A study conducted by the Investment Company Institute revealed that approximately 1 in 4 U.S. households owned ETFs in 2022, demonstrating their extensive usage. The report also noted that ETFs made up 31% of the trading volume on U.S. exchanges, showing their appeal to both retail and institutional investors due to their liquidity.
Exchange-traded funds have increased in popularity and now make up over 20% of market volume, with about a third of daily dollar volume being traded through them.
Therefore, in November 2021, the global ETF market was worth USD 9.6 trillion and consisted of over 8,000 ETFs, providing investors with a cost-effective and versatile option for creating a diversified investment portfolio that merges the qualities of stocks and mutual funds.
Understanding and investing in ETFs is more important than ever for both novice and experienced investors. This comprehensive guide will help you know what ETFs are, how they work, the different types available, and how to invest in them.
Key Takeaways
- Exchange-traded funds (ETFs) are a type of investment fund that can be traded throughout the day on stock exchanges.
- ETFs generally have lower expense ratios and are more tax-efficient than mutual funds, making them a cost-effective investment choice.
- With various types of ETFs available, investors can find ETFs that match their specific investment goals and risk tolerance.
- ETFs can be a powerful tool for building a diversified portfolio, but it's important to understand how to invest in them strategically.
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What Is an Exchange Traded Fund (ETF)?

An Exchange-Traded Fund (ETF) is a type of investment fund that holds a collection of assets, such as stocks, bonds, or commodities, and trades on an exchange like a stock. ETFs are designed to track the performance of a specific index or asset class, making them a convenient way for investors to gain exposure to a broad range of investments through a single security.
ETFs combine features of both mutual funds and individual stocks. Like mutual funds, they pool investors' money to purchase a diversified portfolio of assets. However, unlike mutual funds, ETFs can be bought and sold throughout the trading day at market prices, much like individual stocks. This flexibility makes ETFs a popular choice for many investors.
"ETFs have grown significantly in popularity, with global assets under management (AUM) reaching $9.9 trillion by the end of 2021, up from $6.6 trillion in 2019. "
Benefits and Features of ETF

The key characteristics and benefits of ETFs make it an attractive investment option. Understanding these features can help investors effectively utilize ETFs within their investment strategies. They are:
Diversification
ETFs provide an easy way to diversify your portfolio. Because each ETF represents a basket of assets (like stocks, bonds, or commodities), you can achieve diversification within a particular sector or industry without having to buy each stock.
For example, an ETF that tracks the S&P 500 index provides exposure to 500 of the largest publicly traded companies in the U.S., instantly diversifying your portfolio.
Lower Costs
Buying individual stocks can incur commission fees for each purchase and sale. With ETFs, you typically only pay a single commission fee when you buy or sell shares. Additionally, many ETFs have lower expense ratios compared to actively managed mutual funds. An expense ratio is a fee that covers the costs of operating the fund.
For instance, the Vanguard Total Stock Market ETF (VTI) has an expense ratio of just 0.03%, significantly lower than the average mutual fund expense ratio.
Transparency
ETFs offer a high level of transparency. Most ETFs disclose their holdings daily, allowing investors to see exactly what assets they own. This level of transparency is beneficial for investors who want to know where their money is invested and how the fund is performing.
For example, the iShares MSCI Emerging Markets ETF (EEM) provides daily updates on its holdings, which include a mix of stocks from emerging markets like China, India, and Brazil.
Flexibility
ETFs can be bought and sold throughout the trading day at market prices, just like individual stocks. This is different from mutual funds, which can only be bought or sold at the end of the trading day at the net asset value (NAV) price.
This flexibility allows investors to implement a variety of strategies that can’t be executed with a mutual fund. If an investor anticipates a market downturn, they can sell their ETF shares immediately, rather than waiting until the end of the trading day.
Tax Efficiency
The structure of ETFs can sometimes lead to tax advantages compared to mutual funds. This is because ETFs typically experience less internal trading compared to mutual funds, which can result in fewer capital gains distributions that are taxed.
How ETFs Work

ETFs are designed to track the performance of a specific index, sector, commodity, or asset class. They trade on stock exchanges and can be bought and sold throughout the trading day at market prices, much like individual stocks.
