ETFs have become an increasingly popular investment tool. Though the first ETF wasn’t created until the 1990s¹ — nearly 70 years after the first mutual fund — they’ve still become a favorite investing option for many people. And as of the end of 2022, more than $6.5 trillion in U.S. assets sat in ETFs, which accounted for about 22% of all assets in investment companies.²

ETFs have plenty of complexities, advantages, and disadvantages. Keep reading to learn how ETFs work, the different types of ETFs, how to get started with ETF investing, and more.

What is an exchange-traded fund (ETF)?

An exchange-traded fund (ETF) is a type of investment fund that holds a variety of underlying securities, including stocks, bonds, or alternative assets. It’s essentially a way for investors to pool their money together and each gain exposure to the assets within the fund rather than purchasing each asset individually.

ETFs combine certain features of mutual funds and stocks. First, ETFs are similar to mutual funds in their makeup. They hold many underlying investments and can either be actively managed or track a certain index or set of securities.

But ETFs also have features that look more similar to stocks than mutual funds. First, ETFs trade on stock exchanges rather than being sold directly by the fund company, like mutual funds are. Additionally, ETFs can be traded throughout the day with fluctuating prices like stocks are. Contrast that with mutual funds, which are typically priced only once a day after the close of the New York Stock Exchange; anyone buying or selling during the trading day will receive that price.

Examples of ETFs

As of December 2022, there were more than 2,800 ETFs in the U.S. market. While ETFs come in many shapes and sizes, many are invested in large-cap domestic stocks, followed by other types of domestic stocks.³

The three largest ETFs in the U.S. are all S&P 500 index ETFs, meaning they track the performance of the S&P 500. In fact, one of those ETFs — the SPDR S&P 500 ETF Trust (SPY) — was the first ETF created in the U.S., and today is the largest.⁴

Other top ETFs track:

• The total stock market
• Developed markets
• Value stocks
• The total bond market
• Growth stocks
• Emerging markets
• Dividend stocks
• Mid-cap stocks
• Small-cap stocks

Understanding exchange-traded funds (ETFs)

Composition of ETFs

As we’ve mentioned, ETFs are baskets of securities that hold underlying assets. But with thousands of ETFs on the market, there are also many different types of ETFs.

Many of the most popular ETFs track stocks. Some track the entire U.S. stock market, others track international stocks, while others track just a certain part of the U.S. stock market. For example, an ETF could track a certain sector, a certain size of the company, or a certain type of stock (such as value versus growth).

But ETFs don’t just track stocks. There are plenty of others that track bonds, alternative assets, or a mix of multiple different assets.

Regulation of ETFs

Under the Investment Company Act of 1940, ETFs are required to register with the Securities and Exchange Commission (SEC) as either open-end investment companies (generally known as funds) or as unit investment trusts. They are required to follow U.S. securities laws.

How ETFs are bought and sold

ETFs are considered marketable securities, which means they can be easily bought and sold on public markets. In this way, ETFs differ from mutual funds.

First, they are sold on stock exchanges rather than directly by the fund companies that offer them. Second, they trade throughout the day.

Just like stocks, ETFs have a ticker symbol. This allows them to be easily identified and makes it easy to monitor their intraday price data.

Dynamic share structure and price alignment of ETFs

There’s a unique process in ETFs called creation and redemption that can affect the number of ETF shares outstanding, as well as keep the ETF price aligned with the value of its underlying securities.

ETF prices, like the prices of other assets, are determined by supply and demand. Because of that, it’s possible for the demand — and, therefore, the price — of an ETF to deviate dramatically from its underlying assets.

To help keep the prices of ETFs in check, financial institutions called authorized participants are able to dynamically create and redeem shares. The creation and redemption process can result in more or less shares being outstanding. And adjusting the supply of ETF shares adjusts the price and helps prevent major price deviations between the ETF and its underlying assets.

Understanding expense ratios

The cost to invest in an ETF is the fund’s expense ratio, which is the administration fee associated with the fund. This expense ratio is expressed as an annual percentage rate and is deducted from the share price.

