What's an ETF - The Ultimate Guide

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Andrew Goldman

Andrew Goldman has been writing for over 20 years and investing for the past 10 years. He currently writes about personal finance and investing for Wealthsimple. Andrew's past work has been published in The New York Times Magazine, Bloomberg Businessweek, New York Magazine and Wired. Television appearances include NBC's Today show as well as Fox News. Andrew holds a Bachelor of Arts (English) from the University of Texas. He and his wife Robin live in Westport, Connecticut with their two boys and a Bedlington terrier. In his spare time, he hosts “The Originals" podcast.

An exchange-traded fund, ETF for short, is an investment fund that lets you buy a large basket of individual stocks or government and corporate bonds in one purchase. Think of ETFs as investment wrappers, like a tortilla that holds together the component ingredients of a burrito, and instead of tomatoes and rice and lettuce and cheese, these burritos were filled with stocks or bonds and are considerably less delicious to eat with salsa. Want to dive in deeper to a specific topic on ETFs? We've got you covered:

You could say that the ETF is a relative of the mutual fund, which is another way to purchase many stocks at one time. But there are a few major differences between ETFs and mutual funds. Whereas mutual funds tend to have human mutual fund managers who actively trade stocks in and out of the fund based on which ones they predict will go up or down, the vast majority of ETFs are unmanaged by humans.

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Instead, many ETFs are programmed with an algorithm that simply track an entire economic sector or index, like the S&P 500 or the US bond market. For this reason, mutual funds are generally referred to as being “actively managed” and ETFs “passively managed,” though there are many exceptions to this rule. Unlike mutual funds, which are priced just once a day, ETFs can be bought and sold during the entire trading day just like individual stocks. This explains why they’re called “exchange traded” funds.

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Because most ETFs don’t require humans to make trading decisions, they tend to come with lower management expense ratios (MERs) than mutual funds. MERs, represent the percentage of the value of the entire fund that is deducted annually to cover the fund’s operating expenses. In other words, they're a management fee. Since computers work cheap and humans don’t, it’s not unusual for a mutual fund to charge a 1% or higher annual MER and ETFs a fraction of that. Between 0.05% and 0.25% represent the normal range of MERs for ETFs. Because of this, ETFs are often considered a low-cost alternative for investors on a budget.

Though these numbers may all appear pretty small, a fee or 1 or 2 percent can substantially erode investment gains over the long term. In fact, studies have shown over and over again, fees are directly predictive of returns; the higher the fees, the lower the returns. (For a deeper look on these issues, learn more about passive investing.

Types of ETFs

Though ETF varieties aren’t nearly as plentiful as grains of sand on the world’s beaches, there are a shocking number and variety of them, possibly even more in number than The Fast And The Furious sequels and spin offs—and their numbers are growing every day. Here are the major asset classes and investment products included in the biggest ETF categories.

Stock Market Tracking ETFs

ETFs that mirror indices like the stock or bond market have attracted by far the most investment from individual investors. Also known as index ETFs or bond ETFs, since they track a particular market index, they're a particularly popular way for investors to own a small stake of the American economy is to invest in ETFs that seek to mirror the S&P 500, an index of the 500 publicly-traded American companies with the highest market capitalizations. Since the S&P 500 or other large indexes like the Dow Jones Industrial Average or the NASDAQ-100 naturally favors the largest companies, those who seek to diversify their equity with smaller companies may consider ETFs that track, say, the S&P 400, or the Russell 2000, which track, respectively, midcap and small-cap publicly traded companies. The benefit of these kinds of index funds is that these ETFs offer automatic diversification, and you can easily track past performances by looking at past market activity. Popular index ETFs include the Invesco QQQ and the iShares Russell 3000. For investors looking for more fixed income ETFs, bond markets may be a more attractive option.  

