An Exchange-Traded-Fund (ETF) is an investment fund that holds several underlying assets and much like an individual stock can be bought and sold on an exchange. ETFs can be designed for tracking anything from the price of a single commodity to a large and diverse collection of stocks.

ETFs can also be designed to track specific investment strategies. There are many different types of ETFs for investors looking to grow income, gain exposure, or hedge risk in an investor's portfolio. The first ETF in the United States was the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index.

How ETFs Work

Registration for an ETF must be compulsory in the Securities and Exchange Commission (SEC). In the United States, most ETFs are established as open-ended funds based on the Investment Company Act of 1940, with later regulations modifying their regulatory requirements. Open-ended funds do not limit the number of investors involved in the product.

Vanguard's Consumer Staples ETF (VDC) tracks the Morgan Stanley Capital International (MSCI US) Investable Market Consumer Staples 25/50 Index and has a minimum investment of $1.00. The fund holds shares of 104 companies in the index that produce or sell consumer goods, and most of the companies are well-known. Procter & Gamble, Costco, Coca-Cola, Walmart, and PepsiCo are just a few of the companies owned by VDC.

There is no opportunity for ownership transfer because investors buy a portion of the fund, which essentially owns shares of the companies. Unlike mutual funds, ETF share prices are set for a particular day. A mutual fund trades only once a day after the market closes.

Important: Volatility is relatively low in an ETF because its holdings are more diversified. Industry ETFs are also used to rotate within and outside of divisions during economic rotation.

Types of ETFs

Passive ETFs: Passive ETFs aim to replicate the performance of a diversified index such as the S&P 500 or a broader index of more targeted sectors or trends.

Actively managed ETFs: Portfolio managers decide which securities to buy and sell, rather than targeting a specific index. Actively managed ETFs have many advantages over the passive ETFs, but they charge higher fees.

Bond ETFs: These bonds are used to provide investors with regular income. The allocation of government, corporate, and state and local bonds depend on the performance of the underlying, which is commonly known as municipal bonds. Unlike their underlying instruments, there is no specific maturity date on the bond ETFs.

Industry or Sector ETF: An industry or sector ETF aims to provide diversified exposure to a single industry, including high performers and new entrants with growth potential. A basket of stocks that tracks a single industry or sector, such as automotive or energy. For example, BlackRock's iShares U.S. Technology ETF (IYW), tracks the Russell 1000 Technology RIC 22.5/45 Capped Index.

Bitcoin ETFs: Spot Bitcoin ETFs were approved by the SEC in 2024. These ETFs provide investors with regular exposure to changes in the price of Bitcoin in a brokerage account and purchase and hold Bitcoin as the underlying asset. Bitcoin futures ETFs, which were approved on the Chicago Mercantile Exchange in 2021, use futures contracts traded on the exchange and track the price movements of Bitcoin futures contracts.

Ethereum ETF: Spot Ether ETFs provide an opportunity to invest directly in Ether, the underlying currency of the Ethereum blockchain, without owning any of the cryptocurrency. The SEC permitted the Chicago Board Options Exchange, NASDAQ, and NYSE to list ETFs containing Ether in May 2024. And in July 2024, the SEC officially approved nine spot Ether ETFs to begin trading on U.S. exchanges.

Commodity ETFs: Commodity ETFs can diversify an investor's portfolio. Holding shares in a commodity ETF is more cost-effective than owning the physical commodity. So invest in commodities like crude oil or gold.

Currency ETFs: Currency ETFs track the performance of currency pairs and can predict a currency's exchange rate based on political and economic developments in a country. Importers and exporters use them to protect themselves from volatility in the currency market, while many also use them to diversify their portfolios.

Inverse ETF: Profit from a stock's decline without actually reducing the stock. An inverse ETF uses derivatives to diminish the stock. An inverse ETF is not a true ETF, It is an Exchange-Traded-Note (ETN). An ETN trades like a stock and is backed by a bond issued by an issuer, such as a bank.

Leveraged ETF: A leveraged ETF returns 2 or 3 times the return of the underlying investment. If the S&P 500 rises 1%, a 2× leveraged S&P 500 ETF will return 2%, and if the index falls 1%, the ETF will lose 2%. These products use debt and derivatives, such as options or futures contracts, to generate their returns.

Pros and Cons of ETFs 

Pros: 

• ETFs allow you to invest in many stocks from different industries. 
• They have low costs and fees. 
• Diversification helps manage risks.
• You can choose ETFs that focus on specific industries or commodities. 