Generally speaking, passive ETFs have lower expense ratios than active ones because there’s less management work required. According to the Investment Company Institute, the average ETF expense ratio in 2021 was 0.16%.⁵

Key features of ETFs

ETFs have become popular investment tools in past years because of several key features:

• Exchange-traded nature: ETFs trade throughout the day on stock exchanges, just like stocks do. Prices fluctuate throughout the trading day and it’s easy to quickly buy or sell a particular ETF at the current share price.
• Cost-effectiveness: Many brokerage firms offer low and no-commission ETF trading options. Additionally, they may have lower expense ratios, especially when compared with their mutual fund counterparts.
• Diversification for risk management: ETFs make it easy to diversify your portfolio by offering broad exposure to many different markets. They allow you to spread your risk across many asset types, sectors, and more.
• Targeted industry focus: There are many index ETFs that focus on specific sectors and industries. This allows you to invest in industries that interest you and create a hedge with assets and sectors that perform differently in different parts of the economic cycle.

Although ETFs have some key benefits, but there are also some things worth considering.

• Higher fees in actively managed ETFs: We’ve talked about the lower expense ratios of passive ETFs, but that doesn’t necessarily apply to actively-managed funds. You’ll have to weigh the benefits of those funds against the increased cost.
• Limitations of single-industry-focused ETFs: There are many ETFs that focus on a single industry or sector. While this can be beneficial, it can also create a lack of diversification if you don’t also invest across other sectors.
• Liquidity challenges: Not all ETFs are created equally when it comes to their liquidity. Unfortunately, if you’ve invested in an ETF with low liquidity, you may have a hard time selling it at the exact time you want to.

Types of ETFs

Passive and active ETFs

ETFs generally fall into one of two buckets: active or passive. Active ETFs are those that are actively managed by a fund manager. The manager buys and sells securities with the ultimate goal of outperforming the designated benchmark index.

A passive ETF, on the other hand, generally tracks the performance of a particular index. There are very broad passive ETFs, including S&P 500 or total stock market ETFs. There are also more narrowly focused passive ETFs, such as those that track a particular sector.

Bond ETFs

Bond ETFs are those that specifically hold bonds. Some bond ETFs may hold all types of bonds, such as Treasury bonds, corporate bonds, and municipal bonds. On the other hand, some may hold one specific type of bond.

Just like investing in individual bonds, bond ETFs result in regular dividend payments. However, because the ETF holds many underlying bonds, you end up with greater diversification and less risk.

Stock ETFs

A stock ETF is one that is made up entirely of equities. As we’ve mentioned, stock ETFs can hold stocks from a particular industry, the entire stock market, or something in between. Stock ETFs may make dividend payments as well as capital gains distributions.  Others may be focused on long-term capital gains only.

Industry/sector ETFs

An industry or sector ETF is one that tracks a particular part of the stock market. For example, an energy sector ETF would invest only in companies within the energy sector.

Industry and sector ETFs have several benefits. While they lack diversification on their own, they can provide diversification if you invest in ETFs from many different sectors or industries. Additionally, they give you more control over your portfolio.

Keep in mind that different sectors perform differently during different economic cycles. As a result, holding ETFs from all sectors can help hedge your losses during a market downturn.

Commodity ETFs

Commodities are raw materials used in the production of other goods and services. They’re also an important investment market. Popular commodities include crude oil, gold, and agriculture.

Commodity ETFs are those that invest in these physical raw materials. One of the key advantages of this type of ETF is diversification and the ability to gain exposure to these resources without having to physically trade them.  Commodity ETFs may have unique tax structures that should be considered before investing in them.

Currency ETFs

A currency ETF is one that tracks the performance of specific world currencies. These ETFs come in several forms, including single currencies, baskets of currencies, or currency pairs. Ultimately, the goal of all currency ETFs is to create exposure to the forex market, provide diversification, and allow investors to profit from fluctuations in currency values.

It’s also worth noting that in addition to traditional currency and forex ETFs, there are also now cryptocurrency ETFs, which help investors gain exposure to the cryptocurrency market. Similar to commodity ETFs, currency ETFs may also have unique tax structures that should be considered.

Inverse ETFs

In most cases, investors profit when an ETF’s underlying assets rise in value. But an inverse ETF invests in derivatives that are profitable when the target benchmark or asset(s) decline in value. This strategy is generally known as shorting or a short ETF. Shorting is an advanced and potentially high-risk investment strategy.

