ETFs have been called the tortillas of the investment world. Everyone loves them, they’re cheap, and they can be wrapped around just about anything. While you can’t exactly sink your teeth into an ETF, they’re still easy to digest for beginning investors. So what are they, and why are they popular?
What is an ETF anyway?
ETF stands for “exchange-traded fund.” The three-letter acronym might not sound like much, but it’s a powerful tool that’s rapidly changing the way investors invest and manage their money. In 2021, almost $10 trillion was stored in ETFs, and their popularity continues to grow.
Before we go into the hype surrounding ETFs, let’s first take a step back and talk about what an exchange-traded fund really is. An ETF is a type of financial company called a “fund” that pools together the money of many investors. The fund uses that money to make investments in stocks, bonds, commodities, currencies, or other assets. A stock ETF, for example, invests in stocks, whereas a bond ETF holds bonds. This company then sells shares of itself to investors, who then get a stake in the fund’s holdings and share in its profits or losses.
Look at it this way. You can start a company tomorrow and make investments through it in the stock market. If the market goes up, your company will make money. If the stock market goes down, your company will lose money. The difference between your company and an ETF is that an ETF is a company that’s registered with a financial regulator and traded on stock exchanges. That means investors can buy or sell shares of the ETF just like they would buy shares of any other company.
How ETFs work
ETFs are investment funds that buy and sell assets and create shares, which are then sold to the public. ETFs are called exchange-traded funds because they trade on stock exchanges just like stocks. When you invest in an ETF, you’re buying a slice of everything the fund invests in. For example, when you buy a stock ETF, you’re buying shares of the fund, which owns stocks. When you buy a precious metal ETF, you’re buying a share of the fund, which owns gold, silver, and other metals.
Every ETF has a fund manager, typically a group of individuals structured as a corporation, who decide what assets to buy and sell. However, the majority of ETFs are passively managed. This implies that no one is actively attempting to pick out the investments that will rise and fall. Instead, most funds engage in emotionless investing based on predefined criteria. For example, one of the most popular ETFs, the iShares Core S&P 500 ETF, is based on the value of 500 of the largest companies in America. If someone wanted to invest in the US economy, they could buy this ETF and own a tiny slice of each of these 500 companies.
Consider this example. A German investor believes the German stock market is going to go up. But rather than buying individual German stocks, he buys the iShares MSCI Germany ETF. By doing so, he’s investing in all of Germany’s biggest companies at once. If the German stock market goes up as he expects, his investment will grow. If it falls, his investment will lose value.
Another German investor is suspicious of the first German investor’s home bias. She thinks she’s already over-exposed to the local German economy because her house, salary, and most of her finances are dependent on it. To balance out her exposure and reduce her home-country risk, she buys an MSCI ACWI ETF. Since this fund invests in around 3,000 companies across the globe, she’s less dependent on a single market. If German stocks were to outperform her investment in the MSCI ACWI, she would make less money. However, she would also be less likely to lose money in the event of a crash or black swan event in Germany.
ETFs: Copy-paste investing
ETFs can be made up of pretty much anything these days; however, most ETFs track what's called an index. An index is a group of stocks, bonds, or other assets used to represent an entire market's performance. For example, the S&P 500 is an index that represents the overall US stock market. Similarly, the MSCI ACWI tracks the value of the largest publicly traded companies in 47 countries, including the US, China, India, the UK, and Germany. In these two examples, someone who believes the US market will rise might invest in the S&P 500. In contrast, someone who thinks the entire world will go up but doesn't think the US economy will maintain its momentum could invest in an MSCI ACWI ETF.
The point of an index-based fund is to copy a market and buy everything within that market. Rather than trying to find the one company that will do well, an index fund just buys everything and hopes the market as a whole will go up. This strategy is often called copy-paste investing because it's a passive way of owning a bunch of stocks at once. By buying the market, an investor is buying a tiny piece of everything and spreading out the risk. As the creator of the world's first index fund, John Bogle, once said: "Don't look for the needle in the haystack. Just buy the haystack!"
While S&P 500 and international funds are some of the most popular ETFs because they track economies as a whole, there are thousands of different funds to choose from depending on your investment strategy. If you're interested in alternative assets like gold or real estate, you can find ETFs that track those markets as well. There are even coffee ETFs that follow the price changes of coffee.
