Exchange-traded funds (ETFs) were introduced in the early 1990s and have proven a durable and popular investment for many. As a result, they have expanded greatly, both in number and what they focus on over time.
An ETF is like a mutual fund, but there are major distinctions between them. Both save you the time-consuming work of analyzing companies and picking stocks, though mutual funds often tend to be less tax-efficient and have higher management fees.
Below, we introduce you to ETFs, explain why they've proven so popular, discuss the benefits and drawbacks that come with them, and describe what to look for when choosing among them for your portfolio.
ETFs combine features of both mutual funds and stocks. Like mutual funds, they offer investors an interest in a professionally managed, diversified portfolio of investments. However, unlike mutual funds, ETF shares trade like stocks on exchanges, with prices fluctuating throughout the day based on market demand.
For example, certain ETFs track the S&P 500 or the Barclays Capital U.S. Aggregate Bond Index, which invests in securities in those indexes. But an ETF isn't a mutual fund. Instead, it trades like the shares of a company stock on a public exchange. And, unlike a mutual fund with its net asset value (NAV) calculated at the end of each trading day, an ETF's price changes throughout the day, fluctuating with supply and demand.
While ETFs attempt to replicate the returns on indexes that they track, there is no guarantee that they will do so exactly since each fund has a slight tracking error or difference between how the index would perform and how the ETF does.
ETFs have grown their assets tremendously, increasing from a negligible amount of total U.S. fund assets to about 30% in late 2023, with much of the rest taken up by mutual funds. Below is a chart of their growth in assets since 2010.
Diversification: ETFs offer investors instant diversification, whether across the broad market, asset classes, market sectors, or specific industries.
Accessibility and flexibility: Because ETFs trade like stocks, you can buy and sell them anytime during a trading session. You can also short sell them and buy on margin.
Low fees: The expense ratios of most ETFs are lower than those of the average mutual fund. The average expense ratio for an index ETF was 0.16% in 2022. As of 2024, the SPDR S&P 500 ETF (SPY) had an expense ratio of 0.09%.
Liquidity: Popular ETFs are highly liquid. This means they can be sold easily and at a narrower bid-ask spread.
Tax efficiency: Because of their passive management, ETFs usually have fewer capital gains, which means investors may pay less in taxes. In addition, in-kind (as opposed to cash) exchanges for an ETF's securities also result in less capital gains.
Additional costs: While ETFs may have low expense ratios, you may have other charges related to buying and selling ETFs, such as broker commissions/transaction costs. Moreover, you can expect higher expense ratios if you invest in an actively managed ETF. In addition, the bid-ask spread for an ETF presents a hidden cost for investors.
Excess trading: Because ETFs can be bought and sold intraday, investors may forget their investment goals and trade them unnecessarily in reaction to attention-grabbing news reports or unsupported rumors.
Potentially lower returns: The diversification that makes ETFs (and mutual funds) a smart way to reduce risk can also mean that returns might be less than those obtained by actively selecting and owning individual stocks.
ETFs are the most common type of exchange-traded product and typically include baskets of stocks, bonds, or other assets grouped based on the fund's specific goals. Here are some of the major types you'll see as you explore this landscape, though there are hybrid ETFs that hold more than one kind of asset, and funds overlap categories. Let's first review the two broadest categories before looking at the different strategies ETFs can be based upon. Then, we introduce the categories you'll see most often as you look through your brokerage's platform. There's also a table putting the basics of each together.
Unlike most ETFs, which passively track an index, these have portfolio managers who actively buy and sell securities to try to outperform a benchmark. In 2023, these made up about 15% of the ETFs trading.
The first ETF in the U.S. was the SPDR S&P 500 ETF Trust (SPY), which began trading in 1993 and tracks the performance of the S&P 500 by buying the same 500 stocks and weighting them proportional to the index. Like SPY, index ETFs track the performance of a specific market index, such as the S&P 500 or the Dow Jones Industrial Average. Index funds are by far the most popular, making up over 4/5s of the assets under management in the U.S.
