Benzinga explains the different types of ETFs available to investors.
The exchange-traded fund (ETF) universe grows larger by the day, with more than 8,500 ETFs listed globally as of 2022 holding over $10 trillion in assets under management (AUM).
Selecting the right type of ETF can be challenging given the myriad of choices out there. Because ETFs can hold a variety of assets, adopt a range of strategies and use varied fund structures, it can be easy for new ETF investors to become overwhelmed with the choices available.
If you're looking to kick-start an ETF portfolio, then this guide to understanding the types of ETFs available might be helpful. Knowing how to distinguish among ETFs can help investors select the best options for their portfolios.
What Are the Different Types of ETFs?
Most ETFs can be categorized based on their asset holdings, geography and strategy. It's important to note that these categories are not mutually exclusive. In fact, they are often combined with each other to produce new types of ETFs. Here are some examples:
ETFs can be categorized by their underlying assets. For example, an equity ETF is a type of ETF that holds stocks, while a fixed-income ETF is a type of ETF that holds bonds. Commodities ETFs can hold precious metal energy, or agricultural futures. Other assets include currencies and even derivatives.
ETFs can also be categorized by the geography that their underlying assets originate from. For example, a U.S. market ETF tracks U.S. stocks, while an emerging bond ETF tracks bonds from countries like China and Russia. These ETFs can be country-specific or target one of three main geographical market distinctions: U.S., international developed and international emerging.
An ETF strategy refers to the rules by which it selects and manages holdings. The most common example is the passive ETF, which attempts to track and replicate the performance of an index. Other types include active ETFs that try to outperform a benchmark or target a specific objective such as monthly income or hedging. Then, there are "smart beta" or "factor" type ETFs that use automated quantitative frameworks to try and provide exposure to a specific factor, such as size, value, quality, momentum or low volatility. Finally, some ETFs screen for environmental, social and governance (ESG) considerations.
ETFs can mix and match these types to create a unique strategy. For example, consider an actively managed U.S. equity ETF that targets small-cap value stocks. For this ETF, the asset is equity, the geography is U.S. and the strategy is smart beta/factor.
Where to Buy and Sell ETFs
Why Invest in ETFs?
ETFs aren't the only option for investors these days. Mutual funds and individual stocks or bonds can be potential alternatives. Still, a few compelling reasons exist to make ETFs the core of your portfolio. These include:
Simplicity: Some ETFs offer a one-stop shop for your portfolio needs. For example, investors can easily buy broad-market ETFs that contain thousands of stocks in a single ticker. Managing a few ETFs is also much easier than manually keeping up with and rebalancing multiple individual holdings.
Low Fees: Unless you're with a zero-commission brokerage, trading dozens of individual stocks can cost you dearly both in terms of brokerage fees and bid-ask spreads. With ETFs, investors can minimize the trades needed to keep their portfolios up to date. In particular, some passive index ETFs can have expense ratios as low as 0.03%.
Accessibility: ETFs provide exposure to a variety of strategies and assets that retail investors may find difficult to implement on their own. For example, buying a covered call ETF saves investors the need to manually trade options. Buying a commodities ETF saves investors the need to manually trade futures.
Can You Diversify with ETFs?
Investing in ETFs is one of the best ways to instantly diversify your portfolio at a low cost. However, there are some tips and tricks you can implement to ensure your ETF portfolio becomes as diversified as possible.
Select ETFs that cover multiple assets: Proper diversification means spreading the risk in your portfolio among different assets, such as stocks, bonds, cash and commodities. A great way to do this is by selecting ETFs that track each of these asset classes and holding them in proportions that reflect your risk tolerance and time horizon. For example, a young investor holding for the long term might have the majority of their portfolio in an equity ETF while holding a smaller portion in a bond ETF.
Select ETFs that cover multiple geographies: Betting on a single country's stock market, no matter how well it has historically performed is sub-optimal. While the U.S. stock and bond markets have outperformed over the last decade, there is no guarantee that they will do so in the future. There have also been periods of long stagnation, like during the "lost decade" for U.S. stocks from 2000 – 2010. Therefore, ETF investors should endeavor to hold stock and bond ETFs covering international geographies as well.
Avoid overlap in ETF holdings: It's important to examine the underlying holdings of an ETF to ensure that ETFs in your portfolio do not have redundant holdings. For example, an investor who holds both an S&P 500 ETF and a Nasdaq 100 ETF has significant overlap when it comes to mega-cap tech stocks. This overweight bodes poorly for diversification.
Compare ETF Brokers
Investors looking for further insights and reviews of ETFs can use Benzinga to compare the available options. Here is a list of brokers that support ETF trading and offer research tools to help investors select the right type of ETF.
What Are the Top ETFs to Buy?
There are two ways to answer this question. From the perspective of an individual investor, the best ETF to buy depends on your investment objectives, time horizon and risk tolerance. From the perspective of the overall market, the top ETFs to buy sport a combination of high AUM and daily traded volume. These ETFs would be the SPDR S&P 500 ETF Trust (NYSEARCA: SPY), the iShares Core S&P 500 ETF (NYSEARCA: IVV) and the Vanguard S&P 500 ETF (NYSEARCA: VOO), which all track the S&P 500 index. These ETFs are highly popular thanks to the S&P 500's prominence as a benchmark and barometer of overall U.S. stock market performance.
What Type of ETF is Best?
There's no definitive answer to what type of ETF is the best. It all depends on the individual investor's investment objectives, time horizon and risk tolerance. Once these are determined, an investor can select the best type of ETF by screening for the right asset classes, geography, and strategy. For example, a retiree seeking consistent monthly income may prefer an ETF that targets low-volatility U.S. dividend stocks like the Invesco S&P 500 High Dividend Low Volatility ETF (NYSEARCA: SPHD). A younger investor seeking aggressive growth might prefer a tech-stock heavy index ETF like the Invesco NASDAQ 100 ETF (NASDAQ: QQQM). Investors should be cautious to not select ETFs based on historical performance given that it is not predictive of future performance.