Types of ETFs
ETFs come in ever more shapes and sizes. At the end of 2021, there were over 8,000 ETFs globally, compared to only around 250 in 2003. The largest ETFs are index funds that track broad markets, like the S&P 500 or MSCI ACWI. Others are more specialized, such as sector ETFs that track stock shares in industries like energy, healthcare, or telecommunications. While the selection of ETFs is growing, most fall into one of the following categories:
Stock index ETFs
The most popular type of ETF invests in a group of stocks that make up an index, like the S&P 500, the FTSE 100, or the Nikkei 225. Stock index ETFs are used to track the performance of an entire stock market. For example, the S&P 500 Index is made up of 500 large US companies, and it's often used as a benchmark to track the performance of the US stock market. The Financial Times Stock Exchange 100 Index, or FTSE 100 for short, is an index of the UK's top 100 companies by market capitalization. There are also world indices, like the MSCI World Index, that track the performance of large companies across several different countries.
In addition to tracking broad markets, ETFs can also be used to invest in specific industries or sectors. Some examples include pharmaceuticals, entertainment and media, healthcare, tech, and finance. Imagine someone thinks that the clean energy sector is going to do well in the next few years, for example. They could buy a clean energy ETF that invests in a basket of different companies involved in that industry, like solar and wind energy companies.
Since bonds produce regular income payments, bond ETFs can be a good way to generate low-risk, additional income. There are all sorts of different bond ETFs, from those that track government to corporate bonds and even junk bonds. Unlike their underlying bonds, bond ETFs typically have no maturity date. They generally trade with a mark-up from the underlying bond price.
Commodity ETFs invest in raw materials like oil, gas, gold, and silver. These funds can be used to hedge against inflation or as a way to speculate on the price of commodities during supply crises. For example, someone who thinks the price of oil will rise over the next year or two could buy a crude oil commodity ETF that tracks the price of oil.
Commodity ETFs can provide several benefits over directly investing in the commodity. For example, ETFs can be bought and sold on stock exchanges like any other security through an online brokerage, which makes holding a commodity ETF cheaper and more convenient than storing the commodity yourself or paying someone to storage or insure it.
The foreign currency exchange market is the largest in the world. Currency ETFs invest in various currencies from around the world and can be used to speculate on currency rates or as a way to diversify your portfolio. For example, someone who is worried about what will happen if the US dollar falls might decide to buy a currency ETF that invests in the currencies of other developed countries. There are also bitcoin ETFs that invest in bitcoin and provide investors with exposure to this cryptocurrency.
Benefits and drawbacks of ETFs
ETFs have not become popular for no reason. But of course, like all other types of investments, ETFs have both benefits and drawbacks. The main advantages of ETFs worth exploring are:
ETFs are an easy way to diversify your investment portfolio because they allow you to invest in multiple markets at once. Rather than investing in a single company or even a handful of companies, you can buy into the entire market. This can help reduce risk by spreading your money out over many different markets and assets.
ETFs typically have low maintenance costs. This is especially true for passively managed ETFs, which don't require a manager, marketing, or research teams to constantly make trades in order to outperform the market. Instead, they simply buy and invest in the index they're tracking. ETFs have what's called an expense ratio, which is the percentage of your investment that goes towards maintaining the fund. Most passive ETFs have an expense ratio of 0.20% or less. For comparison, the average actively managed mutual fund has an expense ratio of 1%.
Frees up time
Looking at stock prices and trying to keep up with the market can be a full-time job. Many find it stressful, too. ETFs allow you to take some of that busy work off your plate. ETFs are a great way for hands-off investors to be involved in the market without worrying about individual stocks and their ups and downs. Those who choose a wide-based index fund may be relieved to learn that they own a little piece of everything and don't have to worry about the performance of one company.
Tax laws vary by country and change over time, but in many places, ETFs are more tax-efficient than individual stocks. The main advantage of ETFs worth exploring from a tax standpoint is that they don't require active management, which means they don't have to be sold as often. In many countries, this indicates that the taxed event can be delayed until the ETF is sold. This makes it easier to control your capital gains and losses, as well as the amount of tax you have to pay. Make sure to check with a tax advisor in your country to see how ETFs are taxed where you live.
