ETF Education

What is an ETF?

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. They generally track 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.

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 Governance (ESG) or the advancement of technology on Cyber Security or Autonomic 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 one single trade, removing single stock risk — the risk inherent in being exposed to just one company. Offering this exposure in 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:

  1. Primary Market Liquidity: ETFs have a unique creation/redemption mechanism, which allows Authorised 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.
  2. 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.

Learn more about the ETF creation and redemption process.

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. And, 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.

Master the Mechanics of ETF Trading

Increased Transparency— The holdings of most ETFs are fully transparent and available daily. This disclosure means investors know what they own at any moment, allowing them to make more informed investment decisions with greater accuracy.

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.

More On ETF Education