Exchange-Traded Funds (ETFs)

An exchange-traded fund is a pooled investment vehicle that offers diversified exposure to an asset class (or to a group of asset classes) at a very low cost. Like index mutual funds, some of the largest investment companies in the world sponsor ETFs. However, unlike index mutual funds, investors can buy and sell ETFs throughout the day at fluctuating market prices, just as they would with individual stocks.

Thomas J. Brock, CFA, CPA
  • Written by Thomas Brock, CFA®, CPA
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  • Published: May 10, 2023
  • Updated: October 20, 2023
  • 9 min read time
  • This page features 10 Cited Research Articles
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APA Brock, T. (2023, October 20). Exchange-Traded Funds (ETFs). RetireGuide.com. Retrieved June 21, 2024, from https://www.retireguide.com/retirement-planning/investing/etfs/

MLA Brock, Thomas. "Exchange-Traded Funds (ETFs)." RetireGuide.com, 20 Oct 2023, https://www.retireguide.com/retirement-planning/investing/etfs/.

Chicago Brock, Thomas. "Exchange-Traded Funds (ETFs)." RetireGuide.com. Last modified October 20, 2023. https://www.retireguide.com/retirement-planning/investing/etfs/.

Key Takeaways
  • An ETF is a low-cost way to invest in a basket of securities within a single asset class or across multiple asset classes.
  • ETFs offer investors the ability to diversify their portfolios in a low-cost and highly liquid fashion.
  • On the downside, some thinly traded ETFs can be costly and prone to relatively high tracking error (not performing the same as the underlying index or market). These disadvantages are generally associated with low-volume, relatively expensive and exotic ETFs.

What Is an ETF?

An exchange-traded fund is a pooled investment vehicle that provides investors with low-cost, diversified exposure to an asset class or group of asset classes. ETFs are sponsored by some of the largest, most reputable investment companies in the world, and they trade just like individual stocks on securities exchanges like the New York Stock Exchange and the Nasdaq.

Most ETFs are designed to be passively managed, tracking well-known indices such as the S&P 500 Index and the Bloomberg Barclays U.S. Aggregate Bond Index. However, as the popularity of these vehicles has grown, investment companies have introduced more exotic products, many of which utilize leverage and employ smart beta and derivatives-based strategies.

ETFs can be sensible in any investment plan, but they are especially strong options for retirement plans, given their inherent diversification, low-cost structure and hands-off nature. Mutual funds are an alternative to ETFs, but these vehicles have subtle differences, which we discuss in a subsequent section.

How Do ETFs Generally Function?
  1. The sponsoring investment company establishes the ETF, buys the underlying assets it represents and creates shares in the ETF.
  2. Authorized dealers are appointed by the ETF to sell shares on a public exchange.
  3. The dealers buy large blocks of shares directly from the ETF and sell them to institutional and retail investors.
  4. ETF shares are traded freely among investors, usually with their price approximating the fund’s underlying asset value. However, supply and demand imbalances can mean erratic price swings.
  5. If there is an imbalance between sell and buy orders, the dealers step in to facilitate the transactions.
  6. When dealers have too many ETF shares, they can redeem them with the ETF. This triggers a sale of underlying assets.

Common Fees or Costs

The first comes in the form of commission fees. Some brokerage platforms charge commissions up to $20 per ETF trade. However, this is growing increasingly uncommon. Today, the most competitive brokerage firms offer a large array of commission-free ETFs on their platforms.

The bid-ask spread is another common cost associated with ETFs. It arises because there is normally a difference, or spread, between the ask price (the per-share price at which an ETF can be bought) and the bid price (the per-share price at which an ETF can be sold).

The ask is normally higher than the bid, and the spread is compensation to the broker-dealer. It fluctuates over time, and it varies from one ETF to the next. It tends to be larger for ETFs with low trading volume.