The name "Exchange-Traded Fund" reflects these key components:
- Exchange: ETFs are listed on major stock exchanges, such as the New York Stock Exchange (NYSE) or NASDAQ.
- Traded: Investors can buy and sell ETF shares during regular trading hours.
- Funds: ETFs pool money from many investors to invest in a diversified portfolio of assets.
Creation and Redemption of ETFs
Creation Process
The creation process of an ETF involves assembling the underlying assets that the ETF aims to track. Authorized participants (APs), typically large financial institutions, play a crucial role in this process. Here's how it works:
- Basket of Securities: The AP purchases the individual stocks that make up the ETF in the exact proportions reflected by the target index. For our technology sector ETF, this might involve buying shares of Apple, Microsoft, and Amazon, among others.
- Creation Unit: This basket of securities is exchanged for a creation unit, which is a large block of ETF shares, usually consisting of 50,000 shares.
- ETF Shares: The AP delivers this basket of stocks to the ETF issuer in exchange for a large block of newly created ETF shares. These new shares are then distributed to brokerage firms and made available for investors to purchase.
For example, if an AP wants to create shares of the SPDR S&P 500 ETF (SPY), they would need to gather shares from all 500 companies in the S&P 500 index and exchange them for ETF shares.
The Redemption Process
The redemption process is essentially the reverse of the creation process. When APs want to redeem ETF shares, they do the following:
- ETF Shares: If a significant number of investors want to sell their ETF shares, an AP can step in to redeem them. The AP returns the large block of ETF shares to the issuer.
- Basket of Securities: In exchange for the returned shares, the issuer provides the AP with the corresponding basket of underlying assets that mirrors the ETF's holdings.
- Sell Securities: The AP can then sell these securities on the open market.
In-Kind Creation and Redemption
Most ETFs use an “in-kind” creation and redemption process. This means the AP delivers the underlying assets to the ETF issuer rather than cash. This process is beneficial because it limits the capital gains that investors have to pay taxes on.
By using in-kind transactions, the ETF issuer can avoid realizing capital gains. For example, if an AP provides a basket of stocks to create new ETF shares, the issuer does not need to sell any assets, thus avoiding capital gains.
Role of Authorized Participants
Authorized participants (APs) are critical to the functioning of ETFs. They are typically large financial institutions, such as Banks like Bank of America, JPMorgan Chase, and Brokerage firms like Merrill Lynch, and Goldman Sachs that are authorized by the ETF issuer to create and redeem ETF shares.
They ensure that the ETF shares reflect the value of the underlying assets by performing arbitrage. If the ETF's market price deviates from its net asset value (NAV), APs can buy or sell the ETF shares and the underlying assets to bring the price back in line.
Impact on ETF Liquidity and Pricing
This continuous creation and redemption process plays a crucial role in maintaining an ETF's liquidity. By readily creating new shares when demand is high and redeeming them when selling pressure increases, APs help ensure there are always enough buyers and sellers to keep the ETF tradable.
Additionally, this mechanism helps ETFs trade at prices close to the net asset value (NAV) of their underlying holdings. For example, if the iShares Core S&P 500 ETF (IVV) is trading significantly above its NAV, APs can create new shares to increase supply and bring the price down. If IVV is trading below NAV, APs can redeem shares to reduce supply and bring the price up.
"ETFs are known for their liquidity and trading flexibility. In 2021, the average daily trading volume of ETFs in the U.S. was over $100 billion”
Types of ETFs

There are many types of ETFs available, each offering exposure to different sectors, asset classes, and investment strategies. Here are some examples:
- Stock ETFs (Equity ETFs): These ETFs invest in stocks. They can be broad-based, sector-focused, or follow a specific stock index like the S&P 500.
- International ETFs: International ETFs provide exposure to global markets. For example, the iShares MSCI Emerging Markets ETF (EEM) invests in companies from emerging markets like China, India, and Brazil.
- Sector ETFs: These ETFs track specific sectors like technology, healthcare, or finance.The Technology Select Sector SPDR Fund (XLK) is an example, targeting the technology sector.
- Dividend ETFs: These ETFs focus on companies that pay high dividends. The Vanguard Dividend Appreciation ETF (VIG) focuses on U.S. companies with a record of growing dividends.
