What Is an ETF?
- An exchange traded fund (ETF) is a basket of securities that can be bought and sold in a single trade on an exchange.
- There are a wide range of advantages to ETFs, including targeted exposure, increased diversification, flexible trading, and more.
- ETFs have grown in popularity since they first launched more than 30 years ago. Now, there are more than 9,500 ETFs available globally.1
An exchange traded fund (ETF) is a basket of securities — such as stocks, bonds, currencies, or commodities — that can be bought and sold in a single trade on an exchange. It generally tracks the performance of an index, may charge less fees, and offer targeted exposure to a specific market segment, such as an asset class, geography, sector, or investment theme.
In essence, ETFs are funds that trade like stocks with the diversification benefits of mutual funds. In one trade, they may offer diversified, low-cost, transparent and tax-efficient exposure to companies across the globe. But unlike traditional mutual funds, which are priced once a day at the close of trading, ETFs are priced continuously throughout the trading day and can be bought or sold at any time — allowing investors to react to market conditions and news in real-time and to execute trades quickly and efficiently.
What Are the Benefits of ETFs?
Understanding the benefits of ETFs is an important step toward determining whether ETFs can be an appropriate choice for your portfolio
Targeted Exposure
ETFs generally track an index, offering exposure to a specific segment of the market such as:
- Asset Classes: ETF proliferation has helped make all market segments easy to access, from equities and fixed income, to commodities and alternatives.
- Geographies: You can access global, regional, or single country focused ETFs, as well as ETFs that focus on developed or emerging markets.
- Currencies: ETFs that track the price return of a basket of currencies, such as all emerging market currencies, or individual ones, such as the Japanese yen or Chinese yuan.
- Sectors and Industries: These ETFs track a stock market sector or industry, such as Industrials, Health Care, Homebuilders, or Technology.
- Investment Themes: These ETFs seek to offer exposure to multi-generational investment themes such as Environmental Social and Governance (ESG) or the advancement of technology on cyber security or autonomous vehicles.
- Style/Factors: Smart beta ETFs offer exposures to stocks with attributes like low volatility, value, and momentum.
Lower Expense Ratios
Because most ETFs are passively managed, they typically have lower management fees and operating expenses compared to mutual funds. Transaction costs are minimized due to the low turnover of most ETFs and the indexes they track. When fees and expenses are low, investors can keep more of their returns.
Increased Diversification
ETFs provide one of the easiest ways to diversify a portfolio.
They provide access to many companies or investments in a single trade, removing single stock risk — the risk inherent in being exposed to just one company. The ETF structure helps to lower the risk that a select number of individual stocks could hurt overall portfolio performance.
Added Liquidity
ETFs benefit from two sources of liquidity:
- Primary Market Liquidity: ETFs have a unique creation/redemption mechanism, which allows authorized participants (APs) to build baskets of ETF shares when demand increases (creation), or disassemble the baskets of ETF shares back into single securities should demand decrease (redemption). This happens in the primary market and allows the liquidity of an ETF’s underlying securities to enhance the liquidity of the ETF.
- Secondary Market Liquidity: Because they trade throughout the day on an exchange, or in the secondary market, investors can make timely investment decisions and quickly execute based on shifting market conditions.
Tax Efficiency
ETFs are generally more tax efficient than other investment vehicles due to the ability to transfer securities in and out of the portfolio in the most tax-efficient manner, via the in-kind creation/redemption process. Because ETFs generally track market indexes, turnover is generally low, resulting in fewer capital gains and lower taxes. Additionally, any associated capital gains taxes are paid at the time of final sale, offering greater control on the timing of tax consequences.
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
Most ETF holdings are fully transparent and available daily, which means that investors can see exactly what assets the ETF holds and how its performance is being impacted by changes in the underlying assets. This can help investors make more informed investment decisions with greater accuracy.
Are There Risks Associated With ETFs?
Like any investment, ETFs carry certain risks that investors should be aware of before making a decision to invest:
- Market Risk: ETFs are an investment in the stock market. As a result, they are subject to market fluctuations. The value of the ETF’s shares can go up or down depending on the performance of the underlying stocks in its portfolio.
- Inflation Risk: ETFs may be affected by inflation, as the value of the fund’s assets may be eroded by rising prices 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.
Using a due diligence process, investors should consider their investment objectives and risk tolerance before investing in ETFs. Be sure to visit the fund’s prospectus for more information on the risks associated with a particular ETF.
What Is an Example of an ETF?
One example of an ETF is the SPDR® S&P 500® ETF (SPY) — the largest,2 most traded,3 and most liquid ETF in the world.4 This ETF tracks the S&P 500 Index, which is a broad-based index that consists of 500 of the largest publicly traded firms in the United States, spanning all major sectors. By investing in SPY, an investor can gain exposure to the performance of the entire US stock market, which can help to diversify their portfolio and potentially reduce the impact of market volatility.
The Global ETF Market
ETFs have grown exponentially since 1993 when State Street Global Advisors launched the SPDR® S&P 500 ETF Trust (SPY), the first US-listed ETF. 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.
State Street Global Advisors launched the first US-listed ETF: SPDR® S&P 500 ETF Trust (SPY)
Total number of global exchange traded funds available. 5
Global assets under management in ETFs and ETPs 5