Exchange-Traded Fund (ETF): How to Invest and What It Is

What Is an Exchange-Traded Fund (ETF)?

An exchange-traded fund (ETF) is an investment fund that holds multiple underlying assets and can be bought and sold on an exchange, much like an individual stock. ETFs can be structured to track anything from the price of a commodity to a large and diverse collection of stocks.

ETFs can even be designed to track specific investment strategies. Various types of ETFs are available to investors for income generation, speculation, or hedging risk in an investor’s portfolio. The first ETF in the U.S. was the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index.

How ETFs Work

An ETF must be registered with the Securities and Exchange Commission (SEC). In the United States, most ETFs are set up as open-ended funds and are subject to the Investment Company Act of 1940, except where subsequent rules have modified their regulatory requirements. Open-ended funds do not limit the number of investors involved in the product.

Vanguard's Consumer Staples ETF (VDC) tracks the MSCI US Investable Market Consumer Staples 25/50 Index and has a minimum investment of $1.00. The fund holds shares of all 104 companies on the index, some familiar to most because they produce or sell consumer items. A few of the companies held by VDC are Proctor & Gamble, Costco, Coca-Cola, Walmart, and PepsiCo.

There is no transfer of ownership because investors buy a share of the fund, which owns the shares of the underlying companies. Unlike mutual funds, ETF share prices are determined throughout the day. A mutual fund trades only once a day after the markets close.

Types of ETFs

• Passive ETFs: Passive ETFs aim to replicate the performance of a broader index—either a diversified index such as the S&P 500 or a more targeted sector or trend.
• Actively managed ETFs: Do not target an index; portfolio managers make decisions about which securities to buy and sell. Actively managed ETFs have benefits over passive ETFs but charge higher fees.
• Bond ETFs: Used to provide regular income to investors. Distribution depends on the performance of underlying bonds which may include government, corporate, and state and local bonds, usually called municipal bonds. Unlike their underlying instruments, bond ETFs do not have a maturity date.
• Industry or sector ETFs: A basket of stocks that track a single industry or sector like automotive or energy. The aim is to provide diversified exposure to a single industry, one that includes high performers and new entrants with growth potential. BlackRock's iShares U.S. Technology ETF (IYW), for example, tracks the Russell 1000 Technology RIC 22.5/45 Capped Index.
• Commodity ETFs: Invest in commodities like crude oil or gold. Commodity ETFs can diversify a portfolio. Holding shares in a commodity ETF is cheaper than physical possession of the commodity.
  
• Currency ETFs: Track the performance of currency pairs. Currency ETFs can be used to speculate on the exchange rates of currencies based on political and economic developments in a country. Some use them to diversify a portfolio while importers and exporters use them to hedge against volatility in currency markets.
• Bitcoin ETFs: The spot Bitcoin ETF was approved by the SEC in 2024. These ETFs expose investors to bitcoin's price moves in their regular brokerage accounts by purchasing and holding bitcoin as the underlying asset. Bitcoin futures ETFs, approved in 2021, use futures contracts traded on the Chicago Mercantile Exchange and track the price movements of bitcoin futures contracts.
• Ethereum ETFs: Spot ether ETFs provide a way to invest in ether, the currency native to the Ethereum blockchain, without directly owning the cryptocurrency. In May 2024, the SEC permitted Nasdaq, the Chicago Board Options Exchange, and the NYSE to list ETFs holding ether. And in July 2024, the SEC officially approved nine spot ether ETFs to begin trading on U.S. exchanges.
• Inverse ETFs: Earn gains from stock declines without having to short stocks. An inverse ETF uses derivatives to short a stock. Inverse ETFs are exchange-traded notes (ETNs) and not true ETFs. An ETN is a bond that trades like a stock and is backed by an issuer such as a bank.
• Leveraged ETFs: A leveraged ETF seeks to return some multiples (e.g., 2× or 3×) on the return of the underlying investments. If the S&P 500 rises 1%, a 2× leveraged S&P 500 ETF will return 2% (and if the index falls by 1%, the ETF would lose 2%). These products use debt and derivatives, such as options or futures contracts, to leverage their returns.
  

Pros and Cons of ETFs

How to Invest in ETFs

ETFs trade through online brokers and traditional broker-dealers. Many sources provide pre-screened brokers in the ETF industry. Individuals can also purchase ETFs in their retirement accounts. An alternative to standard brokers is a robo-advisor like Betterment and Wealthfront.
An ETF’s expense ratio is the cost to operate and manage the fund. ETFs typically have low expenses because they track an index.

ETFs are available on most online investing platforms, retirement account provider sites, and investing apps like Robinhood. Most of these platforms offer commission-free trading, meaning that investors don’t have to pay fees to the platform providers to buy or sell ETFs.

After creating and funding a brokerage account, investors can search for ETFs and buy and sell as wanted. One of the best ways to narrow ETF options is to utilize an ETF screening tool with criteria such as trading volume, expense ratio, past performance, holdings, and commission costs.

