How Do ETFs Work?

An exchange-traded fund (ETF) provides investors with exposure to various assets. Investing in an ETF enables you to take advantage of benefits that single-asset investments don’t offer. 

These features make ETFs a unique investment tool, but it’s important to understand how they work to optimize their returns. It’s also necessary to know the different types of ETFs you can invest in and how to trade them, as well as the benefits of opting for this investment.

Let’s find out everything you need to know about how to start investing in an ETF.

What is an ETF?

An ETF is a fund that trades on exchanges. It’s a pooled investment consisting of one class or several classes of assets that track a particular index fund. The most popular index that ETFs track is the S&P 500 index.

You can choose to invest in an ETF that consists of tens or hundreds of stocks or opt for a mixed ETF consisting of stocks, bonds and commodities. ETFs also contain domestic and international stocks, making them the ideal investment for investors seeking diversification.

How Do You Trade ETFs?

You can buy or sell ETFs on an exchange, the same way you would with stocks. To accomplish that, you need to open a brokerage account that offers ETFs.

Before opening a position, decide on the type of ETF you want to trade. Some ETFs offer foreign stocks, bonds and commodities, and others offer only domestic stocks. An ETF can consist of stocks in one industry or several. Your choice will depend on how much you want to diversify.

An ETF’s share price changes throughout the day as it trades. Most ETFs offer lower fees and broker commissions on ETFs compare to individual stock investments, especially when passively managed. Actively-managed ETFs tend to outperform the market if managed by a professional broker, which charges higher fees.

You can buy and sell ETFs to profit from bull and bear markets. Most brokers enable you to buy at the current market price or to place limit orders, allowing you to set a specific price at which to enter the market and the order is only fulfilled if the predetermined price is reached.

When trading ETFs, you need to analyze three expense types as these can significantly decrease profits and magnify losses. 

• Trade commissions: Your broker charges trade commissions for every ETF that you buy or sell. Some brokers offer 0% commission while others can charge $10 for each trade and even higher.
• Operating expense ratio (OPR): Beginner investors are likely to choose brokers to manage their funds, which results in ongoing management fees. OPR is expressed as a percentage and is the fund’s operating expenses divided by the average value of assets in the fund. An OPR is usually charged annually and mostly ranges from 0.05% to 1% but can be higher.
• Bid/ask spread: An ETF share price consists of a bid and an ask price. The bid is the highest price an investor is prepared to pay for an ETF, and the ask is the lowest price an investor is willing to sell an ETF. The difference between the bid and the ask prices is called a spread, which is collected by the market maker for matching a buyer with a seller.

ETFs are open-ended funds, which do not limit the number of investors participating in the investment.

Types of ETFs

Choosing the right ETF will depend on your investment goals matching an ETF’s risk, costs and benefits.

ETFs are a viable investment option for investors seeking diversification across assets, industries and markets. 

1. Stock ETFs

Stock ETFs are the most common types of funds that track various index funds. One of the reasons for their popularity is the offering to choose between domestic, international, sector, dividend and market-cap index ETFs.

This model enables investments in foreign markets and domestic stocks in companies in the same industry. The dividend ETF consists of stocks that pay shareholders dividends, and the market-cap index is determined by the size of each company by market cap. 

2. Commodity ETFs

A commodity ETF can consist of precious metals such as gold and silver, as well as agricultural goods and crude oil. Precious metals are held in vaults, which pose a risk and entail costs for transportation and storage.

You can choose commodity ETFs in futures contracts, which don’t require storage, unlike precious metals. Futures contracts enable traders to do a rollover into another contract when the delivery date approaches so that the commodity can be delivered at a future date.

Commodity ETFs tend to have an inverse relationship to stock ETFs, so they can serve as a hedge during stock bear markets.

3. Bond ETFs

Bond ETFs enable you to invest in a bond portfolio consisting of corporate, government and municipal bonds — debt securities issued by state and local governments. 

Most bond ETFs trade at a premium or discount from the actual bond price, and they don’t have a maturity date.

4. Currency ETFs

A currency ETF consists of various currencies tracking a single currency or various currency pairs domestically and internationally. You can opt for currency EFTs backed by bank deposits in a foreign currency or ones that purchase currency derivatives to get exposure to foreign currencies.

Importers and exporters use currency ETFs as a hedge against volatile exchange rates, and investors use them as diversification to hold non-dollar currencies.

5. ESG ETFs

Environmental, social and governance (ESG) ETFs also provide non-monetary rewards such as the fulfillment of investing in companies that care about the same causes as you.

Some of the industries that exclude ESG investing are tobacco, alcohol, gaming and fossil fuels. The stocks in an ESG ETF are usually made up of companies that pursue causes such as climate change and gender equality.

Benefits of Trading ETFs

Trading ETFs provides you with several advantages that most assets do not offer

Low operating expense ratio: ETFs can be passively managed, enabling you to take advantage of the low annual costs associated with their management.

Diversification: ETFs enable you to invest in local or foreign stocks and in various industries. You can also choose ETFs that hold stocks, commodities and bonds, serving as a hedge and a risk management tool.

Flexibility and liquidity: You can trade ETFs throughout the day, and opening and closing positions are efficient because of the large number of market participants. Most brokers allow you to set limit and stop-limit orders.

Tax efficiency: ETFs are usually tax efficient as they enable investors to keep more of their returns because of low turnover, resulting in the minimal distribution of capital gains.

Compare Online ETF Brokers

Achieving optimal returns from ETFs requires you to choose a broker that offers a large selection of ETFs and low fees. Benzinga found the best ETF brokers online.

Frequently Asked Questions