Leveraged ETFs

A leveraged ETF is one that aims for higher returns than the underlying assets by using debt or financial derivatives. For example, these ETFs may use borrowed funds. They may also invest in options and futures with a particular underlying index rather than investing in that index themselves.

There are also leveraged inverse ETFs, which combine the strategies of inverse ETFs and leveraged ETFs to attempt to gain a higher return from market downturns.

Index ETFs

Index ETFs are those that track the performance of a specific underlying index. One of the most popular examples of such an ETF is an S&P 500 ETF, which tracks the S&P 500 index. Unlike active ETFs, an S&P 500 ETF doesn’t frequently buy and sell assets. In fact, its makeup only changes when the makeup of the S&P 500 changes. And because of this stability and simplicity, index ETFs often have broad market exposure and low fees.

Style ETFs

A style ETF is one that tracks a particular style of security. For example, style ETFs include those that represent the different factions of the capitalization market, including small-cap, medium-cap, and large-cap stocks. Style ETFs could also invest in a particular type of stocks, such as value stocks versus growth stocks.

Style ETFs can help an investor further diversify their portfolio. They can also be an excellent tool for someone with a specific investing style or goal. For example, some investors prefer either value or growth stocks and can help their portfolio reflect that with style ETFs.

Foreign market ETFs

Many U.S. investors have only U.S. stocks and bonds in their portfolios. Foreign market ETFs can help investors gain exposure to international markets. Investing in foreign market ETFs allows for international diversification and could lead to portfolio growth.

Exchange-traded notes (ETNs)

Exchange-traded notes (ETNs) aren’t technically a type of ETF but rather a similar type of security. ETNs are unsecured debt securities that are issued by large financial institutions. However, like an ETF, an ETN tracks the performance of a specific market index.

ETNs have greater risk since they are unsecured debts. In other words, you run the risk of not getting your money back. However, they also have some advantages such as access to niche investments and tax benefits.

Alternative investment ETFs

Alternative investment ETFs are funds whose underlying assets are alternative assets. Examples of these assets could include real estate, private equity, hedge funds, and more. These investment strategies provide diversification to someone’s portfolio. Someone can gain exposure to those alternative markets without having to invest in them directly.

How to buy ETFs

1. Find an investing platform

The first step in buying an ETF is choosing the right investing platform. There are many online brokerage firms that make it easy to purchase ETF shares in just a few minutes. Additionally, many brokerage firms now offer commission-free trading on ETFs, which can significantly reduce your investing costs.

There are many things to consider when choosing an investing platform, and we’ll talk more about your different options later on. A few main factors to consider are the convenience and user-friendliness of the platform, the services and educational content, and the product variety and selection.

2. Research ETFs

It’s important to research your ETF options before choosing the right one for you. One of the primary factors to consider is your investment goal. You may choose a different ETF for your retirement account or another goal that’s many years away than you would if your goal is short-term profits.

There are many tools available online to help you research ETFs. Many brokers offer educational content on their websites. Those websites can also help you learn about specific ETFs and their prices, composition, past performance, and more.

3. Consider a trading strategy

There are many different strategies you can use to approach your ETF investments. One of the most basic and popular strategies is dollar-cost averaging.

Using this strategy, you invest a specific amount at set intervals. For example, you might decide to invest $100 with each paycheck. Dollar-cost averaging has many benefits, including helping you create discipline and smooth out your returns over time.

There are also more advanced strategies, such as swing trading. However, strategies like this one come with a higher risk and shouldn’t be your first move if you’re just getting started with investing.

Special considerations for indexed-stock ETFs

As we discussed, there are many types of ETFs to choose from, with indexed-stock ETFs being among the most popular. Because of the popularity of these ETFs, there are some special considerations to keep in mind.

Diversification challenges in indexed-stock ETFs

Diversification is one of the most important tenets of long-term investing. In many ways, indexed-stock ETFs can make it easy to diversify your portfolio since you can gain exposure to hundreds — or even thousands — of securities in a single investment. For example, a total stock market ETF would give you exposure to every company in the U.S. stock market.

However, some ETF investors may need additional diversification if their ETF holdings are largely in one part of the market.

