What is an ETF? An Introduction to the World of Exchange-Traded Funds (ETFs)

Exchange-traded funds have been around since the 1990s, proving to be a popular and reliable investment for many. Because of this, they have witnessed enormous expansion over the years, both in their numbers and what they've focused on.
ETFs are like mutual funds, but there are some major differences. For one, both are made to save the time-consuming hassle of assessing firms and choosing stocks, although mutual funds are usually less tax-efficient and require greater management fees.

With that, we'll be discussing what ETFs are in more detail below, as well as why they're so popular, the various different types, the pros and cons of engaging with them, and more.

What is an ETF?

As alluded to earlier, ETFs blend features of stocks and mutual funds together. Like mutual funds, investors can access a professionally managed and diversified investment portfolio. But despite that, ETF shares trade similarly to stocks on exchanges, where prices can fluctuate across the day depending on market demands.
For instance, certain ETFs track the Barclays Capital U.S. Aggregate Bond Index, whereas others track the S&P 500. Though ETFs try replicating those returns on the indexes they track, there's no guarantee of them doing so exactly, as every fund has slight tracking differences between how the ETF and index perform.

Why are ETFs so Popular?

ETFs, at one point, only formed a negligible portion of total U.S. fund assets. But by late 2023, they grew tremendously to around 30%, with a lot of the rest still comprising mutual funds. The reason why they've become so popular is largely due to them providing a way to purchase potentially diversified investments. In one single trade, each ETF could grant one exposure to hundreds, if not thousands, of different stocks, bonds, or other kinds of investments. This also means that the performance of an ETF is based on the price fluctuations of all those various assets. So, if one were to purchase a stock, for example, their investment's performance would then be tied to that single firm, and this may increase any associative risks.
If you're interested, you may invest in them via brokers, either a financial institution itself or a broker-dealer. At most places, ETFs can be traded in retirement accounts or brokerage accounts. Popular examples include traditional IRAs and Roth IRAs, with IRAs standing for individual retirement accounts. Some providers may even offer you ETF investment opportunities within your HSA, or Health Savings Account.

Types of ETF

ETFs are one of the most common types of exchange-traded products, typically involving baskets of bonds, stocks, or other assets grouped together on the specific goals of a fund. Outlined below are just a couple of the major types that you'll come across in this landscape, though certain hybrid ETFs exist as well, holding over one type of asset, and some funds can overlap categories too.

Actively Managed ETFs

The concept underlying an ETF that's actively managed is that portfolio managers are tasked with adjusting, as desired, the investments within the fund, all while not subjecting themselves to any of the rules pertaining to tracking indexes, like how passively managed ETFs try to do. Active fund managers seek to outperform a benchmark through strategies and research. With traditional actively managed ETFs, and even passively managed ETFs, for that matter, positions are reported daily and priced across the day. This is one difference between comparable mutual funds and such ETFs.
While passive ETFs tend to dominate the sector more, in the past and now, the active market is undergoing tremendous growth lately and has seen some substantial flows. Some potential benefits include potentially higher returns, flexibility, and more tax efficiency.

Passive Index ETFs

Passive ETFs are financial instruments that seek to replicate how a specific sector or broader equity market or certain trend is performing. Passive ETFs, therefore, simply mirror a designated index's holdings, which is a collection of exchangeable assets deemed to represent a market or segment. Investors may purchase and sell passive ETFs over the trading day, in the same way as stocks on a popular exchange.
Components of passive ETFs follow the underlying sector or index and aren't at the discretion of fund managers, which makes them the complete opposite of actively managed ETFs, where decisions are made to beat the market.
When it comes to executing buy-and-hold strategies, passive ETFs can offer investors greater flexibility in comparison to active funds. Advocates of passive investing believe that it is difficult to outperform markets, so they seek to match rather than beat.
With such a hands-off approach, the provider may charge investors less since they won't need to worry about employee salary costs, research, and brokerage fees. Such strategies also tout the advantage of lower turnover. With assets moving in and out of funds at slower paces, you tend to have fewer transactional expenses incurred and realized capital gains. Investors thus may save once the time comes to file their taxes.

Strategy-Based ETFs

Now that we've gone over some of the assets involved, it's time to explore how ETFs can be grouped into strategies.
Volatility ETFs
Volatility ETFs, also called VIX ETFs or volatility-linked ETFs, are exchange-traded funds that seek to track volatility index performance or simply invest within financial instruments linked to volatility. Such ETFs are made to offer market volatility exposure as another type of asset. In this context, volatility just refers to the range of price fluctuations or uncertainty that affect financial markets. In addition, they may even be used as a sort of hedge against such volatility, thereby opening up potential trading opportunities or diversifying portfolios.

Dividend ETFs

Dividend ETFs are exchange-traded funds that are made to invest within a basket of stocks that pay dividends. Fund managers typically choose the portfolio of stocks, which are based on dividend indexes, paying out dividends to investors, thereby functioning as this income-investing strategy for investors looking to buy the ETF.
Environmental, Social, and Governance (ESG) ETFs
ESG ETFs are investment vehicles that hold baskets of stocks from firms that make environmental, social, and governance (ESG) factors their main priority when conducting business decisions, enabling investors to align their portfolios with sustainable principles while still taking part in the stock trading landscape. Essentially, it's a method of investing in firms known to possess strong sustainable and ethical practices throughout social responsibility, environmental impact, and corporate governance standards.