Sector Tracking ETFs

Should you want to focus on a particular sector of the economy, rather than the entirety of it, you may want to invest in a sector tracking ETF. Two financial research giants, MSC and Standard & Poor’s (S&P), developed a taxonomy of the global economy that could locate all publicly traded companies in one of 11 main sectors, and dubbed it the Global Industry Classification Standard (GICS).

The sectors in the GICS are as follows:

  1. Communication Services

  2. Consumer Discretionary

  3. Consumer Staples

  4. Energy

  5. Financials

  6. Health Care

  7. Industrials

  8. Information Technology

  9. Materials

  10. Real Estate

  11. Utilities

Not only will you find multiple ETFs tracking each of these sectors, ETFs are now also available tracking the subcategories of each sector, which from largest to smallest are categorized as Industry Group, Industry, and Sub-Industry. So if you specifically want to focus on an area like crude oil companies, there's an ETF for that. MSCI hosts a handy interactive tool that provides an overview of all eleven sectors and their subcategories.

International ETFs

Those who want exposure to international stocks, may choose to invest in one of several types of international ETFs.

ETFs that focus on all economies outside the US.

An ETF like Vanguard’s Total International Stock ETF (VXUS) seeks to “track the performance…of stocks issued by companies located in developed and emerging markets, excluding the United States.” So one price will buy you exposure to most all economies outside of the US. You can also invest in ETFs that track the stock markets of specific countries, like the Toronto Stock Exchange (TSX) or the Tokyo Stock Exchange (TYO).

ETFs that focus on developed markets

Developed markets are the markets of countries that have well established economies, generally an established rule of law and are technologically advanced relative to other countries in the world. A few examples of developed countries are Australia, Japan, and Germany. A developed market ETF would provide broad exposure to all developed markets. BlackRock’s iShares MSCI EAFE ETF (EFA) is a prominent example.

ETFs that focus on emerging markets

The term “emerging markets” was coined in 1981 by economist Antoine van Agtmael when he was working for The World Bank’s International Finance Corporation (IFC) as an alternative to the negative connotations suggested by the term “third world.” Emerging economies like those of Brazil, China, Russia and Turkey are countries with relatively low per capita average salaries that are less politically stable than developed markets but open to international investment. Though investing in emerging markets tends to be riskier than developed ones, the risk is somewhat mitigated when an ETF invests in many, many emerging markets. Vanguard’s FTSE Emerging Markets ETF (VWO), the largest of the type by assets under management (AUM), seeks to “closely track the return of the FTSE Emerging Markets All Cap China A Inclusion Index.”

ETFs that focus on the economy of one country outside the US.

Got a—inexcusably cheesy pun alert—yen to invest in the Japanese economy? BlackRock iShares MSCI Japan ETF (EWJ) promises investors the ability to “access the Japanese stock market in a single trade." There are multiple ways to invest in any economy. And if you ever read up on how difficult it is to buy some foreign stocks, like South Korea’s Samsung, you might decide it’s preferable, and a lot easier to buy, for example a South Korea ETFs, like iShares MSCI South Korea ETF (EWY), which will not only get you a stake in the Galaxy maker, but also a bit of Hyundai motors for diversification’s sake.

Thematic ETFs

If ETFs were a family of mostly strait-laced marketable assets, thematic ETFs would represent the quirky cousin with the handlebar mustache and big parrot on his shoulder. Some of these ETFs seek to either make a statement, by investing only in companies that are environmentally friendly. This is often known as ESG (environmental, social, and corporate governance) investing or socially responsible investing. Others act as financial trend spotters, like the ETFs offered by a company called Global X, which offers seemingly narrowcast ETFs such as a “Millennials Thematic ETF,” “Autonomous & Electric Vehicles ETF,” and “Longevity Thematic ETF.”

This category would also include the burgeoning high growth marijuana ETFs, created to take financial advantage of the loosening cannabis laws in the US and Canada. There are even now ETFs available for the connoisseur set which invest in either fine art or wine.

Of course, you should be able to let your financial freak flag fly but be aware that many thematic ETFs are actively managed, and therefore come with considerably higher MERs that often approach or equal those of actively-managed mutual funds. As always, read the fine print.