Dividends and ETFs

Dividends are payments that public companies make to their shareholders as a way to pass along their profits. While companies aren’t required to pay dividends, many choose to do so as a way to attract and reward investors.

If you invest in ETFs that hold companies that pay dividends, you’ll get those dividends just as you would if you had invested in the company directly.

In some cases, you may find that only certain companies within the ETF pay dividends. For example, if you invest in an S&P 500 or total stock market ETF, not all companies will pay dividends. But there are also dividend and income ETFs that specifically invest in companies that pay dividends.

The dividends you earn from your ETF investments can either be used as a source of recurring income or can be reinvested back into the ETF to help further grow your portfolio.

Tax efficiency of ETFs

One of the key advantages of ETFs over mutual funds is their tax efficiency. In an actively managed mutual fund, fund managers frequently buy and sell assets. And whenever that happens, the gains are passed along to the investors. So even if you haven’t sold off your fund holdings, you could still end up with taxable gains. You’ll still pay taxes on your ETFs when you receive dividends or sell for a gain.

Trading volume of ETFs

The popularity of ETFs has grown in past years, as has the number of ETFs on the market. However, not all ETFs are created equally.

Because of the large number of ETFs that have been introduced, some have a low trading volume. Trading volume refers to the number of shares that change hands during a certain period. The lower the trading volume, the fewer the shares changing hands. Unfortunately, this could indicate that it will be difficult to buy and sell shares of certain ETFs.

Market impact of ETFs

A final consideration of ETFs is the impact they have on the overall market and what, if any, instability they help foster.

First, there are questions about the impact ETFs may have on stock prices. There is some debate as to whether the impact of ETFs can inflate stock prices, creating small market bubbles. However, there’s no conclusive evidence that this is the case.

Next, there has been some research that suggests that ETFs can increase market volatility. Findings suggest that stocks with higher ETF ownership may also experience higher market volatility. This is especially the case when the price of an ETF deviates significantly from the price of the underlying assets, as it opens the door for more arbitrage opportunities.^6,7

Finally, ETFs have previously been linked to market flash crashes, which are sudden (and often dramatic) crashes in stock prices. Flash crashes are often the result of electronic, automated trading systems.

Whether the ETFs were the cause of the flash crashes or simply victims of them isn’t entirely clear. However, one can draw a connection to ETFs in the flash crashes in May 2010, August 2015, and February 2018.^{8, 9, 10}

The bottom line

ETFs may be a good addition to your overall financial portfolio. Because of the numerous options available, you may want to consider consulting a financial professional before investing in an ETF. A professional can examine your unique situation and review your overall financial goals and objectives to help you determine which investments may be right for you.

1 SEC, “Investor Bulletin: Exchange-Traded Funds (ETFs),” August 2012.

2 Investment Company Institute, “The US ETF Market: FAQs,” April 2023.

3 Investment Company Institute, “The US ETF Market: FAQs,” April 2023.

4 VettaFi, “Largest ETFs: Top 100 ETFs by Assets,” 2023.

5 Investment Company Institute, “Trends in the Expenses and Fees of Funds, 2021,” March 2022.

6 National Bureau of Economic Research, “Do ETFs Increase Stock Volatility?,” September 2014.

7 SEC, “Do ETFs Increase Volatility?” March 2015.

8 MarketWatch, “ETFs’ growth sparks ‘flash crash’ fears,” November 2010.

9 SEC, “Research Note: Equity Market Volatility on August 24, 2015,” December 2015.

10 The Washington Post, “This week’s stock market drop was machine-made. The freakout that followed was man-made.” February 2018.

Asset allocation, diversification, and/or rebalancing do not ensure a profit or protect against loss.

ETFs are a type of exchange-traded investment product that must register as either an open-end investment company (generally known as “funds”) or a unit investment trust. ETFs are not mutual funds.

Unlike mutual funds, individual shares of ETFs are not redeemable directly with the issuer. ETF shares are a collection of securities bought and sold at market price, which may be higher or lower than the net asset value. Investment returns will vary based on market conditions and volatility, so an investor's shares, when redeemed or sold, may be worth more or less than their original cost. ETFs are subject to risks like those of their underlying securities.

RO3118729-1023