What Is an Exchange-Traded Fund (ETF) and How to Invest?
Exchange-traded funds, or ETFs, are powerful investment instruments that combine the flexibility and convenience of trading stocks and the portfolio diversification of mutual funds. Simply put, ETFs are investment baskets, an affordable way to access a wide range of asset classes.
What is ETF investing, and how to invest in exchange-traded funds? Keep reading to find answers to these questions and more.
Understanding an Exchange-Traded Fund
So, what is an ETF? As the name suggests, an ETF is a fund that contains multiple investments and usually tracks a specific index. In other words, it is a pooled investment security that trades on the stock market just like an individual stock. That’s the ETF stock definition for you.
As we’ve already mentioned, an exchange-traded fund is a basket of investments, such as stocks or bonds, that allows investors to invest in multiple securities at once. When you invest in an ETF, you get a bundle of different assets, which reduces potential risks by diversifying your portfolio.
Exchange-traded funds often have lower fees than other fund types and also offer easier trading opportunities. Unlike mutual funds, ETFs are bought and sold on stock exchanges just like common stocks and experience price changes throughout the day, which ensures liquidity and flexibility.
ETFs: How They Work
In a single trade, an ETF can give you exposure to thousands of different bonds, stocks, and other securities. As an exchange-traded fund, its value depends on the performance of all these assets.
Now, let’s take a closer look at how an ETF works.
- An ETF provider creates a basket of stocks, bonds, currencies, and other investment instruments.
- Investors buy shares of this basket—they do not buy the assets themselves but rather shares of the fund that owns them.
- Buyers and sellers trade ETFs throughout the day on the stock exchange—the price of an ETF changes depending on supply and demand, as well as the price of the individual assets in the basket.
The cost of an exchange-traded fund can vary significantly. It can include trading commissions, an expense ratio, and some other trading costs.
Exchange-Traded Funds Types
Today, investors have access to a wide variety of ETFs to generate income, speculate on price growth, and hedge or partially offset risk. These funds have different investment objectives and vary greatly in their choice of assets.
Let’s review some of the most common types of exchange-traded funds.
Stock ETFs
What are stock ETFs? As you might have guessed, exchange-traded funds of this type mainly focus on stocks and typically aim for long-term growth. While they carry less risk than investing in individual stocks, other ETF types can be even less risky.
Commodity ETFs
These exchange-traded funds track the prices of commodities such as timber, oil, gold, and others. Owning shares in a commodity ETF is usually more financially rewarding than owning the commodity itself.
Bond ETFs
Bond exchange-traded funds are primarily designed to provide investors with a stable income. They have no maturity date, and investors receive payments from the interest generated by the individual bonds within the fund.
International ETFs
When it comes to foreign exchange-traded funds, we are primarily talking about getting access to international companies and markets outside the United States. These ETFs are also an easy option for finding foreign investments.
Crypto ETFs
These are usually Bitcoin ETFs, as exchange-traded funds that offer access to other cryptocurrencies are still limited. Bitcoin ETFs directly track the asset’s price and make cryptocurrency more accessible for investment, since it is available for trading directly on brokerage accounts.
Sector ETFs
These are also called industry ETFs and represent investments in stocks of a specific segment of the stock market. The US stock market has 11 sectors, each including companies operating in that industry. For example, healthcare ETFs will include stocks from companies operating in that segment. This ETF type provides investors with exposure to the industries they are interested in.
Leveraged ETFs
Exchange-traded funds of this type are fairly complex and high-risk. They track the price changes of a market or segment and, thanks to the leverage effect, provide excellent returns when the market rises. However, they can become problematic if the market falls.
Everything You Need to Know About Investing in ETFs
Keep in mind that, as with other forms of investments, there’s no single definitive ETF investing definition or guide. Still, ETFs are an affordable, simple, and efficient way to access a wide range of assets. Investors choose exchange-traded funds for many reasons, including investment portfolio diversification, lower costs, trading versatility and flexibility, and tax efficiency. As an investment instrument, ETFs can meet a variety of goals and needs.
So, how to invest in ETFs? First things first, you’ll need to figure out your investment goals and risk tolerance. After that, you must determine the asset composition that suits your needs, choose an ETF portfolio structure, conduct an exchange-traded fund analysis, and choose your buying strategy.
ETFs are traded through online brokers and traditional broker-dealers, meaning they are available on most online investing platforms and apps. Most platforms that allow buying and selling ETFs offer commission-free trading. Once you have chosen a platform and created a brokerage account, you can begin purchasing ETFs right away. To locate the best ones, consider factors like trading volume, expense ratio, performance, holdings, and fees.
To get the most out of your investment, you should choose an ETF portfolio construction strategy that suits your level of experience and investment style. The strategy chosen will determine purchase timing and ETF selection, as well as more nuanced aspects of trading, like whether to buy fractional shares. Remember, your financial goals, investment period, trading style, and risk tolerance are the key things to consider when choosing a purchase strategy.
You should also regularly monitor and rebalance your ETF to maintain the desired asset allocation. Rebalancing an ETF portfolio can also help the investor stick to their goals and risk levels, as well as avoid losses during market downturns, and improve portfolio returns by earning on price differences. The two most common rebalancing strategies are periodic rebalancing (carried out at certain time intervals) and threshold-based rebalancing (carried out when the ETF balance exceeds a certain percentage).
Final Thoughts
Exchange-traded funds are a profitable and effective option for gaining exposure to a wide range of asset classes. Investing in ETFs means that instead of buying assets themselves, investors purchase shares of the fund that owns them. However, like all investment instruments, ETFs are not a one-size-fits-all solution—it’s always important to consider your investment goals, trading style, and risk tolerance.