Cons:

• Actively managed ETFs come with higher fees. 
• ETFs focusing on a single industry may lack diversification. 
• Sometimes, low liquidity can make trading difficult.  How to Invest in ETFs 

Information on brokerage, costs and investment platforms

ETFs are traded through traditional brokers and online broker-dealers. Information on pre-screened brokers in the ETF industry is available from a number of sources. Individuals can also buy ETFs in their retirement accounts. Robo-advisors like Betterment and Wealthfront are an alternative to standard brokers.

The expense ratio of an ETF is the cost of maintaining and managing the fund. ETFs typically have lower expenses because they track an index.

Most ETFs are available on online investment platforms, retirement account providers, and investing apps like Robinhood. Most of these platforms offer commission-free trading, meaning investors don't have to pay platform user fees to buy and sell ETFs.

After creating a brokerage account and making a deposit into the fund, investors can search for ETFs and buy and sell the desired assets. One of the best ways to narrow the ETF options is to use an ETF screening tool that uses criteria such as trading volume, expense ratio, past performance, holdings, and commission costs.

A Brief Information on ETFs, Mutual Funds and Stocks

Most stocks, ETFs, and mutual funds can be bought and sold without paying commissions. However, unlike stocks, funds and ETFs charge management fees. These fees are usually small and are spread over time. ETFs typically have lower fees than mutual funds.

 Exchange-Traded Funds (ETFs) 

• ETFs are investment funds that follow a group of assets, like stocks or commodities. 
• Their prices can be higher or lower than the actual value of the assets in the fund. 
• ETFs are bought and sold during market hours, just like stocks. 
• Many ETFs can be purchased without commission and are usually less expensive than mutual funds. 
• When you buy an ETF, you don’t directly own the assets in the fund. 
• ETFs spread out risk by including a mix of different assets, industries, or sectors. 

Mutual Funds 

• Mutual funds are investments where money is pooled together to buy bonds, stocks, and other assets. 
• Their prices are based on the total value of the assets in the fund. 
• You can only buy or sell mutual funds at the end of the trading day. 
• Some mutual funds don’t charge fees when you buy or sell them, but they usually have higher management costs than ETFs. 
• When you invest in a mutual fund, the fund owns the assets on your behalf. 
• Mutual funds reduce risk by including a wide variety of assets, industries, or sectors in their portfolio. 

Stocks 

• Stocks are pieces of ownership in a company. 
• The money you make from stocks depends on how well the company performs. 
• Stocks can be bought and sold during market hours. 
• On some platforms, you can buy stocks without paying commissions, and they usually don’t have ongoing fees. 
• When you buy stocks, you directly own part of the company. 
• The risk is tied to the performance of the specific stock. To reduce risk, you would need to invest in multiple stocks. 

Dividends and Taxes

ETF investors can benefit from the dividend-paying company. Dividends are a portion of the company's income that is paid to investors. ETF shareholders are entitled to a certain portion of the interest or dividends earned by the fund. Even if the fund is liquidated, they still have the right to the remaining value.

ETFs (exchange-traded funds) are tax-efficient compared to mutual funds because their shares are usually bought and sold through a stock exchange. When investors want to sell shares, they sell them directly in the market. This does not require the ETF sponsor to redeem the shares.

On the other hand, in the case of mutual funds, when investors sell shares, they have to return them to the fund. This creates a tax liability that has to be paid by the other shareholders of the fund.

Share Creation and Redemption Process:

The supply of shares in an ETF is controlled through a creation and redemption process. Specialized investors called Authorized Participants (APs) participate in this process.

When the ETF manager wants to issue new shares, the AP buys shares of stocks from the index (such as the S&P 500) and sells or exchanges them to the ETF at par. The AP then sells the ETF shares on the market for a profit.

The AP buys ETF shares and sells them back to the ETF sponsor. In return, they receive individual stock shares, which the AP can sell on the market. This reduces the number of ETF shares.

The NAV of an ETF is a calculation method that determines the total value of the assets held in the fund. If the price of the ETF shares in the market is higher than the NAV, the shares are trading at a premium. If it is lower, the shares are trading at a discount.

Summary:

ETFs are a simple and affordable way to invest in a variety of securities on a limited budget. Investors can gain exposure to securities that represent a large market through ETFs. However, it is important to be aware of the additional costs and procedures when investing in ETFs.