What is an ETF? How they work and why they’re popular

Types of ETFs

There’s an aisle for just about anything you could need at the grocery store. Similarly, there’s probably an ETF for almost any investment goal and risk tolerance. Here are the most common categories:

• Broad market ETFs: Track major indexes (like the S&P 500®) to gain exposure to hundreds of companies.
• Bond ETFs: Focus on fixed income securities like government Treasurys, municipal bonds, and corporate bonds.
• International ETFs: Access markets outside the US, such as Europe, Asia, or emerging economies.
• Sector ETFs: Target specific sectors of the economy, like Technology, Health Care, or Energy.
• Thematic ETFs: Invest in overarching trends, such as artificial intelligence, clean energy, or future security.
• Dividend ETFs: Hold companies that regularly pay dividends, offering a mix of income and appreciation potential.
• Commodity ETFs: Provide exposure to assets like gold, oil, agriculture, or a broad-basket of commodities.
• Smart beta and factor ETFs: Use rules-based strategies (e.g., value, momentum, low volatility) to tilt portfolios toward certain characteristics.
• Active ETFs: Invest in funds managed by professionals who aim to outperform the market or achieve specific outcomes, versus passively tracking an index.

Increased diversification

ETFs make it easy to diversify. With one trade, you can own hundreds or even thousands of companies—meaning your performance isn’t riding on the fate of a single stock.

Targeted exposure

ETFs often track an index, allowing you to invest in a specific segment of the market, such as:

• Asset classes: Everything from stocks and bonds to commodities and other alternatives.
• Geographies: Global, regional, or country-specific markets, including both developed and emerging economies.
• Currencies: Some ETFs follow baskets of currencies or single ones, like the Japanese yen or Chinese yuan.
• Sectors and industries: These include, Industrials, Health Care, Energy, Technology, and more.
• Investment themes: Ongoing trends like sustainability, cybersecurity, or autonomous vehicles.
• Style/Factors: Smart beta ETFs help position your portfolio toward attributes like low volatility, value, or momentum.

Lower expense ratios

Because most ETFs are passively managed, they typically have lower management fees and operating expenses compared to mutual funds.⁶ And lower expenses mean more of your returns stay in your pocket.

Added liquidity

ETFs are designed to be easy to trade, with two layers of liquidity working in your favor:

1. Primary market: Large financial institutions (also known as authorized participants, or APs) can create or redeem ETF shares by swapping in or out the underlying securities. This process takes place in the primary market and helps keep prices in line.
2. Secondary market: Since they trade throughout the day on an exchange, investors can make timely investment decisions.

Tax efficiency

Thanks to their structure, ETFs usually trigger fewer taxable events than mutual funds.⁷ Since they tend to have lower turnover and allow managers to move securities in and out efficiently, you may owe fewer capital gains taxes. Plus, you don’t pay capital gains until you actually sell your shares, giving you more control over timing.

Flexible trading

ETFs can be bought through an online brokerage account at their current market price at any time during the trading day. There are no minimum holding periods, and investors can employ a wide range of trading techniques—such as buying on margin, short selling, and placing limit orders—to react to market movements.

Increased transparency

With ETFs, what you see is what you get. Most publish their holdings daily, so you can regularly evaluate holdings and performance. That transparency can help you make more informed and confident investing decisions.

Are there ETF risks to consider?

Yes, investing is never risk-free (and if it sounds too good to be true, it probably is). As with any investment, investors should know the possible risks before adding ETFs to a portfolio:

• Inflation risk: ETFs in certain asset classes may be affected by inflation, as rising prices may impact the value of the fund’s assets over time.
• Credit risk: An ETF may be exposed to credit risk if one or more of the companies in its portfolio experiences financial difficulties or goes bankrupt. This could result in a decline in the value of the ETF’s shares.
• Liquidity risk: There is always a risk that it may be difficult to buy or sell shares of an ETF when you want to, due to market conditions or other factors.
• Tracking error: Any ETF’s performance might not perfectly match the index it follows, especially after accounting for fees.
• Complexity: Some ETFs are more complicated than others, such as leveraged, inverse, or options-based funds. While these ETFs can help achieve certain goals, it’s important to understand how they work before investing in them.

Before investing in ETFs, investors should use a due diligence process and consider their investment objectives and risk tolerance. Be sure to visit the fund’s prospectus for more information on the risks associated with a particular ETF.

ETFs vs. stocks vs. mutual funds: Breaking them down

As you weigh your options, you’ll likely come across three ways to invest in the stock market: individual stocks, mutual funds, and ETFs. The “right” vehicle for you depends on your goals and preferences.

• Buying stock grants you shares of a particular business. This is ideal if you want targeted exposure to specific companies.
• Mutual funds are pooled investments that track a market or strategy, but they only trade once a day after markets close. Annual capital gain distributions can lead to unwelcome taxes, so consider using tax-advantaged accounts like 401(k)s or IRAs to limit the tax impact.
• ETFs are a basket of investments you can buy or sell throughout the day, in a single trade. They combine the diversification benefit of mutual funds with the flexibility of stocks.

What is an example of an ETF?

The State Street® SPDR® S&P 500® ETF (SPY)—the most traded⁸ and most liquid ETF in the world.⁹ SPY tracks the S&P 500 Index, which represents about 500 of the largest publicly traded companies in the US, spanning all major sectors.

Revisiting our grocery cart analogy, it’s kind of like loading up a cart with a wide variety of the most recognized brands in the store. In a single trade, investors gain exposure to the performance of the entire US stock market, making SPY an efficient way to diversify a portfolio and “enter the market.”

How do you buy an ETF?

Buying an ETF is easy.

You can’t buy ETFs directly from State Street, but you can access ETFs through most online brokers or traditional financial advisors. Here’s how it typically works:

1. Open a brokerage account. If you don’t already have one, choose a broker that fits your needs (online platforms make this process accessible).
2. Search for the ETF by ticker symbol. For example, “SPY” for the State Street® SPDR® S&P 500® ETF.
3. Decide how many shares you want to buy. Consider the price per share and your overall budget.
4. Place your order. Like a stock, ETFs can be bought throughout the day at market prices. You can place a market order (buy immediately) or a limit order (buy only at a certain price).

That’s it—once your order is filled, the ETF will appear in your account alongside your other investments.

How have ETFs changed investing?

ETFs have grown exponentially since 1993 when State Street Investment Management launched SPY, the first US-listed ETF that redefined investing forever. Today, investors use ETFs to precisely meet their individual portfolio needs, from finding income and gaining broad market exposure, to lowering costs and investing in difficult-to-reach markets.