What is an Exchange-Traded Fund (ETF)?

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Jack Kramer & Nick Martell
Forbes 30 Under 30 in media, appeared on CBS, Cheddar. Registered representatives of Robinhood Financial LLC.
Definition:

An Exchange Traded Fund (ETF) tracks multiple stocks or other securities to let you invest in a sector, industry, or even region, or to track an index, so you don’t have to pick individual stocks.

🤔 Understanding an ETF

Some people want stock in exactly one company. Others want stock in one type of company. ETFs are for the latter — each ETF is made up of several investments in different underlying stocks or other securities. There are different flavors of ETF depending on their investment focus, which can be a certain industry (automotive or tech), a certain region (European or emerging market stocks), or other certain categories of securities, for instance. ETFs let you invest in a whole sector or to track a broader market index without having to pick any single company in it. And you can buy or sell ETFs just like you would a stock.

Example

If you believe cybersecurity is a smart investment, but don’t know which single cybersecurity company to invest in, you may not have to pick one. Instead, a cybersecurity ETF includes shares of a variety of cybersecurity companies, giving you a more diversified investment in the cybersecurity industry.

Takeaway

An ETF is like an investment smoothie…

Similar to a smoothie, it’s one thing you can invest in that’s made up of a mix of ingredients, available in different asset flavors (i.e., industries, sectors, etc.).

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Common ETFs

Smoothies come in a variety of flavors, sizes, and tastes — similar to your ETFs. Sometimes they track stock indexes, such as the S&P 500. But they can also provide access to other types of securities. There are a variety of different types of stock ETFs. You can also find ETFs that track an underlying mix of currencies (foreign money), bonds (corporate debt), or even commodities (such as undifferentiated products, like oil or orange juice).

Some common ETFs include:

  • Broad index-based ETFs: These are intended to track popular indexes like the S&P 500 stock index, which is made up of 500 of the largest publicly traded US companies based on their value by market capitalization. It offers a certain taste of the general US stock market (i.e., large-cap stocks). This ETF typically rises and falls in a closely correlated fashion with the S&P 500 stock index.
  • Sector or niche ETFs: These ETFs can track a more narrow part of the market as either a speculative 'bet' on certain market segment, or as a way to diversify an existing group of securities (i.e. stocks, bonds, etc.). These types of ETFs can represent unique market segments like commodities (i.e. gold, oil), or can specialize in a more narrow segment of a larger class of assets like small companies, foreign companies or say cybersecurity companies. But investors in these ETFs are typically exposed to additional political, currency, and market risks.

Are ETFs the same as mutual funds?

Both contain the word “fund,” but they’re not exactly the same. Mutual funds and ETFs similarly can provide access or exposure to a wider range of investments in one, bundled, fund. Mutual funds also come in two primary types (open-ended and close-ended), which can each offer different characteristics. But while ETFs and mutual funds both provide investment diversification, they differ in their structure, their benefits, and their risks. Here are a couple differences: 1. An ETF can be traded throughout the day on exchanges, like a stock. But many mutual funds (like open-ended mutual funds) are only priced once daily, at the end of a trading day, and can only be redeemed after that price is determined daily once trading ends. 2. ETFs are often designed to passively track a particular industry, index, or bundle of securities, so management fees can be lower.

Advantages of ETFs

ETFs provide a variety of benefits relative to other types of funds, such as mutual funds. Keep in mind that despite these advantages, all ETFs carry risk based on the underlying investments they hold (and which you, as the investor, would gain exposure to as a holder of an ETF, for instance):

  • “Intraday” trading: Just like a stock, ETFs prices can move during the day and can be traded throughout trading hours. For example, day traders may buy an ETF in the morning, sell it at lunch, and then buy it again in the afternoon. An open-ended mutual fund, on the other hand, can only be redeemed once a day, after the market closes, at the fund’s end-of-day price.
  • Lower fees: Mutual funds may be actively managed by a fund manager, and in that case they typically charge higher fees for this service. But since ETFs often passively track the movements of an index or security without as much active human direction, they typically don’t charge as much of a management fee. Some ETFs are actively managed.
  • Diversification: The wide variety of ETFs available can make it easier to provide diversification to 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, no matter the type of investment — stocks, commodities, mutual funds, or ETFs. In addition to an ETF’s benefits, there are also important disadvantages to keep in mind. And just like any investment, ETFs carry risk, whether that’s the risk of the general market or the specific risk of the companies in which it’s invested. Here are some key disadvantages to keep in mind:

  • Variety: While ETFs can bring diversity into a portfolio, they aren’t all themselves diverse. Some provide access to a wide variety of stocks within a specific region, sector, or topic, but not all do. Make sure you’re aware of exactly what the ETF in which you’re investing includes and whether that actually diversifies your investments, if that’s what you’re aiming for.
  • Market instability: The growth in ETF popularity over the last decade has resulted in a surge of funds tracking various indices or industries. As a result, some research suggests that market volatility can be amplified because of the algorithm-driven investments by some of the funds.
  • Tradeability: ETFs can trade throughout the day like a stock, but that doesn’t mean they’re all necessarily easy to trade. Some ETFs that focus on more niche or obscure sectors may have relatively few buyers and sellers, making it harder to trade your ETF shares quickly at a price you want.
  • Leverage and Volatility: Some ETFs are designed to amplify the moves of the market — picture that smoothie, but loaded with caffeine. One could be structured to track the broader market, but it might be leveraged so that it rises three times greater than what the index did — that also means it falls by three times the amount when markets turn down. Caffeine highs can lead to caffeine crashes. These risky leveraged or inverse ETFs are generally used by short term traders.

Disclosure

Diversification does not ensure a profit nor protect against losses in declining markets. Before investing make sure you read a fund's prospects which contains the objectives, risks, and costs associated with the fund.

Ready to start investing?
Sign up for Robinhood and get your first stock on us.Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory.

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