and collegiate writing and editing experience. Sean’s first foray into writing happened when he enlisted in the Marines, with the occupational specialty of combat correspondent. He covered military affairs both in garrison and internationally when he deployed to Afghanistan. After finishing his enlistment, he completed his BA in English at UC Berkeley, eventually moving to Southern California.

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