What is ETF and how it works?
ETFs or "exchange-traded funds" are exactly as the name implies: funds that trade on exchanges, generally tracking a specific index. When you invest in an ETF, you get a bundle of assets you can buy and sell during market hours—potentially lowering your risk and exposure, while helping to diversify your portfolio.
Most ETF income is generated by the fund's underlying holdings. Typically, that means dividends from stocks or interest (coupons) from bonds. Dividends: These are a portion of the company's earnings paid out in cash or shares to stockholders on a per-share basis, sometimes to attract investors to buy the stock.
Key Takeaways. ETFs are considered to be low-risk investments because they are low-cost and hold a basket of stocks or other securities, increasing diversification. For most individual investors, ETFs represent an ideal type of asset with which to build a diversified portfolio.
At any given time, the spread on an ETF may be high, and the market price of shares may not correspond to the intraday value of the underlying securities. Those are not good times to transact business. Make sure you know what an ETF's current intraday value is as well as the market price of the shares before you buy.
An exchange-traded fund, or ETF, allows investors to buy many stocks or bonds at once. Investors buy shares of ETFs, and the money is used to invest according to a certain objective. For example, if you buy an S&P 500 ETF, your money will be invested in the 500 companies in that index.
An ETF may not be a suitable investment. You can't make automatic investments or withdrawals into or out of ETFs.
| ETF | Assets under management | Expense ratio |
|---|---|---|
| Invesco QQQ Trust (ticker: QQQ) | $244 billion | 0.2% |
| VanEck Semiconductor ETF (SMH) | $14 billion | 0.35% |
| Consumer Discretionary Select Sector SPDR Fund (XLY) | $19 billion | 0.09% |
| Global X Uranium ETF (URA) | $3 billion | 0.69% |
Holding period:
If you hold ETF shares for one year or less, then gain is short-term capital gain. If you hold ETF shares for more than one year, then gain is long-term capital gain.
The top-performing ETF of 2023 is iShares Expanded Tech Software Sector ETF (IGV), with a year-to-date (YTD) return of 55.22%. Triple-digit YTD gains in major technology names like Meta and NVIDIA helped generate the outperforming ETF returns.
Because of their wide array of holdings, ETFs provide the benefits of diversification, including lower risk and less volatility, which often makes a fund safer to own than an individual stock. An ETF's return depends on what it's invested in. An ETF's return is the weighted average of all its holdings.
What happens if ETF shuts down?
An ETF shutting down is not the end of the world. The fund is liquidated and shareholders are paid in cash. It's not fun, though. Often, the ETF will realize capital gains during the liquidation process, which it will pay out to the shareholders of record and that could mean an unnecessary tax burden.
ETFs don't often have large fees that are associated with some mutual funds. But because ETFs are traded like stocks, you typically pay a commission to buy and sell them.
| Symbol | Name | 5-Year Return |
|---|---|---|
| USD | ProShares Ultra Semiconductors | 53.41% |
| FNGO | MicroSectors FANG+ Index 2X Leveraged ETNs | 49.73% |
| TECL | Direxion Daily Technology Bull 3X Shares | 47.63% |
| TQQQ | ProShares UltraPro QQQ | 37.20% |
As with stocks and many mutual funds, most ETFs pay their dividends quarterly—once every three months. However, ETFs that offer monthly dividend returns are also available.
ETFs are bought and sold just like stocks (through a brokerage house, either by phone or online), and their price can change from second to second. Mutual fund orders can be made during the day, but the actual trade doesn't occur until after the markets close.
You expose your portfolio to much higher risk with sector ETFs, so you should use them sparingly, but investing 5% to 10% of your total portfolio assets may be appropriate. If you want to be highly conservative, don't use these at all.
ETFs can bypass taxable events using the in-kind redemption process, while also purging their portfolios of low-cost-basis securities to help portfolio managers avoid realizing large gains if they must sell holdings. But not all ETFs create and redeem shares in kind.
ETFs can be safe investments if used correctly, offering diversification and flexibility. Indexed ETFs, tracking specific indexes like the S&P 500, are generally safe and tend to gain value over time. Leveraged ETFs can be used to amplify returns, but they can be riskier due to increased volatility.
ETFs, in that sense, are often viewed as a more flexible investment strategy, allowing the trader to sell at any time during usual trading hours, and use live trading tools like market orders or limit orders to carry out trades.
- 9 Safest Index Funds and ETFs to buy in 2024. ...
- Vanguard S&P 500 ETF (VOO -1.41%) ...
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- Vanguard Real Estate ETF (VNQ -2.06%) ...
- iShares Core S&P Total U.S. Stock Market ETF (ITOT -1.59%) ...
- Consumer Staples Select Sector SPDR Fund (XLP -1.07%)
What is better than ETF?
Mutual funds and ETFs may hold stocks, bonds, or commodities. Both can track indexes, but ETFs tend to be more cost-effective and liquid since they trade on exchanges like shares of stock. Mutual funds can offer active management and greater regulatory oversight at a higher cost and only allow transactions once daily.
Generally speaking, the best time to trade ETFs is closer to the middle of the trading day rather than the beginning or end.
If you buy substantially identical security within 30 days before or after a sale at a loss, you are subject to the wash sale rule. This prevents you from claiming the loss at this time.
Leveraged ETF prices tend to decay over time, and triple leverage will tend to decay at a faster rate than 2x leverage. As a result, they can tend toward zero.
One way to think about it is every three months taking whatever excess income you can afford to invest – money that you will never need to touch again – and buy ETFs! Buy ETFs when the market is up. Buy ETFs when the market is down.
