What is an ETF?

Question of the day:

Want to earn money by doing absolutely nothing?

We empathize, we do too—and although it’s not as quick or easy as “finance gurus” would make you believe, there are quite a few ways to make passive income nowadays. Using the stock market to your advantage is one of them. But investing is really risky and complicated—right? 📊

Well, it can be—but it doesn’t have to be. That’s where ETFs come into the picture. 

Exchange-traded funds (ETFs) are an asset class that let investors who are not stock-savvy buy into the market and achieve steady growth over time. In fact, they are an extremely popular asset for passive investors—and they are getting more and more so as time goes on.

However, not all ETFs were created equal, and some can be downright disastrous for your savings (and hairline). If you want to invest in ETFs, you need to pick the best ones for you, trade them through a good broker, and know how to keep an eye on them in case something goes awry in the markets.

In this article, we will explain in detail what ETFs are, the different types that exist, and how to invest in them while avoiding rotten apples and other pitfalls.

Sound good? Perfect—let’s jump in.

How Does an ETF Work? 🏗

Exchange traded funds were first tinkered with all the way back in 1989, but that experiment was short-lived— as their true inception came in 1993. Since then, these funds have stuck around and grown quite a bit. In fact, the value of all ETFs combined reached around $7 trillion in early 2020.

Essentially, ETFs track a commodity, sector, index, or some other asset that is traded on the stock exchange. Big investors and professional brokers usually design them and the SEC approves them. They can track various indexes and range from very specific to general.

So when you trade an ETF, you buy a portion of the value of assets they track. This means that they tend to be a safe purchase—it is unlikely that every stock bundled into an ETF is going to collapse at the same time. However, most ETFs won’t give you massive fast gains across the board.

The biggest and oldest ETF is the so-called SPY, the original one that tracks the S&P 500 index which can be viewed as showcasing the market’s average. However, ETFs have been getting more versatile and strange since ye olden days—some of the hip new ones even include Procure Space ETF (UFO), Loncar Cancer Immunotherapy ETF (CNCR), and as of late, Fidelity’s Bitcoin ETF.

As the name implies, exchange-traded funds are traded like stocks. This is to say, unlike mutual funds that are traded at the end of the day, ETFs are regularly traded during trading hours like other securities.

ETF Expense Ratios ⚖️

The way an ETF is managed can have a significant impact on its expense ratio. A passively-managed fund simply tracks an index—they tend to be very cheap to operate. On the other hand, an actively managed ETF requires human oversight, and this can drive up the cost significantly.

To put this into perspective, the super-popular ETF called VOO has an expense ratio of 0.03%, which means you have to pay the fund 0.03% of the dollar value shares you own each year. However, VOO grew by more than 18% in 2020. so that growth far overshadowed the expense ratio.

ETF Dividends 💸

Dividends represent a portion of the profits paid to the investors—often annually. You might also choose to create a dividend reinvestment plan (DRIP), which means your dividend income will automatically be used to buy more stocks/ETFs. Not all options on the stock market pay dividends so it can be counted as an instant plus for ETFs. 

It is noteworthy that some companies only give the option of reinvesting dividends—the logic being that it grows the business which in turn grows future returns. This is another thing to keep in mind when choosing between ETFs. 

It can be very lucrative in the long run if the company is expected to grow like Mickey’s magic beans from reinvested dividends. However, if the firm’s performance is lackluster, or you are looking for a quick cashout, it probably isn’t worth it.

Types of ETFs 🗃

As we said, ETFs are very versatile and come in many shapes and sizes—different types of ETFs are good for different styles of investing. Additionally, various kinds of funds depend on separate market factors, so making a balanced portfolio could do you well both during a recession, as well as during a boom.

Aside from tracking simple popular indices like the S&P 500, ETFs can track, and even aim to outcompete, just about every area of the market. Here are the characteristics of some of the types of ETF you will come across on your investing journey.

Industry ETFs 💼

Industry ETFs cover ETFs bound to a certain industry. For example, these can be commerce, technology, manufacturing, as well the medical industry (CNCR), and even the space research industry—the most popular space stock, UFO, has had a peak trading volume of $294 million, which speaks volumes about the versatility of ETFs. 

Industry-tracking funds are a good way of investing in a certain field without getting too deeply into details of particular stocks. But this does come at a price—while certain companies in an industry might have stellar performance, others might be staggering or diminishing your overall profits.