- Market-Cap ETFs: These ETFs track companies based on market capitalization, such as large-cap, mid-cap, or small-cap stocks.The iShares Russell 2000 ETF (IWM) targets small-cap stocks in the Russell 2000 Index.
- Bond ETFs: These ETFs invest in bonds. They can include government bonds, corporate bonds, or municipal bonds. The iShares Core U.S. Aggregate Bond ETF (AGG) is an example, covering a broad range of U.S. investment-grade bonds.
- Commodity ETFs: These ETFs invest in physical commodities like gold, oil, or agricultural products. The SPDR Gold Shares (GLD) ETF tracks the price of gold.
- Currency ETFs: These ETFs track foreign currencies. The Invesco DB US Dollar Index Bullish Fund (UUP) aims to mirror the performance of the U.S. dollar against a basket of currencies.
- Leveraged/Inverse ETFs: Leveraged ETFs aim to multiply the returns of an index, while inverse ETFs aim to profit from a decline in the index. For example, the ProShares UltraPro QQQ (TQQQ) aims to deliver three times the daily performance of the Nasdaq-100 Index.
- Thematic ETFs: These ETFs focus on specific themes or trends, like clean energy or e-commerce. The Global X Robotics & Artificial Intelligence ETF (BOTZ) targets companies involved in robotics and AI.
- Actively Managed ETFs: Unlike most ETFs, which are passively managed, these ETFs have a manager making decisions about how to allocate assets.The ARK Innovation ETF (ARKK) is a popular example.
- ESG ETFs: ESG (Environmental, Social, and Governance) ETFs invest based on ESG criteria. The iShares MSCI USA ESG Select ETF (SUSA) targets U.S. companies with high ESG ratings.
- Bitcoin ETFs: Bitcoin ETFs are designed to track the price of Bitcoin, allowing investors to gain exposure to the cryptocurrency without directly buying and holding it. These ETFs trade on traditional stock exchanges and offer the same convenience and regulatory oversight as other ETFs. In the U.S., the ProShares Bitcoin Strategy ETF (BITO) was one of the first to gain approval and trades on the NYSE. It uses Bitcoin futures to track the cryptocurrency’s price.
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History of ETFs
The first Exchange-Traded Fund (ETF) was launched in the U.S. in 1993 by State Street Global Advisors and was called the SPDR S&P 500 ETF (SPY). It was designed to track the S&P 500 index, one of the most widely followed equity indices in the world.
The launch of SPY marked a significant milestone in the financial world, providing investors with a new, cost-effective way to gain diversified exposure to the stock market. Since then, ETFs have grown exponentially in size and popularity, with thousands of ETFs now available representing a wide range of asset classes and investment strategies.
Pros and Cons of ETFs
Having explored how ETFs work and the various types available, it's important to understand their strengths and weaknesses to determine if they align with your investment goals. Here's a balanced look at the advantages and disadvantages of ETFs:
Advantages of ETFs
The advantages of ETFs include:
- Diversification: ETFs are designed to track a specific index, sector, or commodity. This means that instead of buying individual stocks or assets, you can buy a single ETF and get exposure to a range of assets. For example, an ETF that tracks the S&P 500 index provides exposure to 500 of the largest U.S. companies.
- Lower Costs: ETFs typically have lower expense ratios compared to mutual funds. This is because most ETFs are passively managed and aim to replicate the performance of an index rather than outperform it. For instance, the average expense ratio for ETFs was 0.20% in 2020, compared to 0.63% for mutual funds.
- Transparency: ETFs disclose their holdings daily, allowing investors to see exactly what assets they own. This level of transparency is not always available with other types of investment funds.
- Flexibility: ETFs are traded on stock exchanges, which means they can be bought and sold throughout the trading day at market prices. This is different from mutual funds, which are only priced at the end of the trading day.
- Tax Efficiency: The unique structure of ETFs allows investors to buy and sell shares without triggering capital gains taxes. This is due to the “in-kind” creation and redemption process, which helps limit the capital gains distributions that investors need to pay taxes on.
Disadvantages of ETFs
The disadvantages include:
- Potential for Lower Returns (for some types): While ETFs generally offer a cost-effective way to achieve market returns, they typically won’t outperform the market. Actively managed funds, on the other hand, aim to beat the market, although they often come with higher fees.