Complex ETFs

There are many, many ETFs that don’t necessarily bet on the stock market just going up. There are number of more complicated funds like leveraged ETFs and inverse exchange-traded funds. Unless you absolutely know what you’re doing and would, say, be able to explain how derivatives work to a third grader, you should avoid these ETFs like you would poison ivy at a picnic. Don’t be afraid of spiders, however. Spiders are simply how many refer to Standard and Poor’s Depositary Receipts (SPDR), some of the very first ETFs. The SPDR S&P 500, in fact, was the largest ETF in the world for many years.

How to buy ETFs

As we covered above, ETFs behave a lot like individual stocks, in that they can be bought and sold all the trading day on stock exchanges right alongside your Amazons and General Electrics.

If you know how to trade stocks, congrats, you already pretty much know how to trade ETFs. If you’re a novice, you’d do well to acquaint yourself with this informative “Beginners Guide To Buying Stocks.” Here are the basic steps, however.

Trade through a low or no-fee brokerage

If you would like the freedom to purchase ETFs from various issuers, you are probably best creating an account and trading through a low or commission-free online brokerage or trading platform. You probably already know the biggies’ names. But do your research: many will assess a trading fee of between £5.00 and £10.00 per trade, which is nothing to sneeze at if you’re making a small investment. Selecting a commission free trading platform could save you money. Make sure beforehand that the discount brokerage you choose is able to trade in the ETFs you’ve selected.

Purchase directly from the ETF issuer

Whatever ETF you decide to buy, in some cases, you’ll be able to buy the ETF directly from the issuer; Vanguard, for instance, sells its ETFs directly to the public through its website. This is the easiest, most inexpensive route if you plan to only purchase Vanguard ETFs.

Vanguard does offer to purchase some ETFs issued by other companies, but certainly not all. Should you want to purchase, for example, certain iShares, Vanguard will allow the ETF to be transferred into your account but will not allow you to purchase it through their FundAccess service.

BlackRock iShares, however, sell directly to the public but rather market and trade their ETFs commission-free though Fidelity investments. Which is ideal if you want to buy all iShares rather than Vanguard funds, since, as this article, “Vanguard Keeps Some of It’s Cheapest Funds Out Of Reach of Fidelity Customers” points out, in its battle for market share, Vanguard won’t allow Fidelity customers access to many of its most popular offerings.

Alternatives to ETFs

Purchasing ETFs has one primary advantage over buying individual stocks. Hint: it involves how you divide those famous eggs among your proverbial baskets. Since purchasing an ETF containing dozens, if not hundreds of stocks, investing in an ETF will automatically diversify your investment over the purchase of one stock and you will be afforded some natural protection cushioning your investment from market volatility.

To more fully understand the importance of this investment strategy, spend a few minutes with this article, “Diversification: What It Is and How It Works.” That being said, any stock market investment, even one in ETFs, is speculative and past results should never be understood to be guarantees, but rather imperfect predictors of future performance.

But what if you don’t feel like you’ve got all it takes to build a well-structured portfolio of ETFs? A portfolio that takes into consideration the three factors that every investor should consider: goals, time-horizon, and risk tolerance (three principles more thoroughly explained in this article, “Best Investing Strategies”). How you assess these factors will dictate the absolute best mix of ETFs offering exposure to both domestic and international stocks and bonds.

If this is the case, you might investigate investing in ETFs with the help of a robo-advisor. The best robo-advisors will create a bespoke portfolio that will suit any investor’s needs at a reasonable annual management. Some will offer their services for investors opening accounts with as little as £1.00. The better robo-advisors also perform tasks that might be beyond your personal abilities, like automatic portfolio rebalancing, a tedious task for investing newbies. The absolute very best robo-advisors will provide unlimited human support at no additional charge to provide the kind of hand holding and advice that no computer algorithm would ever be able to offer.

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Last Updated 8 June 2021

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