An example of a great-performing industry ETF would be the Industrial Select Sector SPDR Fund (XLI) that has had an average annual return rate of 11.64% for the past decade. In the same period, U.S. Global Jets ETF (JETS), which tracks an index of companies involved with air travel, has performed even better, growing by 19.88% by the end of the first quarter of 2021.

Currency ETFs 💱

Currency ETFs invest in various currencies like the USD or EUR. They might go after a single currency, or batch them up. 

In general, you want to invest in a currency that is likely to strengthen, but there are several ways you can go about it. For example, find a currency that has been on a steady rising trend, or maybe “bet” against one that is likely to fall by borrowing and converting to a stable or undervalued currency.

After all, George Soros got his breakthrough toying with the British Pound and had similar success later with the Thai Baht. It is also good to note that currency ETFs might invest directly into a currency or its derivatives, the latter increasing the risks involved.

Invesco DB G10 Currency Harvest Fund (DBV) takes advantage of the fact that high-interest currencies tend to grow faster than low-interest currencies—it borrows from the latter and converts the currency to the former. DBV grew by 4.98% in 2019, declined by a little over one percent in 2020 and has had a strong start in 2021.

Commodity ETFs 🏅

Commodity ETFs are a good way to start investing in things like precious metals, crude oil, and the like. The catch is that they aren’t investing and owning—say gold—directly, but rather these ETFs operate using derivatives. 

Derivatives simply track the underlying price of a commodity and can be cheaper than buying the commodity directly. Also, getting into this kind of investing is excellent for diversifying your portfolio—thus lowering your overall risk.

Aberdeen Standard Physical Palladium Shares ETF (PALL)  has been quite the performer over the past 5 years, growing 35.16% on average over the past five years, and 12.41% over the previous 10 years. This steady rise is likely to continue as some experts believe that palladium is expected to outperform gold in the following years. 

Bond ETFs 🏦

Bond ETFs are considered to be relatively low-risk and steady income. This is because they deal with government, municipal, corporate, and other bonds—generally, things that are “too big to fail.” They also represent a good way to diversify your portfolio even further. 

These types of funds are often not very exciting but can power through crashes and recessions much better than volatile stock ETFs. However, even treasury bond ETFs can be hit by factors like inflation, so they are not immune to a drawdown.

A noteworthy bond ETF is Bloomberg Barclays US Treasury Inflation Protected Notes (TIPS) with its 10 year average being 3.38%. As you might’ve noticed, other ETFs have much bigger returns overall, but this one is more likely to remain positive during a recession.

Specialty-Type ETFs 🦄

Specialty-type ETFs mainly come in two flavors—Inverse ETFs and Leveraged ETFs. They both tend to be high-risk high-reward and while very alluring, it is probably a good idea to consider more steady and sustainable growth investing—especially if you are just starting out.

Inverse ETFs are targeting stock declines to make a profit—they are like investors shorting stocks. As we mentioned before, this is a practice that can be very lucrative but its pitfalls have become very obvious with the recent Gamestop debacle.

This is highlighted by the fact that UltraPro Short 20+ Year Treasury (TTT) has a 5 year return of -62.47%.

Leverage funds borrow money. It is mostly as simple as that—they match every dollar invested with a certain amount of money borrowed to maximize profits. You’ll usually be able to tell how much they leverage as they have indicators in their names. For example, 2X will borrow dollar for dollar.

A good example of a leveraged ETF is Direxion Daily Regional Banks Bull 3x Shares (DPST) which seeks to give three times the returns of S&P Regional Banks Select Industry Index, has a 5 year average of -2.24%—however, its returns of 97.79% in the first quarter of 2021 really showcases how profitable these ETFs can be short-term.

Actively-Managed ETFs 🌎

Actively-managed funds tend to be more agile when it comes to dealing with the stock market than their passive counterparts. The main benefit of this is that, at least in theory, they always net higher returns. However, since they are less hands-off, their managing fees tend to be higher—in practice, this means that you will have to judge on a case-to-case basis if the extra gains are worth the extra expenses.

For example, Ark Innovation ETF (ARKK), which holds stock from companies like Tesla, is an actively-managed fund and has an expense ratio of 0.75%. As it falls in the bracket between 0.5% and 0.75% it is considered reasonable.

On the other hand, the old SPY ETF has a gross expense ratio of 0.095%—which isn’t the lowest among passively managed funds that go all the way down to 0.03%. In general, passively-managed ETFs have very low expense ratios averaging around 0.2% across the board.