Another example is the Invesco QQQ (QQQ) ETF, which tracks the Nasdaq 100 and consists of the 100 largest and most actively traded nonfinancial domestic and internationalcompanies on the Nasdaq. It offers investors broad exposure to the tech sector. Its diversification can be a big advantage when there's volatility in the markets. If one tech company falls short of projected earnings, it will likely be hit hard, but owning a piece of a hundred other companies can cushion that blow.
These hold one type or a variety of bonds, providing investors with exposure to fixed-income securities. There are several subcategories of bond ETFs, each focusing on different types of bonds. Government bond ETFs invest in Treasurys and other government securities, offering exposure to debt issued by national governments. Corporate bond ETFs focus on corporate debt securities, and, lastly, high-yield bond ETFs invest in lower credit rating bonds that offer higher yields, but also come with increased risk compared with government or high-quality corporate bonds.
Bond ETFs offer diversification and the potential for generating income, making them attractive to investors looking to put a portion of their portfolio into fixed-income securities.
These invest either directly in physical commodities, such as gold, silver, or oil, or in commodity futures contracts. They offer exposure to commodity markets without the need for direct investment in the underlying assets.
For instance, if you think that natural gas companies are a good prospect, you might consider a fund like the United States Natural Gas Fund (UNG). This ETF tracks natural gas prices by buying natural gas futures contracts.
| Top ETF Asset Categories by AUM | |
|---|---|
| ETF Type | 2024 AUM |
| Equity | $6.95 trillion |
| Bond | $1.53 trillion |
| Commodity | $139 billion |
| Real Estate | $70.5 billion |
| Crypto | $65.2 billion |
| Hybrid | $33.5 billion |
| Preferred Stock | $32.3 billion |
| Alternatives | $6.3 billion |
| Volatility | $2.9 billion |
Crypto ETFs
These track the performance of one or more cryptocurrencies, such as Bitcoin. The U.S. Securities and Exchange Commission (SEC) has expressed concerns about market manipulation, liquidity, and the custody of assets on crypto exchanges. This kept futures-based crypto ETFs off U.S. exchanges until 2021, when ProShares Bitcoin Strategy ETF (BITO) was approved. The approval of Bitcoin futures ETFs, like the ProShares Bitcoin Strategy ETF, marked a significant regulatory breakthrough and set a precedent for other futures-based crypto ETFs. They were approved under the idea that futures markets are more regulated and thus offer higher levels of investor protection than spot cryptocurrency markets.
In January 2024, the SEC relented and allowed the first spot bitcoin(BTCUSD) ETFs to begin trading. This set off massive buying of bitcoin in the first few months of trading, sending it up about 60% in value in the first quarter alone. Major investment houses like Fidelity and Grayscale have proposals for ether ETFs, but we've reported that the SEC isn't likely to approve one for its tokens soon. In addition to the SEC's concerns about spot bitcoin funds, Ethereum, the platform behind the currency, uses a staking mechanism where randomly selected holders of ether lock up their funds as collateral and are rewarded with more ether for supporting the blockchain network. The SEC is reported to believe this makes ether far more like a security than bitcoin, meaning its regulatory place would have to be sorted before an Ether ETF could be approved and offered to investors.
Currency ETFs
Currency ETFs are exchange-traded funds that have exposure to foreign exchange markets, allowing investors to trade currencies much like stocks. They track a single currency or basket of them, offering a way to speculate on currency moves or hedge against currency risk.
Investors use currency ETFs to diversify their portfolios beyond traditional asset classes, speculate on economic conditions in different countries, or hedge against currency fluctuations in export and import-driven businesses.
Equities ETFs
These focus on stocks from major indexes like SPY, sectors like health care, or offer dividends. They can also choose to invest in companies with different market capitalization or specific themes, like artificial intelligence, which might involve companies across different sectors. These have, by far, the largest market share in ETFs.