Drawbacks of investing in ETFs
ETFs have been met with some criticism in the investing world. While they have gained popularity in recent years, there are still some drawbacks to consider before investing:
Amplifying good and bad times
According to research, ETFs have been linked to greater volatility during periods of stress and uncertainty. ETF markets and the underlying markets are said to interact via feedback trading, with the result that ETFs appear to amplify market movements. As more trillions pour into ETFs, this effect may become more pronounced and potentially more destabilizing.
ETFs are also criticized for being merely a bet on the market's direction. Critics of ETFs argue that even when the market is not at extreme, high volumes in passive trading may result in inefficiency in prices. When asset prices are no longer connected to fundamental values, markets no longer serve their basic purpose of efficiently allocating money, and this decoupling has the potential to have a significant long-term impact.
Every year, hundreds of ETFs are shut down. This is usually because the ETF isn't making enough money or there's not enough interest from investors. It's mostly exotic ETFs that close, while funds from large providers such as BlackRock, Citibank, and Vanguard are less likely to shut down. But it's still a risk to consider before investing in an ETF. When an ETF is shuttered, shareholders get paid the value of their shares, which often creates a tax obligation. While this isn't a huge risk, it's something to be aware of before.
Lack of tax benefits
We discussed how ETFs can be more tax-efficient than managing individual stocks, but this isn't always the case. In some countries, ETFs may not be as tax-efficient as individual stocks because they are subject to unrealized capital gains tax. This means that even if you don't sell your ETF, you may still owe taxes on the gains it has made. There are also times when an ETF will make capital gains distributions to its investors. This is not always desirable for ETF investors because they must pay capital gains tax. It's typically preferable to keep the gains and invest them rather than distribute them to postpone an investor tax obligation.
How to buy index ETFs
If you decide that ETFs are a good fit for your investment strategy, the next step is to learn how to buy ETFs. Investing in ETFs has become much easier in recent years with the advent of online brokerages. Many brokerages allow you to buy, sell and hold ETFs without commissions. Here are some tips to help you get started:
1. Select an index
The largest ETFs are those that track major benchmarks such as the S&P 500. These funds are often called index ETFs. If you want to invest in an ETF that tracks a specific index, you'll need to select the index you want to track. While many online brokers have good research tools for finding ETFs, they are often difficult to understand and confusing for beginners. Many new investors will find an ETF there that has done well recently and try to invest in that. This is usually not the best strategy, as it's important to have a long-term investment plan and keep the big picture in mind.
Here are some examples of well-known indexes that can be traded via ETFs:
- S&P 500 Index: Tracks the stocks of large US companies. There's an overwhelming number of ETFs that track this index. Some of the most popular are the iShares Core S&P 500 and Vanguard S&P 500.
- Nasdaq 100 Index: The tech-heavy index is a stock market index composed of firms such as Apple, Microsoft, Amazon, and Google. Because of its high concentration in technology equities, it's known to be a volatile index.
- MSCI World Index: This index tracks large and mid-sized stocks from 23 developed countries, including the US, Canada, Japan, and the UK. The iShares MSCI World is the most traded ETF that tracks this index, though not the one with the lowest TER.
- MSCI ACWI and FTSE All-World: These two indexes are nearly the same as the MSCI World, but with a few key differences. Both include stocks from developed and emerging markets, which make them popular with investors who want exposure to both markets.
2. Pick an ETF that tracks it
Once you've picked the index you think is a winner, it's time to find an ETF that tracks it. There are many ETFs on the market, and more are being created all the time. Here are a few things to look for when choosing an ETF:
- Expense ratio: This is the ETF's cost as a percentage of its total assets. It's how much you're paying the ETF company to manage your investment. Choose an ETF with an expense ratio of 0.2 percent or less as a rule of thumb. The lower this ratio, the more you may save in terms of fees over time.
- Tracking error: Since ETFs track a specific index, they should theoretically be the same as the index. In reality, small tracking errors can occur. These arise because the ETF must follow suit with the index, which can change rapidly under different circumstances.
- Fund size: Fund size is how much money is invested in the ETF. A good rule of thumb in ETF investing is bigger is better. The larger an ETF is, the more money is invested in it and the more liquid it is. A highly liquid ETF can be traded quickly and with minimal impact on the price.