Two examples of actively managed funds would be Amplify Transformational Data Sharing ETF (BLOK)—an ETF that tracks companies that invest in blockchain and is up by 39.02% when it comes to three year average—and Amplify Seymour Cannabis ETF (CNBS), a fund that boasts both a telling name and a 180.78% growth over the one-year period since its inception until April 2021.

In essence, a passively managed ETF aims to match an index it is tracking, an actively managed one strives to beat its performance. Also, the fact that ETF trackers aren’t always perfectly accurate should be kept in mind when deciding if you want human oversight on your funds.

Bitcoin ETFs ₿

Simply put, this is an ETF that holds Bitcoin, among other investments. Although a U.S. BTC ETF doesn’t exist yet despite numerous requests to the SEC, other countries including Canada, Germany, and Brazil have approved and are trading their Bitcoin ETFs.

A Bitcoin ETF will likely be approved in the U.S. at some point, but before it does, it’s good to know what its advantages would be and how to prepare accordingly. This type of fund would track the price of BTC to some extent but would also offer tax benefits and ease of access to long-term investors who are more used to brokerage platforms than crypto exchanges.

All in all, the implementation of this ETF type in some countries is seen as a positive step towards diversification (which is one of the key characteristics of funds), and the further popularization of cryptocurrency. If you can’t wait for this ETF to get approved by the SEC, don’t worry—investing in Bitcoin is very simple and easy in this day and age.

How to Invest in an ETF ✅

It is rather easy to get into ETF investing. There isn’t really a buy-in price and you have a lot of flexibility when choosing where to start. The only barrier you’ll find most of the time is the price of an individual share included in the fund, but certain brokers might even allow you to buy a fraction of a share.

So, what are the steps you need to take to start investing?

You’ll need to open a brokerage account and pick a broker you like—and while there are a lot of them, the top-tier ETF brokers are better than others.

However, you also need to come up with a good strategy, diversify your portfolio, and make sure that Uncle Sam getting his due in taxes doesn’t mess up your dreams. Let’s see how all of this looks in practice.

Choose your Strategy 🧠

Consider this: How long-term do you plan your investments to be? What is the current state of the market? What is the current state of an industry, or branch you are interested in? What is the historical performance of ETFs and possibly individual stocks you are interested in?

The first step to figuring this out is analyzing the fundamentals of an ETF to see if its current price has not been overblown by excited investors. Another approach would be through technical analysis which allows traders to find patterns in an asset’s behavior and predict their future movements—although fundamentals are much, much more important for long-term assets like ETFs.

There really isn’t a one-size-fits-all solution here—you’ll have to decide for yourself once you decide whether you want a risk-averse, slow-growing portfolio or the exact opposite. If you want to make money quickly and have cash you are willing to risk, an inverse ETF might be the way to go—on the other hand, if you want long-term security, bond ETFs and strong industrial ETFs are probably a good fit for you.

A nice, balanced mix of aggressive and safe can also work. With more than 5000 ETFs to choose from, it is important to go even more in-depth when it comes to investment strategy.

Find the Best ETF for You 🥇

When it comes to the issuer of an ETF you want someone with a long history and a reputation for reliability—like Zippo lighters 🔥. 

On the other hand, past performance isn’t always indicative of future success so you might consider giving a shot to some of the newer, less proven competitors. Just try and make sure you aren’t following a pipe dream and don’t expect an ETF with a 100% predicted return rate to work as intended.

Another thing to look out for when picking a fund is its level of assets—as we’ve said it is usually not safe to pick one below $10 million. Trading volume is another important indicator as it will let you gauge the liquidity of the fund—the higher the volume, the bigger pool of potential buyers you have available.

Market position is another factor that merits looking into. An ETF in a particular sector that has appeared first has good chances of containing a lion’s share of assets in that sector.

How to Build your Portfolio 📚

Asset allocation is crucial. Often your choice of stocks in your portfolio will determine your ability to weather storms. It is also an argument for long-term diversification, or a temporary focus if you are trying to exploit a trend.

You have probably heard of the 5% rule—never have more than 5% of your portfolio invested in a single security. This holds whatever you are investing in—especially since allocation affects overall returns the most out of any individual factor.

That being said, it is viable to build an all-ETF portfolio. As stated before, they are very versatile and diverse when it comes to what they are composed of—and here lies the biggest benefit of choosing ETFs over stocks.

