
What is an Exchange-Traded Fund?
An exchange-traded fund or ETF is a type of investment fund, similar to a mutual fund, that can be traded like a stock on a stock exchange.
An ETF will pool money from investors and invest in a portfolio of assets or track a specific index in an index fund structure. The investor in an ETF will then become a part-owner in the underlying assets that are owned by the ETF. And the investor can buy or sell the ETF on a stock exchange through a brokerage account just like he can buy or sell any stock.
On the other hand, an investor in a mutual fund owns units in the fund that can only be traded or redeemed for cash once per day after the market closes.
Similar to a mutual fund, an ETF can invest in a broad range of assets including stocks, bonds, commodities, and currencies.
The Origin of the Exchange-Traded Fund
The exchange-traded fund was created after the success and popularity of the index fund, which was first introduced by Vanguard in 1976.
Characteristics of the Index Fund
An index fund is a type of mutual fund that is not actively managed by a fund manager. It consists of a portfolio of assets that is designed to match the components of a specific broad market index.
The index fund attempts to mimic the performance of its benchmark index and thus provides its investors with broad exposure to the overall market.
The structure of the fund’s holdings is simple: The fund aims to match the holdings and performance of its benchmark index. So if the weighted composition of companies in the index changes, the fund manager will change its portfolio to match this change.
The original idea was simple: Give the average investor, who has no time or interest in studying stocks, an opportunity to own a diversified portfolio of stocks in the broad market and enjoy passive investment returns that match the returns of the broad market.
Introduction of the Exchange-Traded Fund
At the time of the index fund in the 1970s, mutual funds tended to require minimum investment amounts and were rather illiquid as investors had to redeem the fund units at designated times in order to exit their investments.
So financial institutions sought to create a cheaper and more liquid form of a mutual fund that could be traded easily like a stock. This led to the exchange-traded fund.
In 1990, the Toronto Stock Exchange (TSE) introduced the Toronto 35 Index Participation Units (TIPS 35), a receipt-based financial instrument, that tracked the TSE 35 Index. The TSE 35 index, which was administered by Standard & Poor’s, represented the 35 biggest public companies in Canada. It was the first ETF.
TIPS 35 traded on the TSE just like a regular stock. It gave investors a one-stop ability to own a stake in most of Canada’s largest companies.
Like a stock, TIPS 35 also paid dividends. And an investor could take a long or short position in TIPS 35.
TIPS 35 had a low management expense ratio (MER), which is the fee paid by the investor to the fund manager, of 0.05% of net assets.
In 1993, Boston-based asset management firm State Street Global Investors launched its receipt-based financial instrument, the Standard & Poor’s Depositary Receipts, in the U.S. It was the first ETF in the U.S.
Today, it is called SPDR S&P 500 Trust ETF. It is nicknamed spider. It first traded like any regular stock on the American Stock Exchange but it also trades on other stock exchanges today including the New York Stock Exchange.
Investors have embraced ETFs and pushed the industry to grow exponentially since its inception. As of 2021, there were over 8,500 ETFs that managed over $10 trillion in assets.
Types of Exchange-Traded Funds
Given that there are over 8,500 ETFs across the globe, there are as many types of ETFs as there are investment strategies and asset classes.
The broad categories include:
Equity/Stock Exchange-Traded Funds
This is the most popular category. A stock ETF consists of a portfolio of stocks in an ETF that invests in and tracks a specific industry or geography in which these underlying companies operate. The biggest stock ETFs track broad benchmark indices like the S&P 500.
Some Stock ETF examples:
– Technology Select Sector SPDR Fund is an ETF that invests in stocks of large-cap companies in the U.S. technology sector. It does not single out a particular tech sector. Instead it invests across the entire technology sector including IT services, wireless communications services, and semiconductors. Thus, the ETF invests in companies like Apple and IBM.
– Vanguard FTSE Emerging Markets ETF is an ETF that invests in stocks of large-cap companies in the emerging markets geographical region.
– SPDR S&P 500 Trust ETF is an ETF that invests in and tracks the S&P 500 index, which consists of the 500 largest companies listed on U.S. stock exchanges.
With a simple purchase of the ETF like a stock, the investor can invest in a diversified portfolio of companies in that industry or geography or index.