- Fund domicile: We discussed how exchange-traded funds are a type of financial companies, and these companies have to be incorporated in a country. The country of domicile can have an impact on the taxes you pay as an investor. For example, the majority of funds in Europe are registered in Ireland. This is because Ireland has a favorable double tax treaty with the US, while it does not withhold taxes on distributions to non-residents.
- Accumulating vs. distributing: Whether you want an ETF that pays out its funds on a regular basis or you want one that reinvests its dividends is an important consideration. Depending on what's more optimal tax-wise in your country of residence and your type of investor, you may want an accumulating ETF that reinvests its dividends or a distributing ETF that pays them out to your investment accounts.
- Taxes: You should consider the tax implications of ETF investing in your country. Some countries treat dividends paid out by an ETF more favorably than accumulating dividends. In other countries, there is no difference. For example, Switzerland law treats distributed and accumulated dividends the same, with no capital gains taxes but a wealth tax on the investor's entire assets. There are a few things to think about, and you should research in your own language to make sure you know what's best for you.
3. Open a brokerage account
ETFs are available on nearly all online brokerages. In order to invest, you will need to open an account on your laptop or smartphone and fund it with money. If you're new to investing, keep in mind that investment accounts have different fees and minimums depending on the broker. However, many brokerages now offer commission-free trading, which means you can buy and sell ETFs without having to pay a commission or fee to the brokerage.
An ETF-only investor is looking for a no-nonsense approach and a simple platform. Many new platforms, for example, will attempt to entice investors into active stock trading or other services like options or futures. These products can be more complex and risky, so an ETF investor would likely want to avoid them. More established brokerages will offer a more sober experience and educational resources to help beginners learn about investing.
4. Decide your investment strategy
A popular ETF investment strategy is dollar-cost averaging, which simply means that you invest a set amount of money into the same index every month or week. It's an investment strategy that helps spread out the risk over time and smooths out fluctuations in the market. With this approach, investors can avoid investing large sums of money at market peaks (or lows). It promotes a disciplined investing mentality because it compels investors to make regular purchases even when the market is down.
How to pick an ETF
Thousands of ETFs are entering the marketplace, and it can be time-consuming to sift through all of them to find a good one. There are a few general rules for choosing an ETF that will help investors narrow down their selection.
Simplicity over complexity
Many new investors think they need a complicated ETF portfolio composition. They make the mistake of buying every possible ETF that sounds interesting to them. In general, you want to keep things simple and avoid making any arbitrary choices. That being said, you should consult with a professional to find a strategy that makes sense to you.
But if you have a tangled mess like this, things will be overlapping and there will be no methodology in the madness.
ETFs have a fee called an expense ratio, which is the amount you pay to the fund to cover operating costs. Passive index fund ETFs tend to have lower expense ratios, while actively-managed ETFs tend to have higher expense ratios. A low expense ratio is important because it means more of your money is going towards actual investments and less towards fees.
Tracking error is a measure of how closely an index ETF tracks the index it follows. A lower tracking error is better because it means the fund is not deviating too much from the index it's trying to track. Differences in tracking are caused by many things, such as the fund's expenses, the way it is structured, and whether or not it uses derivatives. You can use a tool like Trackinsight.com to see the tracking error for almost any ETF.
When it comes to ETFs, size matters because it can affect the fund's performance and durability. Fund size represents the total assets held in the ETF. A fund with €100 million in assets is small, while a fund with €20 billion is large. Smaller funds tend to be less liquid, which means it can be harder to buy and sell shares of the ETF. They also tend to have wider bid-ask spreads. Smaller funds are more at risk of closing down if they don't perform well because they have fewer assets to fall back on.
While US investors have it easy when it comes to investing in ETFs because the majority of all stocks wrapped in ETFs are American companies, other countries are not so lucky. In Europe, most ETFs are registered in Ireland because Irish funds benefit from the US/Ireland tax agreement, which lowers US dividend taxation to 15% rather than 30%, as is the standard for countries without a tax agreement. Furthermore, Ireland does not withhold taxes on dividends paid to non-residents. Other countries have similar arrangements, and it's worth investigating whether investing in locally-registered funds will save you money in the long run. For example, Bulgaria and Romania have a 10% (lower than Ireland) tax agreement on US dividends.