Most Popular ETFs

Below are some popular ETFs. Some ETFs track an index of stocks, thus creating a broad portfolio, while others target specific industries.

• SPDR S&P 500 (SPY): The oldest and most widely known ETF tracks the S&P 500.
• iShares Russell 2000 (IWM): An ETF that tracks the Russell 2000 small-cap index.
• Invesco QQQ (QQQ): Known as "cubes," tracks the tech-heavy Nasdaq 100 Index.
• SPDR Dow Jones Industrial Average (DIA): Known as "diamonds," tracks the 30 stocks of the Dow Jones Industrial Average.
• Sector ETFs: ETFs that track individual industries and sectors such as oil (OIH), energy (XLE), financial services (XLF), real estate investment trusts (IYR), and biotechnology (BBH).
• Commodity ETFs: These ETFs track commodities, including gold (GLD), silver (SLV), crude oil (USO), and natural gas (UNG).
• Country ETFs: Funds that track the primary stock indexes in foreign countries but are traded in the U.S. in dollars. Examples include China (MCHI), Brazil (EWZ), Japan (EWJ), and Israel (EIS). Others track foreign markets across multiple countries, such as emerging market economies (EEM) and developed market economies (EFA).

ETFs vs. Mutual Funds vs. Stocks

Most stocks, ETFs, and mutual funds can be bought and sold without a commission. Funds and ETFs differ from stocks because some of them charge management fees, though fees have been trending lower for years. ETFs tend to have lower fees than mutual funds.

Dividends and Taxes

ETF investors can also benefit from companies that pay dividends. Dividends are a portion of earnings allocated to investors. ETF shareholders are entitled to a share of earned interest or dividends and may get a residual value if the fund is liquidated.

An ETF is more tax-efficient than a mutual fund because most buying and selling occur through an exchange, and the ETF sponsor doesn't need to redeem shares each time an investor wishes to sell shares of the ETF.

In the case of a mutual fund, each time an investor sells their shares, they sell it back to the fund and incur a tax liability that must be paid by the shareholders of the fund.

Creation and Redemption

The supply of ETF shares is regulated through creation and redemption, which involves large specialized investors called authorized participants (APs). When an ETF manager wants to issue additional shares, the AP buys shares of the stocks from the index—such as the S&P 500 tracked by the fund—and sells or exchanges them to the ETF for new ETF shares at an equal value. In turn, the AP sells the ETF shares in the market for a profit.

When an AP sells stocks to the ETF sponsor in return for shares in the ETF, the block of shares used in the transaction is called a creation unit. If an ETF closes with a share price of $101 and the value of the stocks that the ETF owns is only worth $100 on a per-share basis, then the fund’s price of $101 was traded at a premium to the fund’s net asset value (NAV). The NAV is an accounting mechanism that determines the overall value of the assets or stocks in an ETF.

Conversely, an AP also buys shares of the ETF on the open market. The AP then sells these shares back to the ETF sponsor in exchange for individual stock shares that the AP can sell on the open market. As a result, the number of ETF shares is reduced through the process called redemption. The amount of redemption and creation activity is a function of demand in the market and whether the ETF is trading at a discount or premium to the value of the fund’s assets.

ETFs in the United Kingdom

The U.K. ETF market is one of the largest and most diverse in Europe. ETFs listed on the London Stock Exchange (LSE) offer exposure to various asset classes and markets, including equities, fixed income, commodities, currencies, real estate, and alternative investments.

Buying ETFs in the U.K. allows inclusion in Individual Savings Accounts (ISAs), which are tax-efficient savings vehicles that allow people to invest up to £20,000 per year without paying any income or capital gains tax on their returns. Another benefit is that ETFs attract no stamp duty, which is a tax levied on ordinary share transactions in the U.K.

U.K. investors can buy shares in U.S.-listed companies from the U.K., but due to local and European regulations, they're not allowed to purchase U.S.-listed ETFs in the U.K. Some U.K.-based ETFs track U.S. markets; they have 'UCITS' (Undertakings for the Collective Investment in Transferable Securities) in their name. This means the fund is fully regulated in the U.K. and allowed to track U.S. investments.For broad-based exposure to U.K. equities, there are several ETFs that track the FTSE 100 index, which consists of the 100 largest publicly listed companies in the country. The HSBC FTSE UCITS ETF is listed on the London Stock Exchange and trades under the ticker symbol HUKX. The ETF has an ongoing charge of 0.07% and a dividend yield of 3.62% as of January 2024.

The Bottom Line

Exchange-traded funds represent a cost-effective way to gain exposure to a broad basket of securities with a limited budget. Investors can build a portfolio that holds one or many ETFs. Instead of buying individual stocks, investors buy shares of a fund that targets a representative cross-section of the wider market. However, there can be additional expenses to keep in mind when investing in an ETF.