Additional benefits of this approach are easy access to alternative asset classes like commodities, as well as the ability to trade ETFs all day long—an edge primarily over mutual funds. Of course, this doesn’t mean that you have to build an all-ETF portfolio, nor that you shouldn’t pick different types of these funds.

Buy and Hold the ETF, or Act Quickly ⏱

One example of coming up with a strategy is looking at the effects of the COVID-19 pandemic on the market. While it is true that the market performed far better than expected the previous year, the airline industry has taken a major hit. For example, American Airlines Group stocks dropped significantly, so much so that they reported an expected net loss of about $2.7B in 2021.

If you have been looking to make quick money on airlines this is probably bad news. However, if you are looking to invest long-term, now might be a good time to look up airline, and other transport industry ETFs—the fact that not many people are traveling at the moment doesn’t mean the trend is likely to continue and we might see these stocks rise significantly in the near future.

No matter how tempting trying to make quick money on the market is, going in for the long-haul is generally more profitable—this is because the market is always rising long-term. While going through a crash can be scary, the market has so far always recovered and kept growing afterward.

Generally, the stock market is a good place to put your savings if you want them to really grow, especially since it is likely that the FED won’t increase interest rates before 2024. 

Taking Advantage of Annual Events 📅

An interesting option when trading in ETFs is taking advantage of seasonal trends. For example, due to festivals in India, the prices of gold tend to rise in autumn, so that might be the time to look into gold-related ETFs. This is just one of the examples of why it is always important to pick the right time to invest.

Another annual pattern is the underperformance of the stock market spring-to-autumn. So your strategy could rely on being active during winter, and passive during summer. A bit like a reverse bear 🐻.

Whether it is currently the bear or the bull market is another important factor. Since shorting can be very profitable during an entrenched bear market, you might wonder if ETFs can be traded in that capacity—and the answer is a resounding yes. In fact, as we mentioned before, inverse ETFs rely greatly on shorting.

However, it should be noted once again that short selling carries a great number of risks—and is therefore not recommended for beginners and relative beginners. Top-tier stock brokers and brokers in general are advisable though. And this holds true for any kind of investing you are interested in.

Picking the Perfect Broker 🗂

There are four main things to consider when picking a broker: operational costs, the kind of investments you are interested in, the number of available options, and, as with the ETF issuer, their reputation.

Operational costs are rather self-explanatory. You are on the look-out for brokers that charge you the least while offering the best possible returns. This ties in neatly into their reputation and it’s generally best to keep to household names like Vanguard.

Regulation is another crucial aspect. Here are a few regulated brokers with great reputations among traders across the globe:

Picking a broker that offers a wide array of different ETFs is important as it gives the investor a lot of flexibility when building their portfolio. You don’t want to find a very limited trader and soon have to deal with the hassle of juggling between multiple brokers, or going from one to another in quick succession.

When it comes to the style of investing you are into, it is prudent to look if they specialize. For example, a broker that offers a better cost-to-returns ratio might mostly deal with passive funds—and this wouldn’t be that useful if you want to be an active investor. Another real option is to check if a robo-advisor is good for you.

Know Your ETF Taxes 🚨

Filling out IRS forms can be as annoying as spring allergies, but is unavoidable. Getting to know exactly how taxes on stocks work can get you a long way—especially since ETFs are taxed in the same way as everything else on the stock market.

When you sell your ETFs, you need to pay the government—and this can either be long- or short-term capital gains tax. If possible, try holding assets for more than a year, and you will achieve a lower tax rate—usually 15-20%. 

This immediately means that it is best to keep track of which of your funds are earners—those you want to keep for longer than a year. On the other hand, funds that are losing money are usually best sold before a year is out, so it might be better to sell them off quick.

We have been talking a lot about the long-term benefits of ETFs and those apply here as well. Ideally, you want to manage your funds through an IRA, or even better, a Roth IRA—this is because most income coming this way is either not taxable, or not taxable until withdrawn.

You might feel that this isn’t particularly useful if you are young and just starting out—however, it is never too early to open an IRA. There is a selection of excellent Roth IRA brokers readily available. 

Most estimates state that you will ideally need $1 million before you can retire, and no matter when you plan on doing that, the earlier you start, the more money you are going to have to spoil your grandkids with.

Are ETFs the Best Asset Class? 🔎

Comparing ETFs to other asset classes is a bit strange. This is mostly because they track and include most other main asset classes which means that they share many of their strengths and weaknesses.

Both industry and bond ETFs share many of the weaknesses of the shares they track. The real difference boils down to the inherent diversity of these funds versus the increased precision of targeting specific stock.