Dividend distribution policy
ETFs are either accumulated or distributed. The largest ETFs have a version of each. Accumulated means that all dividends are reinvested in the fund, while distributed means that they are paid out to shareholders. These dividends originate from the stocks held in the ETF and are paid out according to the schedule of each individual stock. For example, if an ETF holds shares in Coca-Cola, which pays dividends quarterly, then the dividends from Coca-Cola will be paid out quarterly to shareholders of the ETF.
Taxes are an important consideration when choosing an ETF. Depending on the country where the investor pays taxes, the dividend distribution policy (whether the dividends are reinvested in the fund or paid out to shareholders) can affect how much tax is owed. In some countries, accumulating dividends may be better in the long run because they aren't taxed there until the fund is sold. Other countries tax dividend payments and accumulated dividends the same. Moreover, many countries have special tax-wrapper vehicles, such as the ISA in the UK, which shelter investments from taxes. All these considerations must be taken into account when choosing an ETF.
How is an ETF created?
Say you wanted to create an ETF that tracks the S&P 500 index. First, you need to create an investment company in a country where it is feasible to do so, such as Ireland. Since Ireland is the home to over 50% of all ETFs in Europe, it is a good choice for this example. However, the process varies from country to country.
An Irish fund is typically registered as a Collective Asset-management Vehicle (ICAV) or Invest Company. Both are types of public limited liability companies that allow the sale of shares to the general public. When establishing the fund, it is necessary to register it with the Central Bank of Ireland and get it authorized as a UCITS fund. If a UCITs fund is authorized in an EEA member state, such as Ireland, it may be marketed and sold throughout the entire EEA without the need for separate regulation in each member country.
To lead our Irish UCITS investment fund, we need to appoint a board of directors or an external fund manager. The Central Bank of Ireland requires that UCITS investment management firms and board of directors must be certified by it. Both must also satisfy certain minimum capital standards. The management is responsible for portfolio management and risk management, among other things.
The most important service providers to an investment fund are the investment manager, the administrator, and the depositary. The investment manager's role is to handle the fund's daily operations. The fund administrator is in charge of valuing the underlying assets and setting prices, as well as maintaining and updating accounting records. It is also responsible for communicating with investors. The depositary is a credit institution that must be authorized in an EEA country and is responsible for safeguarding the fund's assets, ensuring that only eligible assets are included in the fund, and preventing any unauthorized outflows of assets from the fund.
Finally, to make it possible for the general public to invest in an ETF, it must be listed on a stock exchange. The fund needs to appoint a listing sponsor to help with this process. The listing sponsor handles many of the legal and regulatory requirements for listing, such as preparing all necessary filings to get listed on a stock exchange.
Do I own my ETF?
The world has moved away from physical ownership of assets to digital ownership. When you buy an ETF, you are not actually buying shares of the underlying assets in the fund. You are buying units or shares of the ETF itself, which is a security that is traded on a stock exchange. Not so long ago, this ownership was testified by a paper share certificate. Physical share certificates are nowadays only rarely given, with digital records taking their place in most instances.
When you buy an ETF, your broker will send your order to an exchange, where it will be matched with another trader's sell order. When the trade is settled, your ownership is recorded in the ETF's register of shareholders. More often, your name will not appear in the register. Instead, your broker will keep track of your shares in what is called an omnibus account. This arrangement is considered more efficient for both you and the ETF, as it reduces paperwork and the associated costs. It also allows the ETF to avoid having to know the identity of each shareholder. The market price of your units in the ETF will be supplied by the broker on your account statement, which demonstrates that you own units in the ETF.
ETFs vs. stocks
If you are a beginner in investing, one of the first decisions you need to make is whether you should invest in stocks or ETFs.