Real Estate Investment Trust (REIT) ETFs
These invest in a portfolio of REITs, giving you exposure to the real estate market without having to buy properties directly. The REITs whose shares the fund holds generally generate income through leasing space and collecting rents, which they then distribute to shareholders as dividends. REIT ETFs are popular for their potential to provide stable income and diversification benefits, as real estate often moves independently of stocks and bonds.
| Exchange-Traded Fund Types | |||||
|---|---|---|---|---|---|
| ETF Type | Description | Underlying Assets | Typical Investor Use | Major Advantage | Major Disadvantage |
| Actively Managed ETFs | Portfolio managers actively buy and sell securities, including stocks, bonds, futures, and more. | Various securities chosen by the fund manager | Seeking to outperform a benchmark | Potential to outperform benchmarks through experienced management. | Higher expense ratios due to active management |
| Bond ETFs | Invest in one or more types of bonds | Government, corporate, or high-yield bonds | Diversification, income generation | Provides stable income through dividends from bonds. | Susceptible to interest rate risk, affecting bond prices inversely |
| Commodity ETFs | Invest in physical commodities or commodity futures | Gold, silver, oil, or other commodities | Diversification, inflation hedge | Offers a hedge against inflation and an alternative to stocks and bonds. | Can be volatile, influenced by international climate, political, and economic factors |
| Crypto ETFs | Track the performance of cryptocurrencies by holding them or with futures | Bitcoin for spot bitcoin ETFs; bitcoin and ether futures | Exposure to cryptocurrency markets | Provides exposure to cryptocurrency markets without needing to directly buy or store digital currencies. | Highly volatile and can be impacted by regulatory changes and problems in largely unregulated underlying markets |
| Currency ETFs | Track the performance of a currency or currency basket | Currencies | Hedging, speculation | Useful for insuring against currency risks or speculating on foreign exchange moves | Forex markets can be extremely volatile and influenced by sudden global events |
| Dividend ETFs | Focus on stocks that pay consistent dividends | Dividend-paying stocks | Income generation | Offers a regular income stream from dividends. | Depend on the health of dividend-paying companies that could cut dividends in tougher economies |
| ESG ETFs | Invest in companies that meet environmental, social, and governance criteria | Stocks or bonds of ESG-friendly companies | Aligning investments with values | Investing aligned with personal values on environmental, social, and governance issues. | Potentially limited exposure to certain industries; need to ensure ESG claims are legitimate |
| Futures-Based ETFs | Invest in futures contracts (contracts to buy an asset in the future at a preset price) | Futures contracts on various assets | Diversification, hedging, speculation | Provides exposure to various asset classes without needing to directly own the assets. | Futures contracts can be complex and have costs rolling over contracts and tracking errors |
| Leveraged and Inverse ETFs | Multiplied returns on indexes (whether wagering for or against the index going up) | Short selling or long positions in index funds | Short-term trading, hedging, speculation | Offers potential for significant gains in a short period if the market moves as predicted | High risk of significant losses, especially if held for more than one day because of compounding effects |
| Options ETFs | Use options strategies to generate income or manage risk | Options contracts | Hedging, speculation | Benefits of options strategies to generate income or hedge against portfolio risks | Strategies are complex and may lead to significant losses if not managed well, or if you don't know options well when buying ETF shares |
| Preferred Stock ETFs | Invest in securities that combine aspects of stocks and bonds seeking dividend yields | Preferred stocks | Income-seeking and institutional investors wanting diversification | Can offer attractive dividend yields and higher claims on assets than common stocks | Less potential for capital appreciation compared to common stocks; sensitive to interest rate changes |
| REIT ETFs | Invest in real estate investment trusts | REITs, which own income-generating real estate | Diversification, income generation | Provides exposure to real estate without needing to directly manage properties | Sensitive to changes in interest rates, which can affect real estate prices and occupancy rates, lowering them precipitously |
| Sector or Industry ETFs | Focus on a specific sector or industry | Stocks from companies within the sector or industry | Targeted exposure to a specific market segment | Can focus on trends and industries you think are likely to rise | Higher risk of volatility due to exposure to a single sector or industry |
| Volatility ETFs | Provide exposure to market volatility | VIX futures or other volatility-linked derivatives | Hedging, speculation | Useful for hedging against market downturns when volatility is expected to rise | Can have severe losses, especially in stable or rallying markets |
ETF Type By Strategy
Having looked at the kinds of assets that might be involved, we can now turn to the strategies different ETFs use.