Industry-Based ETFs

Industry or sector ETFs happen to be a dynamic market. Virtually every significant industry group has several indexes that can track industry performance. The most obvious advantage of these types of ETFs is that they offer a way to invest in entire sectors, such as chemicals, energy, biotechnology, etc. But they may be used for other purposes too.

Asset-Based ETFs

Within such broad categories, you'll come across funds that focus more on assets instead.

Commodity ETFs

Commodity ETFs have to do with investing in physical commodities, like natural resources, agricultural goods, and precious metals. Commodity ETFs are usually focused on either a single commodity physically stored or investments within commodity futures contracts.
Other commodity ETFs tend to track how a broad commodity index is performing, which can include several individual commodities that represent a blend of both derivatives positions and physical storage.
Investors will typically buy commodity ETFs when they're seeking inflationary hedges or to achieve some level of profitability when the stock market is not doing well. But, just like any investment, these ETFs carry their own set of risks and aren't a guarantee of profits by any means.

Bond ETFs

Bond ETFs, as their name implies, are ETFs that invest exclusively in bonds. They're a bit like bond mutual funds in that they hold portfolios comprising bonds with various distinct strategies and holding periods, which can either be long or short term.
Bond ETFs may be managed passively and traded, just like how stock ETFs are traded on prominent stock exchanges. This can help encourage market stability by bringing in more liquidity and transparency amidst times of stress.
Bond ETFs can be traded over the day on centralized exchanges, unlike your typical individual bonds, which bond brokers sell over the counter. Oftentimes, the very structure of conventional bonds can make it challenging for investors looking to find bonds with attractive prices. Bond ETFs can circumvent this problem by trading on popular indexes like the New York Stock Exchange (NYSE).
As a result, they may offer investors the potential to gain more exposure to the wider bond market with the transparency and ease associated with stock trading. Bond ETFs will be more liquid than their individual counterparts too, which usually trade at one price each day once the market closes. Also, amidst times of stress, investors may exchange a bond portfolio regardless of the underlying bond market not functioning well.

Currency ETFs

Currency ETFs are pooled investments that offer investors forex, aka foreign exchange, or currency exposure. They enable investors to acquire exposure to those exchange rates that you may experience in one or more pairs of currencies. Like other ETFs, investors may buy these currency ETFs on major exchanges, just like corporate stock shares. Such investments are typically managed passively, with the underlying currencies held within a single basket of currencies or country.

Equity ETFs

These concentrate on stocks from top indexes such as SPY, industries like automobiles or health care, or provide dividends. They may also pick companies with different capitalizations or particular themes such as AI, which may involve firms throughout several sectors. By far, these have had the biggest market share within ETFs.

Cryptocurrency ETFs

These ETFs, which have become quite popular lately, track how one or more cryptocurrencies like Bitcoin are performing. The U.S. Securities and Exchange Commission (SEC) has noted concerns regarding market liquidity, manipulation, and asset custody on cryptocurrency exchanges. This stopped futures-based cryptocurrency ETFs from being traded on U.S. exchanges. But that only lasted until 2021, as that was when the ProShares Bitcoin Strategy ETF, or BITO for short, got approved. Bitcoin futures ETFs like BITO being approved marked a substantial breakthrough, setting a regulatory precedent for other futures-based cryptocurrency ETFs. The idea underlying their approval was that futures markets tend to be more regulated, offering greater levels of investor safety when compared to spot cryptocurrency markets.
However, the SEC finally relented in January 2024, allowing BTC/USD, the first spot bitcoin ETFs, to start trading. This was what set off that enormous BTC buying spree in the initial months of trading, raising its value all the way up to 60% during that first quarter alone. But the surprises didn't stop there. In May 2024, three additional applications, coming from the NYSE, CBOE, and Nasdaq, to list ETFs tied to Ethereum’s price, were approved by the SEC. Since then, top investment houses like BlackRock and Fidelity have approved spot ETH ETFs too, which started trading on U.S. exchanges in July of 2024.

Pros and Cons of ETFs

Starting with the pros, ETFs can be a great way to diversify your holdings, as ETFs can contain potentially hundreds or even thousands of bonds or stocks, and this could spread out your risk exposure. Then there's also how you may enjoy lower investment minimums, especially in comparison to mutual funds, which might require upwards of $1,000 to $3,000 to get started. The pricing can be more transparent too in that you have real-time pricing, so you can see how the prices shift throughout a trading day. Other than that, there's also the fact that it can be a low-cost investment option and that it gives you more trading flexibility.
As for the cons, well, if you're seeking to automate specific transactions, ETFs might not be the best option, as you cannot automate withdrawals or investments. In addition, ETFs might not perfectly track the performances of underlying indexes or sectors because of factors like trading costs, alterations in the composition of funds, and fees. Consequently, this results in differences between the performance of the fund and the index it's tracking.

Conclusion

ETFs blend features of stocks and mutual funds. They're listed on various stock exchanges and are tradable over a trading day like any individual stock. They can track certain market indexes, sectors, commodities, or other asset classes, and so through ETFs, investors are exposed to a diverse number of securities within single investments.