Preferred Stock Exchange-Traded Funds
Most ETFs invest in the Common Stock of companies in their portfolio. But some ETFs specialize in investing in Preferred Stock instead.
Preferred Stock is a class of Shares in a corporation that has a higher claim on the assets and earnings of a company than Common Stock should there be a liquidity event in the company. Preferred stockholders normally receive dividend payments, which are set at the time of issuance of the stock to the investor, along with the par value of the Preferred stock.
Creditors of the corporation have a higher claim on the assets and earnings of a company than Preferred stockholders. So Preferred stockholders sit below creditors (or debt holders) but above Common stockholders in terms of priority. Preferred stockholders receive payments like creditors and also own a stake in the company like Common stockholders. As such, Preferred Stock is considered a hybrid debt-equity financial instrument.
A Preferred Stock ETF example:
– iShares Preferred & Income Securities ETF is an ETF that invests in Preferred stocks and convertible bonds of about 250 large-cap companies across multiple sectors in the U.S. market.
With a simple purchase of the ETF like a stock, the investor can invest in a diversified portfolio of Preferred stock in large companies across the U.S.
Bond Exchange-Traded Funds
A Bond ETF invests in a portfolio of bonds including corporate bonds, government bonds, state bonds, and municipal bonds.
As the ETF holds debt in governments or companies, it receives regular income for its investors.
Since the ETF trades like a stock and not a bond, the bond ETF has no maturity date. A bond ETF normally trades at a premium or discount to the underlying bond price.
Some Bond ETF examples:
– Vanguard Total Bond Market ETF is an ETF that invests in a portfolio of investment-grade bonds including Treasury Bills and mortgage-backed securities across all sectors in the entire U.S. market.
– Schwab U.S. TIPS ETF is an ETF that invests in a Treasury Inflation-Protected Bonds (TIPS), which are bonds issued by the U.S. government that feature a principal dollar amount that adjusts based on certain measures of inflation. These bonds are designed to protect investors against the risk of inflation eating into the investment returns of the investor.
With a simple purchase of the ETF like a stock, the investor can invest in a diversified portfolio of bonds in governments and large companies.
Commodity Exchange-Traded Funds
A Commodity ETF invests in commodities such as gold and crude oil.
Most investors invest in commodities such as gold as a hedge against a downturn in the stock market. When stock markets experience a decline, investors tend to rush to invest in gold as a safe haven.
A Commodity ETF example:
– SPDR Gold Shares is an ETF that invests in gold bullion that is stored in secure vaults. As such, the ETF price tends to move in lock step with the spot price of gold.
However, there are other gold ETFs that invest in gold futures contracts, which do not involve owning the actual physical product.
With a simple purchase of the ETF like a stock, the investor can invest in a commodity like gold without the complexity of having to own and store the physical product.
Sector Exchange-Traded Funds
A Sector ETF invests in companies that operate in a specific sector or industry.
For example, Financial Select Sector SPDR Fund is an ETF that invests in a portfolio of U.S. companies in diversified financial services, insurance, commercial banks, capital markets, real estate investment trusts, thrift and mortgage finance, consumer finance, and real estate management and development.
As such, this ETF effectively invests in the largest companies in the financial services industries in the U.S.
With a simple purchase of the ETF like a stock, the investor can invest in a diversified portfolio of large-cap financial services companies across the U.S.
Another example: Vanguard Real Estate ETF is an ETF that invests in a portfolio of U.S. equity real estate investment trusts (REITs), and the ETF also makes small investments in specialized REITs and real estate firms.
With a simple purchase of the ETF like a stock, the investor can invest in a diversified portfolio of large-cap companies involved in real estate across the U.S.
In a long position, this ETF provides the investor with an opportunity to benefit from increasing real estate prices across the U.S without having to take on the risk of investing in real estate in specific properties or markets. And because REITs must distribute at least 90% of their income to investors, the investor can also receive periodic income from his ETF investment.
Currency Exchange-Traded Funds
A Currency ETF tracks the performance of a pair of currencies.
A currency ETF enables an investor to speculate on the price movements of currencies just like any forex trader would.
This ETF can be used as a hedge against currency volatility by importers and exporters who do business in multiple currencies.
It can also be used as a hedge against inflation that can reduce the value of the currencies that the investor holds.