Dividend ETFs
These funds focus on dividend-paying stocks across various sectors and provide regular income and the potential for capital appreciation. These ETFs are especially attractive to income-seeking investors, including retirees, because they distribute the dividends they collect from their underlying stock holdings to their shareholders.
Dividend ETFs can vary by targeting high dividend yields, dividend growth, or stability, which allows you to choose a fund that fits your income needs and risk tolerance.
Environmental, Social, and Governance (ESG) ETFs
These funds have been gaining market share among investors looking to make socially responsible investments. They apply ESG criteria to select stocks, aiming to invest in companies with responsible practices. However, they can vary widely in focus. Some target low-carbon emission firms, while others focus on specific themes in sustainable or other ways to have a beneficial social impact.
Global ETFs
These hold a broad range of securities from countries outside the U.S., providing exposure to international markets. Some focus on mature and growth-oriented markets, enabling you to diversify beyond your country's borders. This type of ETF particularly appeals to those looking to mitigate country-specific risks and capitalize on prospects in foreign markets. For example, if you were interested in gaining exposure to some European stocks through the Austrian market, you might consider the iShares MSCI Austrian Index fund (EWO).
For emerging markets, an example includes the iShares MSCI Emerging Markets Index (EEM), an ETF created as an equity benchmark for international securities.
Leveraged and Inverse ETFs
Not every ETF is designed to move in the same direction or even in the same amount as the index it tracks. The prices of inverse ETFs go up when the markets go down and vice versa. They can be very useful to those investors interested in hedging portfolio risk. By buying shares in them, you're hoping to profit when the underlying index or benchmark falls. Leveraged ETFs amplify both gains and losses. Inverse ETFs, meanwhile, aim to profit from a decline in the underlying index, providing negative exposure that is typically equal to -1, -2, or -3 times the daily performance.
These ETFs use financial derivatives like futures, options, and swaps to achieve their goals. For example, the Direxion Daily Financial Bear 3x Shares (FAZ) is a triple bear fund. It attempts to move 300% in value in the opposite direction of the Financial Select Sector Index. It uses derivatives and other types of leverage to boost its performance returns. However, because of their complex nature and the risks of compounding effects over longer periods, leveraged and inverse ETFs are best suited for experienced investors who understand the potential for rapid and significant value changes.
Options-Based ETFs
These use options strategies for potential income generation, downside protection, or magnified returns compared with traditional index-tracking investments. An option is a financial derivative that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price, known as the strike price, on or before a specific date. Call options give the holder the right to buy an asset at the strike price within a particular time frame. Put options give the holder the right to sell the underlying asset at the strike price within a specific time frame.
A common options-based strategy is the covered call, where the ETF holds an underlying asset and sells call options on it, generating income from the option premiums. Other methods include using put options for hedging or combining options for specific risk and return profiles.
Preferred Stock ETFs
These are funds that hold a type of stock that shares characteristics of both equity and debt instruments. Preferred stocks come before common stocks for dividend payments and asset distribution in case of liquidation, but they usually don't carry voting rights like common stocks. They typically have higher dividends than common stocks and even some bonds, making preferred stock ETFs attractive for income-seeking investors.
While generally less volatile than common stock, preferred stock ETFs can be sensitive to changes in interest rates. Like bonds, their prices typically fall as interest rates rise. Among the better-known funds is the iShares U.S. Preferred Stock ETF (PFF), which holds a portfolio of diverse U.S. preferred stocks. It has assets of about $15 billion, an expense ratio of 0.46%, and five-year returns of 3.01%.
Preferred stock ETFs are suited for institutional investors wanting higher yields than those typically available from corporate bonds, with a moderately higher risk profile. They serve as a good tool for diversifying an income-generating portfolio, especially in a low-interest-rate environment when traditional fixed-income instruments may have lower yields.
Sector or Industry-Specific ETFs
These focus on technology, health care, energy, and other parts of the economy. This allows you to gain targeted exposure to specific market areas that interest you. For example, if you're bullish on people having excess money for consumer goods, you might invest in a sector ETF to gain exposure to firms in the sector.
These ETFs are also useful for diversifying without having to select individual stocks. In addition, sector funds can serve as a hedge against sector-specific risks and are valuable for thematic investing, where the investor can take positions based on expected economic shifts or trends affecting particular industries.