Here are some essential differences between index-based ETFs and individual stocks:
|Exchange traded funds||Stocks|
|What it is||A professionally managed fund that invests in a basket of securities to replicate the performance of a specific index, such as the S&P 500.||A stock is a share of ownership in a single company.|
|What you own||You own shares in a fund that holds assets, like stocks.||You a partial owner of the company that issued the stock.|
|Number of holdings||A typical index ETF will have hundreds or even thousands of holdings.||A stock represents a single company.|
|Diversification||Index ETFs offer built-in diversification. Global ETFs are the most diversified, while sector ETFs are diversified within the sector.||With stocks, you need to actively seek out different companies to build a diversified portfolio.|
|Upside potential||ETFs have limited upside potential, as they track the performance of an index.||Stocks have greater upside potential, as their price is based on the future expectations for a company's growth and profitability, and the potential to generate higher returns|
|Risk||ETFs have diversified risk because they are spread out over many different companies, though they still have market risk.||Stocks have concentrated risk because they are based on a single company. If the company performs poorly, there is nothing to cushion the blow.|
|Costs||ETFs purchased for a commission, though some brokers offer ETFs commission-free. ETFs have annual expenses (known as the expense ratio), ranging from 0.05% to 0.50%.||Stock ownership does not have yearly fees, but there can be broker fees for trading them.|
|Time commitment||It takes time to pick index ETFs, and an ETF portfolio sometimes require rebalancing or replacement of lagging ETFs with newer ones. However, ETFs adjust their holdings on a regular basis, so they don't require significant ongoing care.||It takes time to research different companies to build a well-diversified portfolio of stocks. This process is fun for some, stressful for others.|
|When to invest||ETFs are worth exploring if you're a passive investor and don't think your picks can beat the market.||Stocks are for those who believe in the value of single companies. If you have a higher risk tolerance and you're trying to outperform the market, you might want to consider stocks.|
Who invented ETFs?
The first ETF was introduced in 1989 by the American Stock Exchange. It was based on an index of stocks and tracked the price performance of the Standard & Poor's 500 Index (S&P 500). Unfortunately, a federal court in Chicago forced the company to withdraw its product from trade. However, this opened the door for subsequent investors to embrace ETFs. In 1993, the Standard & Poor's Depositary Receipts (SPDRs) was introduced and became the first successful ETF. It became known as "Spiders" because of its abbreviation. iShares, now the world's largest ETF provider, was founded in 2000 by Barclays, and Vanguard ETFs were introduced in 2001.
Are ETFs safe?
The short answer to the question of whether ETFs are secure is "it depends." It all boils down to how you use ETFs, as well as to the specific ETF and its underlying assets. As one would expect, investors must conduct their own research and make their own risk judgments conducting any trade. That said, for investors with a buy-and-hold approach to investing, ETFs can provide a diversified, cost-effective way to build a long-term portfolio.
ETFs that track large indexes are fairly safe investments since they tend to be well-diversified and therefore not subject to the same kinds of risks as individual stocks. As long as there is no problem with the companies the ETF holds or the market in general, index-based ETFs will also be relatively safe. An index ETF simply invests in all of the companies in an index, such as the S&P 500. This means that if one company in the index performs poorly, the index will be affected, but the adverse consequences will be offset by the performance of other companies. Historically speaking, index ETFs have been some of the best-performing investments.
However, ETFs that track smaller indexes or sector-specific indexes may be more volatile since they are not as diversified. In addition, leveraged ETFs and inverse ETFs are designed for short-term trading and are therefore riskier than traditional ETFs. These types of ETFs use financial derivatives and debt to achieve their objectives, which means that they can magnify both gains and losses.
There are some ETFs that are riskier than others, just like any other investment product. However, if you pick your ETFs intelligently and understand the risks involved, ETFs can provide steady returns over the long term and be a great investment vehicle.
Can ETFs go bust?
Every year, many ETFs shut down. In most cases, this is due to a lack of interest from investors or because the ETF is not performing well. For example, in 2018, 218 ETFs in the US were shut down or merged with other funds. When an ETF closes its doors, any remaining funds are distributed back to the investors and can be reinvested in the market fairly quickly. Investors who want to avoid a "bad" ETF should examine the ETF's manager, what it invests in, and whether the amount of assets under management is increasing on a yearly basis.
The bottom line
ETFs emerged in the 1990s and have since become one of the most popular investment products on the market. ETFs offer many benefits, such as diversification, low costs, and flexibility. Every year, new ETFs are launched, and the fees for investing in ETFs continue to decline. However, like any investment product, there are also risks associated with ETFs.
A passive ETF that tracks a large, well-known index is generally a good starting point for beginner investors. As you become more familiar with the market and your own risk tolerance, you can begin to add other types of ETFs to your portfolio. The key is to always remember that no investment is risk-free and to carefully research any new investment before committing your hard-earned money.
The author held positions in ETFs tracking MSCI's developed and developing indexes at the time of publication.