ETFs – Exchange-Traded Funds

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Exchange-Traded Funds (ETFs) are a type of fund comprising various securities, such as stocks, often mirroring an index, although they can invest in any sector within the industry or employ different strategies. ETFs share many aspects with mutual funds; however, they are listed on exchanges and traded throughout the day like regular stocks.

Some prominent examples include the SPDR S&P 500 ETF (ticker symbol SPY), which tracks the S&P 500 Index. ETFs can encompass various types of investment assets, including stocks, commodities, bonds, or a mix of investments. An ETF is a tradable security, meaning it has a market price allowing it to be easily bought and sold.

ETFs hold multiple underlying assets, rather than just one like a stock. Because of the diversity of assets within an ETF, they are a popular choice for investors seeking diversification.

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An ETF may own hundreds or thousands of stocks in different industries, or it may focus on a specific industry or sector. Some funds concentrate on the U.S. service sector, while others have a global portfolio. For example, ETFs focusing on banking will purchase stocks from various banks across the industry.

Types of ETFs

There are various types of ETFs catering to investors with income generation, speculation, capital appreciation, and to hedge or offset portfolio risks. Below are some examples of ETF types:

• Bond ETFs may include government bonds, corporate bonds, and municipal bonds, known as municipal bonds.
• Sector ETFs mimic a specific industry such as technology, banking, or the oil and gas sector.
• Commodity ETFs invest in commodities including crude oil or gold.
• Currency ETFs invest in currencies such as the Euro or the Canadian dollar.
• Inverse ETFs attempt to profit from declining securities by short-selling stocks.
• Investors should note that many inverse ETFs are Exchange-Traded Notes (ETNs) and not actual ETFs. ETNs are a type of bond but commonly traded and backed by an issuing entity like a bank.

In the United States, most ETFs are set up as open-end funds and comply with the Investment Company Act of 1940. Open-end funds have no limit on the number of investors participating in the product.

Real-Life Examples of ETFs

Here are examples of popular ETFs in today’s market:

• SPDR S&P 500 (SPY): The oldest and most widely known ETF tracking the S&P 500 Index.
• iShares Russell 2000 (IWM): Mirroring the small-cap Russell 2000 stock index.
• Invesco QQQ (QQQ): Mirroring the Nasdaq 100, typically containing technology stocks.
• SPDR Dow Jones Industrial Average (DIA): Representing 30 stocks of the Dow Jones Industrial Average index.
• Sector ETFs: Tracking individual sectors such as oil (OIH), energy (XLE), financial services (XLF), REITs (IYR), Biotechnology (BBH).
• Commodity ETFs: Representing commodity markets including crude oil (USO) and natural gas (UNG).
• Precious Metal ETFs: SPDR Gold Shares (GLD) and iShares Silver Trust (SLV) holding physical gold and silver bullion in the fund.

Advantages and Disadvantages of ETFs

ETFs offer lower average costs because it would be expensive for investors to buy each type of asset held in the ETF individually. Investors need only execute one trade to buy and one to sell an ETF, leading to lower costs. Some brokers even offer commission-free trading on select low-cost ETFs, further reducing costs for investors.

The expense ratio of an ETF is the cost to operate and manage the fund. ETFs typically have lower expenses because they track an index. For example, if an ETF tracks the S&P 500 index, it can hold all 500 stocks from the S&P, making it a passively managed fund and less time-consuming to research. However, not all ETFs passively track an index.

Advantages

• Access to many stocks across different industries.
• Lower expense ratio and reduced brokerage commissions.
• Risk management through diversification.
• Sector-specific ETFs cater to targeted industries.

Disadvantages

• Actively managed ETFs have higher fees.
• Liquidity concerns impede trading.
• Actively managed ETFs, where portfolio managers actively buy and sell stocks and change holdings in the fund more frequently, typically have higher fees than passively managed ETFs. It’s important for investors to determine how the fund is managed, whether actively or passively, the expense ratio, and weigh the costs against the return to ensure it’s worthwhile to hold.

Stock Index ETFs

An index-tracking fund provides investors with diversification of an index fund as well as the ability to short, buy on margin. However, not all ETFs are equally diversified. Some may have a high concentration in one industry or a small group of stocks or assets highly correlated with each other.

Dividends and ETFs

ETFs not only provide investors with the ability to profit from rising and falling stock prices, but they also benefit from dividends paid by companies. Dividends are a portion of income allocated or paid to shareholders by companies. ETF shareholders receive a share of profits, such as interest or dividends already paid, and may receive residual value in the event the fund is liquidated.

ETFs and Taxes

An ETF is tax-efficient compared to a mutual fund because most buying and selling transactions occur through exchanges, and ETFs do not need to repurchase shares every time an investor wants to sell or issue new shares every time an investor wants to buy. Repurchasing shares of a fund can trigger tax liabilities, so listing shares on an exchange can keep tax costs lower. In the case of a mutual fund, each time an investor sells their shares, they are selling them back to the fund and are responsible for taxes—borne by the shareholders of the fund.

Market Impact of ETFs

As ETFs become increasingly popular with investors, many new funds have been created, leading to some ETFs having low trading volumes. The result can lead to liquidity issues when investors cannot easily buy and sell shares of a low-volume ETF.

Concerns have arisen about the impact of ETFs on the market and whether the demand for these funds can inflate stock prices and create bubbles. Some ETFs rely on untested investment portfolio models in various market conditions and can lead to massive inflows and outflows from funds at certain times, negatively affecting market stability. Since the financial crisis, ETFs have played a significant role in major market disruptions and instability. Issues with ETFs were a significant factor in rapid market downturns in May 2010, August 2015, and February 2018.

Creation and Redemption of ETF Shares

The supply of ETF shares (or stocks) is regulated through a mechanism called creation and redemption, involving specialized investors, called Authorized Participants (APs).

Creation: When an ETF wants to issue additional shares, APs purchase shares on the market, for example, from the S&P 500 group that the fund tracks, and sell or exchange them with the ETF to obtain new ETF shares of equivalent value. The process of an AP selling shares