Volatility ETFs
These funds track volatility indexes, most commonly the CBOE Volatility Index (VIX). The VIX measures the stock market's expectations of volatility using S&P 500 index options. Volatility ETFs are typically used as trading instruments for hedging risk or speculating on changes in market volatility rather than long-term investing.
Although ETFs are tax efficient, you are taxed on any income, such as dividends and capital gains that you earn while you hold the fund and after you sell it.
Factors To Consider When Investing in an ETF
When reviewing specific funds, there are several of the main factors to review first:
Objectives and strategies: Understand the ETF's investment objectives and strategies. Consider whether it aligns with your own goals, risk tolerance, and time horizon.
Underlying assets: Look at the ETF's holdings and asset composition. Ensure that you understand what the ETF is invested in and you're comfortable with the risks it involves.
Expense ratio: This is the annual fees charged by the fund. Lower expense ratios can help keep costs down and improve your overall returns.
Tracking error: For index-tracking ETFs, consider the tracking error, which measures how closely the ETF's performance matches that of its underlying index. A lower tracking error indicates better accuracy in replicating the index's returns.
Liquidity: Look at the ETF's trading volume and bid-ask spread. Higher trading volume and narrower spreads generally indicate better liquidity, making it easier to buy and sell shares at a fair price, both when entering and exiting from your position in it.
Issuer and fund size: Consider the reputation and financial stability of the ETF issuer. In addition, review the fund's total AUM, as larger funds may have better liquidity and lower operating costs.
Performance history: While past performance doesn't guarantee future results, reviewing an ETF's historical returns can help you consider how it's done in various market conditions.
Portfolio fit: Assess how the ETF fits within your overall investment portfolio. Ensure that it contributes to the asset allocation you want and helps you maintain proper diversification.
Tax implications: Be aware of the tax implications of investing in the ETF, such as capital gains distributions or tax treatment of dividends. This can help you manage your tax liability more effectively.
Before investing in any ETF, always review its prospectus and related documents to gain a broad understanding of its goals, risks, fees, and other characteristics.
What Are the Most Popular ETFs?
One way to see which funds are the most popular is to look at those with the most assets under management. SPY, the first ETF, is still the biggest, with about $515 billion in AUM, an expense ratio of 0.09%, and five-year returns of 14.96%. iShares Core S&P 5000 (IVV) is next with securities related to the large-cap stocks of the S&P 500. It has assets of about $455 billion, an expense ratio of 0.03%, and five-year returns of 15.02%. At third is another S&P 500 index fund, the Vanguard S&P 500 ETF (VOO), with an AUM of about $435 billion, an expense ratio of 0.03%, and five-year returns of 15.01%. The largest bond ETF is the Vanguard Total Bond Market ETF (BND), with about $104 billion in AUM, an expense ratio of 0.03%, and five-year returns of 0.37%.
What's the Difference Between an ETF and a Mutual Fund?
An ETF and mutual fund both pool money from investors and invest that capital in a basket of related securities. They can be actively or passively managed. Unlike mutual funds, ETFs trade like stocks and you can buy and sell them on stock exchanges.
Another key difference between ETFs and mutual funds is the associated cost. Mutual funds generally charge higher management fees than ETFs.
Can I Use ETFs For My Retirement Funds?
Absolutely. ETFs are commonly included in retirement portfolios because of their diversification benefits and low cost. They can be used to construct a balanced portfolio aligned with your risk tolerance and retirement timeline while offering exposure to a wide range of asset classes, such as stocks, bonds, and commodities.
The Bottom Line
ETFs combine features of both mutual funds and stocks. They are listed on stock exchanges and can be bought and sold throughout the trading day like individual stocks. ETFs typically track a specific market index, sector, commodity, or other asset class, providing investors with exposure to a diverse range of securities in a single investment. Their benefits include liquidity, lower expenses than mutual funds, diversification, and tax advantages.
When considering an ETF, review its goals and strategy, underlying assets, expense ratio, tracking error, liquidity, issuer and fund size, performance history, risks, and how it fits within your overall portfolio.
