What Is an ETF?
ETFs, or exchange-traded funds, are investment funds that are designed to track the performance of a specific index or sector of the market. ETFs are made up of a basket of underlying securities, which can include stocks, bonds, or other assets. ETFs are created by financial institutions called “authorized participants” (APs), who purchase the underlying securities that make up the ETF’s basket and exchange them for “creation units” of the ETF. Creation units are large blocks of shares that can be bought and sold on stock exchanges.
How Do ETFs Work?
Once the ETF has been created, it can be traded on stock exchanges like a stock. Investors can buy and sell shares of the ETF throughout the day, and the price of the ETF will fluctuate based on supply and demand. The ETF is designed to track the performance of the underlying index or sector of the market. The ETF’s value will generally move up or down in tandem with the value of the underlying securities in the ETF’s basket.
ETFs charge expenses to cover the costs of managing the fund. This expense ratio is typically lower than that of actively managed mutual funds, as ETFs are designed to passively track an index or sector of the market. When an investor wants to sell shares of an ETF, they can do so on a stock exchange. The APs that created the ETF can also redeem creation units of the ETF by exchanging them for the underlying securities in the ETF’s basket.
Types of ETFs
There are several different types of ETFs, each designed to track a specific index or sector of the market. Here are some of the most common types of ETFs:
- Equity ETFs: These ETFs track stock indexes, such as the S&P 500 or the Nasdaq 100.
- Bond ETFs: These ETFs track fixed-income indexes, such as Treasury bonds or corporate bonds.
- Sector ETFs: These ETFs track specific sectors of the economy, such as technology or healthcare.
- Commodity ETFs: These ETFs track the performance of commodities, such as gold, oil, or agricultural products.
- Currency ETFs: These ETFs track the performance of foreign currencies, such as the Euro or the Japanese Yen.
- Style ETFs: These ETFs track the performance of stocks based on their style, such as growth or value.
- International ETFs: These ETFs track the performance of foreign stock markets, such as the FTSE 100 or the Nikkei 225.
- Alternative ETFs: These ETFs track alternative asset classes, such as real estate investment trusts (REITs) or master limited partnerships (MLPs).
Overall, there are many different types of ETFs available to investors, each offering exposure to a different segment of the market.
Examples of ETFs
Here are five examples of popular ETFs:
- SPDR S&P 500 ETF SPY: This ETF tracks the performance of the S&P 500 index, which is composed of 500 large-cap U.S. stocks.
- Invesco QQQ Trust QQQ: This ETF tracks the performance of the Nasdaq-100 index, which is composed of 100 of the largest domestic and international non-financial companies listed on the Nasdaq stock market.
- iShares Russell 2000 ETF IWM: This ETF tracks the performance of the Russell 2000 index, which is composed of 2,000 small-cap U.S. stocks.
- SPDR Dow Jones Industrial Average ETF Trust DIA: This ETF tracks the performance of the Dow Jones Industrial Average DJIA, which is composed of 30 blue-chip U.S. stocks.
- Vanguard Total Stock Market ETF VTI: This ETF tracks the performance of the CRSP US Total Market Index, which is composed of nearly 4,000 U.S. stocks across all market sectors and capitalization ranges.
All of these ETFs are designed to provide exposure to specific segments of the stock market and allow investors to build diversified portfolios.
The Bottom Line
Overall, ETFs provide investors with a convenient and cost-effective way to invest in a diversified portfolio of securities, and they have become increasingly popular in recent years as more investors seek out low-cost, passive investment strategies.