Exchange-Traded Funds – What Are They and How to Use Them

Exchange-traded funds are investment tools designed to provide exposure to certain sectors of a market or entire market indices. These funds are assembled out of a basket of individual securities including, stocks, bonds, and commodities. They can provide consistent, incremental growth to a well-diversified portfolio.

Key Takeaways

• Exchange-traded funds are baskets of securities assembled by a fund manager and publicly traded like individual stocks or bonds.
• ETFs can contain stocks, bonds, or other securities, and are often assembled based on specific themes and investment goals.
• These funds are generally considered reliable and lower-risk investment than trading individual stocks, offering diversification and certain tax benefits.

What is an ETF?

Exchange-traded funds are similar to typical securities like stocks or bonds, in that they can be traded on stock exchanges by investors and brokerages. Unlike individual stocks, though, ETFs provide an additional level of risk management by spreading the investor’s money across a variety of securities.

Common Types of ETFs

Which specific securities are included in an ETF depends on what type of fund is being utilized. Certain funds are based on entire market sectors, while others are based on tiny sections of the market. Some of the most common forms of ETFs include:

• Fixed Income. A fixed income ETF is a collection of bonds traded as a single package, providing diversified returns to an investor over time. These types of ETFs are some of the most stable and predictable investing tools traded on the market, as they don’t carry the same volatility as stock trading. Fixed income ETFs are an easy way for investors to get started trading bonds, as they don’t mature in the way a typical bond does and they are typically spread across a large number of different types of bonds, requiring less specific knowledge of the market.
• Equity. Unlike fixed income ETFs, equity ETFs are collections of individual stocks traded as a single financial instrument. These collections of stocks can be based on specific sectors of the economy, like agricultural businesses or tech stocks, the level of risk and possible return on investment, or a market as a whole—certain equity ETFs are based on the average of an index, providing insulation from risk in a way that individual stock investments do not.
• Commodity. Instead of investing in stocks and bonds, investors might choose to put their money into a commodity-based ETF focused on the value of specific tangible goods. Commodities like gold, oil, or agricultural products are all common inclusions in a strong commodity-based ETF.
• Speciality. While some ETFs aim to insulate investors from risk by including a broad swath of the market within the fund, other ETFs are focused on a very specific section of the market or niche commodity. These funds might be appealing to investors with specialized knowledge of a certain industry, or those seeking to profit from a perceived shift in a niche sector of the market.

ETF Benefits

ETFs provide a wide array of benefits when compared to investing in individual stocks and bonds.

Diversification

One of the biggest advantages of ETF investing is the reduced risk carried by the diversification of your investments. With individual stocks, an unexpected downturn for a specific company could be financially damaging for an investor who has overcommitted to that company’s stock. With ETFs, unexpected hardships within a single company or even an entire sector of the economy will have a much smaller effect on the fund’s performance, thanks to the balancing effect of the other stocks and bonds it holds.

Efficiency

Another major perk for ETF investors is the tax efficiency of these funds. ETF providers are typically able to avoid capital gains tax on the sale of these bundles of stocks and bonds through a process known as “in-kind transfer.” These shares of funds are exchanged directly with authorized participants in the ETF rather than sold for cash, thereby avoiding capital gains taxes, which mutual funds typically cannot do.

Lower management expenses

Generally speaking, ETFs have lower overhead than other investment vehicles, such as mutual funds. This is because ETFs typically track an index rather than seeking out specific stocks and bonds, as a mutual fund does, and this passive monitoring approach requires fewer employees and less day-to-day research to succeed. Because ETF shares can be transferred in-kind, they also require fewer transaction fees, which helps to keep overhead low as well.

Drawbacks of ETFs

While ETFs can be a smart choice for many types of investors, they are not a one-size-fits-all solution. Despite their many benefits, there are sometimes good reasons to avoid these types of funds.

Market Volatility

One of the main benefits of investing in ETFs can also become a liability under the right circumstances. While these funds protect investors from poor performance in certain sectors or individual businesses, they can also transfer that volatility to other sectors in unexpected ways. An unexpected shift in one sector could lead to panic selling of an ETF that contains securities from that sector, and that volatility could potentially then ripple outward to other securities included in the same ETF. Because these funds are traded just like individual stocks, they can amplify volatility in the right circumstances.

Limited Scope

An ETF provides risk management for investors, insulating them from major losses based on poor performance in specific areas. By the same token, however, these funds can sometimes limit returns on investment as well. In the same way that these funds mitigate losses from a poorly performing company, they also prevent major gains from specific companies outperforming expectations. While they are often a safer choice, ETFs may sometimes provide lower yields than other, riskier investment strategies.

Tracking Errors

An ETF is simply a collection of securities assembled by a fund manager to accurately reflect a specific index. While many ETFs accurately reflect the index on which they are based, there can sometimes be deviations between the fund’s performance and the index’s. ETFs are typically relatively diversified investments, but there will always be a level of human error and market unpredictability which must be accounted for when putting money into this type of fund.

How to Invest in an ETF

Investing in an ETF usually involves opening a brokerage account, selecting a fund or funds that align with your investment goals, and purchasing shares in that fund. A common strategy is to invest a regular amount of each paycheck or a specified amount at regular intervals in your chosen fund, and then holding those shares for the long-term rather than buying and selling in short intervals.

Bottom Line

ETFs are a great tool for both new investors and experienced traders looking for a reliable, generally consistent return on their initial contributions. As with any investment tool, it’s important to be well-informed from the outset and keep track of the potential risks involved with trading in these funds. With some preparation and the understanding that these funds will typically yield strong returns in the long run, ETFs can play a significant role in a strong, balanced portfolio. 

If you’re interested in ETF trading, a financial advisor is a great place to start. Horizons Wealth Management offers services like financial planning, managed portfolios and wealth management to help you solidify your financial future.

ETF FAQ

What’s the difference between Index Funds and ETFs?

There are many similarities between ETFs and index funds. The main difference between the two is how often they can be traded. While ETFs can be traded throughout the day like normal stocks, index funds are traded once daily after the market closes.

What costs are involved with buying and selling a fund?

ETFs are often traded without a commission from the broker, keeping investment overhead relatively low. The most common costs incurred are related to the difference between what a seller asks and a buyer is willing to pay, known as the bid/ask spread, as well as administrative fees associated with operating the fund.

What are the tax advantages to investing in ETFs?

The biggest tax perk associated with ETF investing is in-kind transfer, a process by which shares are transferred directly between authorized participants in a fund rather than sold for cash before being transferred to a new owner. Because the shares are never technically sold, the typical capital gains tax incurred through the sale of a security is avoided.