- Intraday Price Fluctuations: Because ETFs are traded like stocks, their prices can fluctuate throughout the day. This can create potential for price discrepancies between the ETF and its underlying assets, especially in volatile markets.
- Expense Ratios: While ETFs generally have lower expense ratios than mutual funds, they still come with costs. These costs, which cover things like management and administrative expenses, can eat into your returns over time.
- Less Control: With actively managed ETFs, you’re relying on the fund manager to make investment decisions. This means you have less control over the individual assets in the fund compared to if you were buying and selling individual stocks or bonds.
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ETFs vs. Mutual Funds vs. Stocks
When considering investment options, it's important to understand the differences between ETFs, mutual funds, and individual stocks. Each has its unique characteristics, advantages, and drawbacks. They include:
Feature | ETFs | Mutual Funds | Individual Stocks |
Trading Flexibility | Trades on stock exchanges; buy/sell throughout the day. SPDR S&P 500 ETF (SPY) | Bought/sold at the end of the trading day at NAV. Fidelity Contrafund (FCNTX) | Trades on stock exchanges; buy/sell throughout the day. Apple Inc. (AAPL) |
Underlying Assets | Diversified portfolio tracking an index or sector. iShares MSCI Emerging Markets ETF (EEM) | A diversified portfolio; can be actively or passively managed. T. Rowe Price Blue Chip Growth Fund (TRBCX) | When you buy a stock, you’re buying a share of ownership in a single company. Tesla Inc. (TSLA) |
Cost Structure | Generally lower expense ratios; no load fees Vanguard S&P 500 ETF (VOO) - Expense Ratio: 0.03% | Higher expense ratios, especially if actively managed; may have load fees American Funds Growth Fund of America (AGTHX) - Front-end load fee | Commission-free trading available on many platforms Microsoft Corporation (MSFT) - Commission-free trading |
Tax Implications | More tax-efficient due to in-kind creation and redemption iShares Core U.S. Aggregate Bond ETF (AGG) | Less tax-efficient; capital gains distributed to investors Fidelity Magellan Fund (FMAGX) | Taxed on capital gains when stocks are sold Alphabet Inc. (GOOGL) - Long-term capital gains tax rates |
Investing in ETFs

Investing in Exchange-Traded Funds (ETFs) can be a smart way to diversify your portfolio, gain exposure to a wide range of assets, and potentially earn returns. However, it’s important to approach this with a clear strategy and understanding. Let’s learn the process and strategies for investing in ETFs.
How to Choose the Right ETF for You
Choosing the right ETF requires careful consideration of several factors:
Investment Goals and Risk Tolerance
Your investment goals should guide your choice of ETF. If you’re investing for long-term growth, you might choose ETFs that focus on sectors or industries with high growth potential. Conversely, if you’re investing for income, you might choose bond ETFs or dividend ETFs.
Your risk tolerance also plays a crucial role. For instance, sector ETFs and small-cap ETFs might be suitable for risk-tolerant investors, while broad-market ETFs and bond ETFs might be more suitable for risk-averse investors.
Understanding the Underlying Index
Each ETF tracks a specific index. Understanding the composition and methodology of this index is key to understanding the ETF.
For example, an ETF that tracks the S&P 500 index offers exposure to 500 of the largest U.S. companies, while an ETF that tracks the MSCI Emerging Markets Index offers exposure to stocks from emerging markets.
Expense Ratio and Fees
The expense ratio is a measure of what it costs an investment company to operate an ETF. The lower the expense ratio, the less you pay in fees, which can lead to higher returns over time.
Some ETFs may also have other fees, such as transaction fees, so it’s important to understand the total cost of owning the ETF. For instance, the Vanguard Total Stock Market ETF (VTI) has an expense ratio of just 0.03%, making it a cost-effective option.
How to Invest in ETFs
Once you've chosen your ETF, here's how to get started:
Open a Brokerage Account
To invest in ETFs, you need a brokerage account. Many online brokers offer commission-free ETF trading, making it easier and cheaper to get started. Popular brokers include Fidelity, Charles Schwab, and Vanguard.