Generally, the most significant fees associated with ETFs are the ongoing management fees charged by the sponsors. Generally, you can expect to pay less than 0.010% per year for passively managed domestic and international stock and bond funds. However, the expense ratios for actively managed and specialty ETFs may run much higher.

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Types of ETFs

At the highest level, ETFs can be categorized as either passively or actively managed. Passively managed vehicles are designed to track specific indices, with little to no managerial discretion. Actively managed vehicles involve substantially more strategic and tactical decision-making and may incorporate specialized trading algorithms.

Beyond the passive vs. active distinction, there are many different types of ETFs. Some are designed to be portfolio solutions, providing exposure to a variety of asset classes. Others focus on specific asset classes, and still others focus on sectors or styles within asset classes. The offerings are increasingly broad.

A handful of the most important types of ETFs to be aware of are:
Stock ETFs
Stock ETFs are designed to provide diversified exposure to publicly-traded equities. The broadest stock ETFs have a global focus, with companies of all sizes from all industries. Some ETFs focus on specific countries or regions, some focus on company size and some focus on select industries.
Bond ETFs
Designed to provide exposure to multiple issues of fixed-rate, publicly traded bonds. There are domestic and international bond funds. Some focus on all sectors (sovereign government, state and local government, corporates and asset-backed securities); others focus on specific sectors. Many ETFs also focus on credit quality (investment grade and non-investment grade) and duration (short, intermediate and long).
Commodity ETFs
Designed to track the price of a commodity or a basket of commodities.
Currency ETFs
Track an index of a single sovereign currency or a basket of currencies.
Smart Beta ETFs
Employ non-traditional weighting methodologies and screening techniques to construct portfolios tilted toward a specific style, such as high-quality, low volatility or high-dividend.

In addition to the vehicles described above, there are a handful of more exotic ETFs in the market. Inverse ETFs are designed to profit from a decline in a specified index or market. Leveraged ETFs use borrowed money to amplify returns. Bitcoin ETFs provide exposure to bitcoin or assets closely related to the value of the cryptocurrency.

ETFs vs. Stocks

A stock is a financial security that represents an ownership interest in a specific company. When you buy a share of stock, you obtain a proportionate claim on the company’s net assets and future earnings.

A stock ETF share is different. It represents an ownership interest in a basket of underlying stocks and an indirect claim on all their net assets and future earnings.

For most investors, buying individual stocks is not an efficient way to build an investment portfolio. Doing so is costly, time-consuming and unlikely to produce an optimal degree of diversification. Utilizing low-cost ETFs is a better approach.

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ETFs vs. Mutual Funds

ETFs and mutual funds are both fund-style investment vehicles that provide investors access to a basket of assets. However, these vehicles trade differently.

ETFs trade like stocks and can be bought and sold throughout the day at fluctuating prices determined by the intersection of marketplace supply and demand. Conversely, the purchases and sales of open-ended mutual funds are transacted directly with the issuing fund company. Their prices are determined at the end of each trading day based on the fund’s underlying assets and liabilities.

Both ETFs and mutual funds can be passively or actively managed. Most ETFs are designed to be low-cost and passively managed, tracking well-known indices such as the S&P 500 and the Nasdaq Composite. Most mutual funds are actively managed, but passively managed vehicles, commonly referred to as index funds, do exist.

ETF Definition and Venn Diagram

Pros and Cons of Investing in ETFs

The most prominent benefit of ETFs is the fact they offer investors a very low-cost means to achieve a high degree of diversification. This is especially true for passive ETFs.

Investors also value that most ETFs are also highly liquid and easy to trade. You can buy or sell them at any time during regular trading hours, entering into and out of positions with minimal effort. Most ETFs are also very transparent, with regulations mandating clear visibility into their holdings daily.

ETFs, though, are not without their notable drawbacks. Some thinly traded ETFs exhibit relatively wide bid-ask spreads, which can be costly — especially if the investment is held for a very short time. In these circumstances, buying at the high end of the spread and selling at the low end of the spread can lead to an automatic loss.