Two main classes of assets that are truly different from ETFs are commodities—precious metals, for example—and real estate. This is because, as we’ve discussed before, ETF funds rarely own gold, silver, and the like directly but rather deal with derivatives. This means that if you are into commodity trading and can get your hand directly on a commodity, it is probably better than an ETF.

Real estate is an entirely different beast. On one hand, it lets you monetize your investment even further by renting out to tenants or businesses, but on the other, this comes with a myriad of other potential problems—hassle with the tenants, unfavorable tax climate, dubious liquidity, etc.

ETFs or Mutual Funds: Which is Better? ✔️

ETFs tend to be far cheaper than mutual funds—their expense ratios go as low as 0.03%, and average around 0.2%, while this number stands at 0.52% for mutual funds. Additionally, taxes are more favorable for ETFs than for mutual funds.

One more advantage of ETFs when compared to mutual funds is the fact that ETFs trade throughout the day, while mutual funds only trade at the end of the day. However, the fact that the costs of actively managed ETFs can go higher than the mutual fund average—especially combined with the fact that mutual funds are more numerous—still, make learning about mutual fund investing very worthwhile.

So let’s compare a large ETF with a popular mutual fund.

One more thing to note is that ETFs have, in general, been on the rise. However not all ETF types are growing quickly compared to mutual funds. 

Just as an example, Industry ETFs have been steadily gaining assets, their growth cumulatively reaching nearly $1 trillion by 2018, while mutual funds have in the same period diminished by around half a trillion dollars.

On the other hand, while bond ETFs have been also on the rise, their cumulative flow of half a trillion dollars is dwarfed by $1.76T mutual funds have gained. All in all, the more popular ETFs with growth potential are what grabs public attention, and why it is said that ETFs are outgrowing mutual funds.

ETF vs. Individual Stocks ✔️

ETFs do trade similarly to individual stocks and offer a great way to diversify your portfolio. Also, since they represent stocks that are bundled up, they offer a buffer and safety net from potential market volatility. 

That being said, picking out individual stocks—especially undervalued stocks—can help you capitalize on a rising trend in ways most ETFs can hardly compete with. On the other hand, if you can pick your own bundle of, say, growth stocks or just copy a popular growth ETF’s portfolio, you will get a similar result without worrying about expense ratios—however, that will take a bit of legwork.

ETF vs. ETN ✔️

Exchange-traded notes bear a surface-level similarity to ETFs as they also track an index. However, they are structured differently in two principal ways: first is that they are part bond, part derivative, and the second is that they contain said derivatives—something that isn’t true of most types of ETFs.

iPath Series B Carbon ETN (GRN) is a peculiar ETN that targets carbon credits from the EU Emission Trading Scheme and Kyoto Protocol’s Clean Development Mechanism. OK, this was quite a mouthful, but it is an interesting investment option—this ETN allows investors to benefit from a reduction in carbon emissions in various countries.

ETNs are guaranteed by the issuer which means that your investments are only as safe as the said issuer and additionally since you end up only owning derivatives, they are ultimately riskier than ETFs. On the other hand, since ETNs don’t hold securities directly, they avoid the K-1 tax form, and can in general be more favorable when it comes to taxes than ETFs.

ETF Creation and Market Impact 🚀

As we have seen here, since their inception three decades ago, ETFs have left a huge impact on the market. They have grown incredibly and have been a driving force behind the popularization of passive investing. However, not everyone sees this as a good thing. 

Michael Burry, the investor who famously predicted the 2008 crash views them as a driving force in creating a new market bubble. He believes that the popularity of passive investing has made people who would never normally invest put their money behind stocks they otherwise would never have bought—thus, inflating the prices and causing a bubble.

Only time will tell whether this “everything bubble”, as some have taken to calling it, will truly burst or if it’s just an unrealistic scare. Whatever the case, right now ETFs represent an ever-growing presence on the market, and a worthy contender for a place in your portfolio.

Conclusion

If you’ve made it this far then you know pretty much all there is to know about ETFs. The next step is to do your own research and pick out the ones that will work for you—and not necessarily the most popular ones that everyone is throwing their money into.

The ETF can have many different purposes in a portfolio depending on what type it is, but it doesn’t have to be the only asset class you invest in. Remember, ETFs are inherently diversified, but if you are an investor who likes to do their research, consider looking a bit deeper and investing in the best of the underlying stocks instead of the ETF itself too.