Find the Right ETF
Use screening tools provided by brokers or financial websites to find ETFs that match your criteria. Look for ETFs with strong performance, low expense ratios, and good liquidity. For example, if you're interested in technology, you might choose the Invesco QQQ ETF (QQQ), which tracks the Nasdaq-100 Index.
Buy and Sell ETFs
After you’ve chosen an ETF, you can buy shares through your broker. ETFs are traded like stocks, so you can place different types of orders, such as market orders, limit orders, and stop orders.
Strategies for Investing in ETF
There are several strategies you can use when investing in ETFs:
Passive vs. Active Management
Index ETFs that passively track a market index offer a low-cost, hands-off approach. Actively managed ETFs involve a fund manager making investment decisions, potentially leading to higher returns but also higher fees and potentially outperforming the market.
Core-Satellite Strategy
This approach involves building a core portfolio with a broad market ETF for long-term growth. You can then add "satellite" positions with more targeted ETFs focused on specific sectors or asset classes to align with your investment goals and risk tolerance.
For example, a core holding might be an S&P 500 ETF, while a satellite position could be an ETF focused on clean energy or biotechnology.
Thematic Investing
Thematic ETFs focus on specific themes or trends, such as technology, healthcare, or renewable energy. Investing in these ETFs can be a way to gain exposure to these trends.ETFs like the Global X Robotics & Artificial Intelligence ETF (BOTZ) allow investors to capitalize on specific trends they believe will drive future growth.
Dollar-Cost Averaging
Dollar-cost averaging involves regularly investing a fixed amount of money into ETFs, regardless of market conditions. This strategy reduces the impact of market volatility and can lower the average cost of your investments over time.
For instance, investing $100 monthly into the SPDR Gold Shares ETF (GLD) can help build your position gradually without worrying about short-term price fluctuations.
Impact of Regulatory Changes
Regulatory developments play a crucial role in shaping the ETF context. Changes in regulations can impact the structure, operation, and taxation of ETFs. For example, the SEC’s approval of non-transparent active ETFs allows fund managers to keep their trading strategies confidential, which could attract more active managers to the ETF space.
Additionally, ongoing discussions about reducing the tax advantages of ETFs could influence investor behavior. Investors need to stay informed about regulatory changes and their potential implications.
The introduction of new regulations in markets outside the U.S., such as Europe’s MiFID II, which aims to increase transparency and investor protection, also impacts the global ETF market.
"The ETF market continues to expand globally, with Europe experiencing robust growth. European ETF assets reached €1.3 trillion in 2021, driven by increasing adoption among institutional and retail investors seeking diversified exposure across asset classes."
Conclusion
ETFs offer a powerful and versatile way to invest. They provide instant diversification, lower costs, and trading flexibility compared to individual stocks. From broad market exposure to niche themes, there's an ETF to suit most investment goals.
Understanding how ETFs work, their advantages and limitations, and how to choose the right ones equips you to build a well-rounded portfolio. As the ETF industry embraces new technologies and caters to evolving needs, it's poised to be a major player in the investment landscape for years to come.
Frequently Asked Questions
ETFs, or Exchange-Traded Funds, are investment funds that can be bought and sold like individual stocks. They can track a variety of things, from the price of a commodity to a large and diverse collection of securities.
An example of an ETF is the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index. This ETF holds shares of 500 large-cap U.S. companies, offering investors exposure to the overall performance of the stock market.
ETFs are considered low-risk investments because they are low-cost and hold a basket of stocks or other securities, increasing diversification. They can be a good way to get started investing.
You can make money from ETFs in these ways: price appreciation (selling for a higher price than you bought), dividends (regular payments from the companies within the ETF), and capital gains (profits from selling securities within the ETF)
Bitcoin itself is not an ETF. However, there are Bitcoin ETFs available, such as the ProShares Bitcoin Strategy ETF (BITO). These ETFs track the price of Bitcoin and allow investors to gain exposure to Bitcoin without directly buying the cryptocurrency
To invest in an ETF, you need to open a brokerage account if you don't already have one. Once your account is set up, you can buy ETF shares through the brokerage platform, just like you would buy individual stocks. You simply search for the ETF you want to invest in, enter the number of shares you want to purchase, and place your order.
Yes, you can cash out ETFs by selling them on the open market. The proceeds from the sale will then be available in your brokerage account