how does an etf work

How Does an ETF Work?

An easy answer is an ETF is an exchange-traded fund. However, when it comes to investing, the ETF combines the diversity you get in mutual funds with the ease of trading stock. Here’s your ETF 101 crash course to bring you up to speed on why exchange-traded funds (ETFs) might be ideal for you.

Exchange-traded funds defined

An exchange-traded fund (ETF) is a fund that acts as a basket of securities, but you can trade it like a stock on an exchange. So you can buy and sell them all day if you wanted. This is an advantage over a straight-up mutual fund because they are only priced at the end of the trading day.

What makes an exchange-traded fund (ETF) Attractive?

Exchange-traded funds give you the diversity of assets you can buy and sell (like a stock) without worrying about purchasing individual components. You’ll often find lower fees compared to other funds. They, of course, also come with different levels of risk. This allows you to pick the ones that suit your investment strategy.

What happens when I invest in an ETF?

Good question. When you invest in ETFs, it is still owned by the fund provider. Their job is to use the underlying assets and create the ETF to track the assets’ performance. The shares are then sold to investors at market-determined prices. So you own a chunk of the ETF, not the underlying assets.

How does that work for me?

Let’s use a few steps to show you how exchange-traded funds work:

  • The ETF provider (or Authorized Participant AP) creates a basket of assets like bonds, currencies, stocks, and commodities
  • The ETF has its own ticker symbol
  • You buy a share of the basket-like shares in a company
  • The ETF is bought and sold on the stock exchange
  • You get either lump dividend payments or stock reinvestments 

These are the basics of how your ETF investment works for you.

How do I make money from ETFs?

Basically, you’re earning money the same way you would with mutual funds with one key difference: exchange-traded funds are actively traded throughout the day, not just at the end of the trading day like mutual funds.

We already mentioned this, we know. But here’s why that’s important. This setup allows the trader to watch the price fluctuations of ETFs, knowing when it is the best time to buy and sell holdings in the ETF. These decisions are based on criteria or benchmarks.

You make money from the holdings, based on either capital gains due to increased stock prices OR dividends on those stocks based on an underlying index. In the case of bond ETFs, your holdings are either Treasuries or high-performing corporate bonds, which help minimize risk if the stock market tanks.

Why not stick to mutual funds?

Of course, you can stick to mutual funds (which are more actively managed) if that’s your thing. But consider this: ETFs offer tax-efficiency advantages to investors. While you still pay taxes on the income, dividends, and short-term capital gains, you aren’t faced with long-term capital gains like with mutual funds.

For actively managed mutual funds, your share of the fund makes money when the fund invests your cash. It’s what we call a “cash-for-shares exchange.”

While you exchange cash for fund shares for ETFs, it’s between you and the AP, not the fund. This makes it less likely you’ll have to worry about long-term capital gains.

With mutual funds, there’s more buying and selling. This puts you on the hook for capital gains. When managers of mutual funds sell securities to raise cash, it can also lead to capital gains.

What about stocks?

Well, as mentioned, exchange-traded funds are traded like stocks. However, the difference is the ETF basket. Your ETF is diverse, with multiple assets, which can reduce risk. Since stocks relate to a single company, if it tanks, your investment does too.

In some cases, ETFs can also increase risk. For example, if they are too focused on one sector. As long as you match the basket’s diversity to your risk level, you tend to be safer with ETFs.

Why is diversity so important?

Diversification helps add stability to an investment. So if one area isn’t doing so well, another helps the investment maintain its value. An ETF might have stocks, bonds, or a particular commodity and include diversity across different sectors and industries. While you can do this yourself, an ETF makes it easy to own interest across a broad assortment of investments with a single purchase. You get the benefits of diversification and the convenience of a single purchase.

I hear ETFs have fewer trading costs, is that true?

Yes and no. From the basics of trading costs, ETFs tend to have lower expense ratios. Expense ratios cover operating expenses such as administration, marketing, and even fund manager payment. In the case of ratios, ETF’s are lower because they are “passive” index-based funds, so they have lower operating costs.

According to Morningstar’s 2019 Annual Fund Fee Study, the asset-weighted average expense ratio for active funds fell to 0.66%, while passive funds were just 0.13%. But ETFs are also exchange-traded, so they often have commission fees. So you have to consider those costs when figuring out overall trading costs.

What about liquidity for ETFs?

This is an ongoing debate. ETF fans like to think of them as a cash replacement because they are more liquid than most funds. In fact, according to Bloomberg, a large number of institutions are investing in ETFs as part of their cash management strategy.

As with any investment, it depends on the specific ETF. Although many trade over $1 billion shares a day, the rest are under $1 million. So when it comes to liquidity management, it’s all about watching how actively traded the ETF is in its sector.

There’s also fund liquidity risk as the ETF will close when it doesn’t have enough assets to pay administrative costs. When this happens, you’ll have to sell sooner, in which case you might experience loss.

How are ETFs tracked?