Some Currency ETF examples:
– ProShares Bitcoin Strategy ETF is an ETF that invests in and tracks the cryptocurrency Bitcoin. This ETF tracks the price movement of Bitcoin relative to the U.S. Dollar.
– Invesco DB US Dollar Index Bullish Fund is an ETF that invests in and tracks the price of a basket of currencies of G10 developed countries relative to the U.S. Dollar. The ETF decreases in value when the trade-weighted basket of currencies strengthens and increases in value when the U.S. dollar appreciates in value. This ETF tracks the price movement of G10 currencies relative to the U.S. Dollar.
Active Exchange-Traded Funds
An active ETF is an ETF that is actively managed by a fund manager. That is, there is a team of people that are periodically analyzing, buying, and selling assets in the portfolio.
This fund management activity of researching and trading in and out of investment positions means active ETFs tend to have higher management expense ratios (MER) than passively-managed ETFs.
Passive Exchange-Traded Funds
A passive ETF is an ETF that is not actively managed by a fund manager.
Most passive ETFs seek to mirror the holdings and performance of a specific broad benchmark index like the Dow Jones Industrial Average, which is a price-weighted measurement stock market index of 30 prominent companies listed on U.S. stock exchanges.
The passive nature of the ETF operation makes it very cost-effective. It does not need a large research department and there is less trading in and out of investment positions, thus the transaction and MER fees are lower than in actively-managed ETFs.
Leveraged Exchange-Traded Funds
A leveraged ETF is an ETF that seeks to deliver higher returns than the returns of the underlying assets in its portfolio by using high levels of leverage in its investments.
Leveraged ETFs include leveraged stock, bond, real estate, commodity, and currency ETFs.
For example, ProShares UltraPro QQQ is an ETF that invests in a portfolio of stocks of companies in the NASDAQ-100 by investing with 3 times daily long leverage to deliver higher returns than the portfolio of underlying stocks that it holds.
Inverse Exchange-Traded Funds
An inverse ETF is an ETF that seeks to make short investments in stocks to profit from the decline in these stock prices.
When the underlying market declines in value, the ETF increases in value.
For example, ProShares UltraPro Short QQQ is an ETF that shorts a portfolio of stocks of companies in the NASDAQ-100 and the ETF invests with 3 times daily short leverage to deliver higher returns than the portfolio of underlying stocks that it has shorted.
Index Exchange-Traded Funds
Index funds can be structured as mutual funds or exchange-traded funds.
The ETF invests in a portfolio of assets to match the holdings and performance of a specific benchmark index. Then, an investor can make a long or short investment in the ETF as he would trade in any stock.
For example, SPDR S&P 500 Trust ETF is an ETF that invests in and tracks the S&P 500 index, which consists of the 500 largest companies listed on U.S. stock exchanges.
Benefits of Exchange-Traded Funds
Through the examples above, we have discussed some benefits of investing in exchange-traded funds.
Lower Costs
It would be prohibitively expensive for the average investor to purchase all the individual stocks in a benchmark index or sector or geography.
An ETF provides the investor with a simple inexpensive means to buy the ETF stock, which gives the investor an indirect stake in the underlying stocks held by the ETF.
Some ETF brokerage services also offer free trading in ETF stocks, which further reduces the costs to the investor.
Lower Management Fees
Many ETFs are designed to mimic a specific benchmark such as the Russell 3000 index, which tracks the 3,000 largest public companies in the U.S.
This ETF operation is less expensive to run and thus the management fees (or management expense ratios) are lower.
But active ETFs do have higher fees than passive ETFs.
Diversification
By buying an ETF, an investor can diversify across sectors, geographies, and investment strategies in the market.
This diversification protects the investor’s returns from a negative performance in any single company or industry or region.
Liquidity
An ETF can be bought and sold in a brokerage account just like any stock.
Thus, the investor enjoys the benefit of liquidity, which can be very important if the investor needs to quickly enter or exit an investment position. As long as there is sufficient trading volume in the ETF, this transaction can be executed within minutes in a brokerage account.
Dividends and Income
When an ETF invests in a portfolio of assets, some of these underlying issuers of equity or debt may distribute dividends and fixed income payments to investors.
ETF investors can receive dividend and fixed income payments while they hold their ETF investments.