ETFs are also exposed to the risk of tracking error, which means actual investment performance may deviate from the intended investment performance. For large, low-cost and passive ETFs, this usually isn’t a big issue. However, for low-volume, relatively expensive and more exotic ETFs, tracking error can be significant.

And finally, the popularity of ETFs has led to the introduction of an array of vehicles, many of which are complicated with a high degree of risk. For novice investors, exposure to these vehicles can detract from your ability to accumulate wealth.

The primary advantages and disadvantages of ETFs, whether implemented inside or outside of retirement plans, are highlighted below.

Pros & Cons of Investing in ETFs
Pros
  • Low-cost means to achieve high diversification
  • Highly liquid and easy to trade
  • Transparent with clear visibility into holdings
Cons
  • Thinly traded ETFs may have wide bid-ask spreads
  • Exposed to the risk of tracking error
  • Popularity has led to the introduction of complicated and risky vehicles

How To Invest in ETFs for Retirement

ETFs can be a great investment vehicle for all types of investment portfolios, but they are an especially strong option for retirement portfolios. Their highly diversified and passively managed structures are ideal for long-term, hands-off investing, and their modest fees enable you to fully capitalize on the power of compound interest.

That said, not all ETFs are the same. It’s important to do some research to identify an ETF (or collection of ETFs) that aligns with your investment objectives and tolerance for risk. If you have access to educational materials and research tools as part of your 401(k) plan or individual retirement account (IRA), be sure to leverage them to better understand your options. Ideally, discuss your situation with a fiduciary financial advisor.

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Other Frequently Asked Questions about ETFs

What is an expense ratio in an ETF?
The expense ratios for passively managed ETFs have declined considerably in recent years. Generally, you can expect to pay less than 0.010% per year for domestic and international stock and bond funds. However, the expense ratios for actively managed and specialty ETFs may run much higher.
How do you trade an ETF?
You can buy and sell ETFs through your broker or financial advisor. The leading online brokerage firms include Charles Schwab, E-Trade and Fidelity. Each can facilitate your trades, maintain pertinent records and safeguard your holdings.
How many ETFs should I own?
There is no hard and fast rule on the ideal number of ETFs to own. Some investors buy a single ETF that provides exposure to all desired asset classes. Other investors buy a handful of asset class-specific ETFs to allow for tactical asset allocation changes.
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Last Modified: October 20, 2023

10 Cited Research Articles

  1. FINRA.org. (2023, April 12). Exchange-Traded Funds and Products. Retrieved from https://www.finra.org/investors/learn-to-invest/types-investments/investment-funds/exchange-traded-fund
  2. Corporate Finance Institute. (2023, March 21). Smart Beta ETF. Retrieved from https://corporatefinanceinstitute.com/resources/capital-markets/smart-beta-etf/
  3. Corporate Finance Institute. (2023, March 16). Hands-Off Investor. Retrieved from https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/hands-off-investor/
  4. Intercontinental Exchange, Inc. (2023). Make the Connection. Retrieved from https://www.nyse.com/index
  5. Investor.gov. (2023). Mutual Funds. Retrieved from https://www.investor.gov/introduction-investing/investing-basics/glossary/mutual-funds
  6. Corporate Finance Institute. (2019, April 8). Bid and Ask. Retrieved from https://corporatefinanceinstitute.com/resources/equities/bid-and-ask/
  7. Bloomberg. (n.d.). Bloomberg US Agg Total Return Value Unhedged USD. Retrieved from https://www.bloomberg.com/quote/LBUSTRUU:IND
  8. Nasdaq.com. (n.d.). About Nasdaq. Retrieved from https://www.nasdaq.com/about
  9. Nasdaq.com. (n.d.). Nasdaq Composite Index. Retrieved from https://www.nasdaq.com/market-activity/index/comp
  10. S&P 500®. (n.d.). S&P Dow Jones Indices. Retrieved from https://www.spglobal.com/spdji/en/indices/equity/sp-500/