What is an exchange-traded fund (ETF)?

Exchange-traded funds (ETFs) — a type of exchange-traded product (ETP) — have grown in popularity. And it’s easy to see why. ETFs pull together an assortment of stocks, bonds, or other securities, allowing people to invest in a wide range of companies with the purchase of a single ETF share. Understanding the basics of ETFs (and ETPs in general), along with the various types available, is crucial for investors to make informed decisions.

What is an ETF?

An ETF is a basket of securities (like stocks, bonds, and other investments) that trades on an exchange like an individual stock. It’s a pooled investment vehicle that lets investors put money in multiple investments without having to buy each one individually.

One of the key advantages of this structure is diversification, which helps distribute risk across various holdings.

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What types of ETFs are there?

ETFs can be categorized by how they invest and what they invest in. 

Passive and active ETFs

Passive ETFs follow the market by tracking indexes like the S&P 500. Active ETFs aim to outperform the market by letting portfolio managers pick individual securities based on their expertise. 

Broad market ETFs

A broad market ETF tries to match the performance of the S&P 500, NASDAQ-100, or another market index. These ETFs give investors access to many stocks at a low cost.

Smart beta / factor ETFs

These ETFs invest in stocks that have similar qualities, or “factors” (for example, those that have low volatility or pay higher dividends). The idea is to invest in stocks that may help you target a specific opportunity like mitigating risk or generating income. 

Sector ETFs

A sector ETF concentrates on a particular industry like technology, health care, or energy. It lets investors target growth opportunities or hedge against downturns in other sectors.

Fixed income ETFs

A fixed income ETF invests in bond securities like corporate, government, or municipal bonds. Bonds can pay a steady income and are generally less risky than stocks. 

International ETFs

An international ETF lets an investor put money in stocks and bonds from another country. It can be a way to diversify beyond US-based investments.

What other ETPs exist?

ETFs are a subcategory of ETPs. While ETFs tend to focus on securities, ETPs may also include other underlying assets.

Digital asset ETPs

These ETPs give investors access to a variety of digital assets including cryptocurrencies like bitcoin, blockchains like Ethereum, and companies that benefit from decentralized finance. This type of ETP can be an easy way to include transformative technology in an investment portfolio. 

Commodity ETPs

A commodity ETP follows the price of physical goods like gold, oil, or an agricultural product. ETPs can invest in specific commodities or a broad group. Commodities provide diversification potential. For example, some commodities may benefit during times of inflation while other investments fall. 

What are some potential benefits of ETFs?

Wondering whether an ETF is right for you? Here are a few items to consider.

Flexibility

ETFs can be bought and sold anytime during the trading day since transactions take place on exchanges. 

Transparency

You can see the prices of ETFs in real time and know exactly what securities they’re holding on a daily basis. 

Taxes

ETFs have tax benefits rooted in their unique structure. With ETFs, capital gains and taxes are generally recognized only when investors sell their own shares.