Since ETFs trade like stocks, different strategies are used to track them. Passive ETFs use buy-and-hold indexing strategies based on specific benchmarks. It’s more like waiting until a safe benchmark is reached. Most ETFs are passively managed and are lower cost. However, actively managed ETFs aren’t stuck with any one strategy. They look at several ways to outperform a benchmark. As a result, they are better at delivering above-average returns.

Types of ETFs

The AP or ETF provider will create different baskets based on different strategies. As a result, you’ll find ETFs will have various focuses. Here are some of the most common types of ETFs:

Stock ETFs

If you are looking for long-term growth, ETFs with a large balance of stocks are a good choice. You have the opportunity to own a diverse portfolio of stocks without the risk of investing in each stock individually.

Commodity ETFs

Commodities are goods that are bought and sold. Think of the orange juice and pork bellies from the Akroyd/Murphy movie “Trading Places,” and you get the idea. So this would include a combination heavy on things such as coffee or gold.

These can get tricky because the fund can own different aspects of commodities. For example, some hold the actual commodities while others own equity in companies related to the commodities. This is a far more involved ETF, so advice is essential. Otherwise, you might end up with some tax issues, not to mention unexpected risks.  

Bond ETFs

If you’re interested in bonds, bond ETFs are an excellent option because you don’t have maturity dates. This helps provide you with regular cash payments over a more extended period. These are high-paying, lower-risk investments ideal for the newbie investor or someone afraid of taking too much risk. They are also an excellent option to help diversify your portfolio.

International ETFs

This is an excellent investment to help provide diversity against economic issues in the U.S. By owning an interest in a variety of foreign stocks, you can reduce risk should the U.S. economy suffer.

Sector ETFs

There are 11 sectors in the U.S. stock market:

  1. Information Technology
  2. Health Care
  3. Financials
  4. Consumer Discretionary
  5. Communication Services
  6. Industrials
  7. Consumer Staples
  8. Energy
  9. Utilities
  10. Real Estate
  11. Materials

When you invest in Sector ETFs, you can take advantage of business cycles. You gain whether it is an expansion period or contraction period. You can still get into riskier investments with Sector ETFs. But the benefit is you can invest in areas of interest or with promise. Maybe it’s the emerging cannabis industry. You invest in the upward trend without as much risk choosing a specific company.

What are some ideas to help me find an ETF?

While broad market ETFs tend to be the most popular, you can use a whole list of different criteria to zero in on the right ETF for you. Here are some ideas to help in your research:

  • Asset class: This is the investments in the ETF basket. Stocks and bonds tend to top the list. Still, you can track down different funds that vary with other asset types, commodities, and alternative investments that might pique your interest. Just remember diversity is key to reducing risk.
  • Geography: Consider global investments to help you benefit from stronger economies. Again, it’s a great way to diversify in case the U.S. experiences challenges.
  • Segment: We’ve discussed segments briefly. Is there a segment you might know more about or that is of interest to you? This can make your investments more personalized and more exciting to track. Look at how an ETF has categorized its assets, whether it is based on company size, sectors, or some kind of emerging trend. You might be more interested in micro-companies while someone else might favor the big guys. You also have fixed-income ETFs, which can include high yield and investment-grade corporate or even government bonds.
  • Investment style: Is there something in your values or lifestyle that makes sense for your ETF choices? Maybe you feel good about eco-friendly or socially conscious companies? Might you like investing in growth? It might also be a preference for actively managed ETFs over passively managed ETFs.
  • Transparency: ETFs are based on indexes, so they tend to have more public holdings, making it easier to follow. You can also look for ETFs with holdings of interest.

These ideas help you find something that suits your interests. It also enables you to find your ideal investment strategy.

How do I choose the right ETFs?

That’s the big question. There are so many ETFs available it can be challenging to know where to start. However, as with any investment, it makes good sense to understand more about what the ETF offers. Here are some things to compare once you narrow down your ETFs:

  • Administrative expenses: We’ve briefly touched on expense ratios. Although ETFs have lower ratios than mutual funds, you still have to contend with them. So you want to compare the administrative expenses since they’ll eat into your profits! Keep in mind the average expense ratio of 0.13% we mentioned above as a marker. If you see something that is way high, you might want to avoid it.
  • Commissions: When you buy or sell an ETF, you are charged commission. However, online brokers don’t usually charge them, and many traditional brokers waive them. Just check in case you happen upon one that still charges commission.
  • Volume: This will show you how popular the ETF is based on how many shares are trading hands.
  • Holdings: You want to check this as it shows you the individual investments in the basket.
  • Performance: While performance fluctuates, you can still look at how the ETF performs and compare it to the other ETFs you are considering. Look at the net asset value (NAV) of the ETF over the long-term, as well.
  • Price of the ETF: Since ETFs trade like stocks, you check the price of the ETF so you know how much it will cost and how many shares you can manage.

As with any investment, you need to consider the risks, assess the liquidity, and make a decision that helps you meet your financial goals sooner.