An exchange-traded fund a type of investment fund that trades on a stock exchange like a stock. ETFs are typically designed to track the performance of a specific index, such as the S&P 500, NASDAQ, or Dow Jones Industrial Average.
What is an ETF?
While some people want to invest in individual selected companies, others want to invest in multiple companies and securities at the same time. Exchange-traded funds are made for that second group, enabling them to invest in a mix of different stocks and securities. Stock exchange funds are available in several varieties. They can range in investment focus, which can be linked to a particular industry, region, and other specific categories of securities. With some exchange-traded funds, you can invest in an entire sector and track a broader market index rather than having to choose a particular company within it. So you can buy and sell ETFs just like stocks.
If you believe cybersecurity is a smart investment but don’t know what kind of cybersecurity company to invest in, you may not have to choose. Instead, a cybersecurity ETF can include stocks of different cybersecurity companies, giving you a broader range of investments in the cybersecurity industry.
Some widely used ETFs include:
- Broad index-based ETFs: These are intended to track popular indices, such as the S&P 500 stock index, which consists of the 500 largest publicly traded U.S. companies based on their value by market capitalization. It offers a certain flavor of the overall U.S. stock market (i.e., large-cap stocks). The up and downs of this ETF are usually closely related to the S&P 500 stock index.
- Sector or niche ETFs: These ETFs may track a narrower portion of the market, either as a speculative “bet” on a particular market segment or as a way to diversify an existing group of securities (e.g., stocks, bonds, etc.). These types of ETFs may represent unique market segments such as commodities (e.g., gold, oil), or they may specialize in a narrower segment of a larger asset class (e.g., small companies, foreign companies or cybersecurity companies). However, these ETF investors are usually exposed to additional political, currency and market risks.
Are ETFs the same as mutual funds?
They both contain the word “fund,” but they are not the same thing. Mutual funds and ETFs can also provide access to a broader range of investments in one mutual fund. Mutual funds also come in two basic types (open-end and closed-end), each of which may have different characteristics. Even though ETFs and mutual funds provide diversification investments, they differ in their structure, benefits and risks.
Here are a couple of differences:
1. ETFs can be traded throughout the day on exchanges like stocks . However, many mutual funds (e.g., open-end mutual funds) are priced only once a day, at the end of the trading day, and can only be settled once that price is determined daily after trading ends.
2. ETFs are often designed to passively track a particular industry, index or package of securities, so management fees can be lower.
Advantages of ETFs
There are many advantages to ETFs over other types of funds, such as mutual funds. Despite these advantages, all ETFs have a risk based on the benchmark investments that they hold (and that you, as an investor, will receive as an ETF owner, for example):
– “Intraday” trading: Like stocks, ETF prices can change throughout the day, and ETFs can be bought and sold during trading hours. For example, an intraday trader may buy an ETF in the morning, sell it in the afternoon and buy it again in the afternoon. An open-end mutual fund, on the other hand, can only be redeemed once a day, after the market closes, at the end-of-day fund price.
– Lower fees: Mutual funds can be actively managed by a fund manager, In this case, they usually charge a higher fee for this service. But since ETFs often passively track the movements of an index or security without active human involvement, they usually don’t charge such a high management fee. Some ETFs are actively managed.
– Diversification: The wide variety of ETFs available can make it easy to diversify your portfolio . Different and increasingly niche ETFs specialize in certain sectors, areas and securities that can help balance out your other investments.
Disadvantages of ETFs
Investing is serious, regardless of the type of investment. In addition to the advantages of ETFs, there are also some disadvantages to keep in mind. And like any investment, ETFs carry risk.
Here are a few key disadvantages to keep in mind:
- Diversity: Although ETFs can help diversify a portfolio, they are not necessarily diverse in and of themselves. Some ETFs provide access to a wide range of stocks in a particular region, sector or theme, but not all. Make sure you know exactly what the ETF you’re investing in includes and whether it will truly diversify your investments, if that’s what you’re aiming for.
- Market volatility: Over the past decade, the growing popularity of ETFs has led to a dramatic increase in funds tracking various indices or industries. As a result, some studies suggest that market volatility may be exacerbated by investments of some algorithm-driven funds.
- Tradability: ETFs may trade throughout the day like stocks, but that doesn’t mean they are always easy to trade. Some ETFs focused on more niche or obscure sectors may have relatively few buyers and sellers, making it difficult to quickly trade your ETF shares at the desired price.