Contributor, Benzinga
December 20, 2023

Invest in all types of ETFs with Webull as your online brokerage.

Exchange-traded funds (ETFs) are popular investments because they offer simple and affordable diversification across a wide range of asset classes. But before stacking your brokerage account with ETFs, it's essential to understand how they work and the risks involved. In this article, you’ll learn how ETFs differ from mutual funds, what types are available and how these assets can fit into your portfolio.

What is an ETF?

An ETF is an exchange-traded fund, an investment vehicle holding a basket of stocks within a single asset. It’s similar to a mutual fund in many respects, but unlike mutual funds, ETF shares can be traded on exchanges like the New York Stock Exchange and the NASDAQ. The first ETF was created in 1993, and their numbers have grown in the decades since. As of 2022, over 2,700 ETFs trade on U.S. exchanges.

For long-term investors, choosing ETFs or mutual funds comes down to several specific factors. But if you’re a day trader, the decision is made for you — ETFs can be bought and sold during the trading session like individual stocks, while mutual funds cannot. Regardless of your investing strategy, ETFs are available that fit your needs. Here is a list of different types of ETFs based on the type of asset they track.

Types of ETFs to Invest In

ETFs come in so many packages that it can be confusing for novice investors looking for an appropriate vehicle. Not only can ETFs be broken up by asset class, but they can be further narrowed by market cap, sector or strategy. Here are six basic ETF types to familiarize yourself with before investing.

Equity ETFs

An equity ETF holds publicly traded stocks, like Microsoft Corp. (NASDAQ: MSFT) or Walmart Inc. (NYSE: WMT). While many equity funds are broad index ETFs like the SDPR S&P 500 ETF Trust (NYSE: SPY), the equity ETF industry is full of narrower funds that track small caps, specific sectors or targeted strategies like momentum or dividend investing. Equity ETFs like SPY can be ideal for beginners because they hold broad baskets of stocks, but diversification doesn’t mean eliminating risk.

Fixed-Income ETFs

A fixed-income ETF holds a group of bonds instead of stocks, but the main idea is the same — diversification across an asset class based on specific goals and objectives. Fixed income is also a broad asset class with corporate and government bonds of varying duration and risk. Bond ETFs can also be used to invest in foreign or municipal debt or assets like mortgage-backed securities.

Commodity ETFs

A commodity ETF is slightly more complex than a traditional bond or equity ETF. Commodity ETFs track the price of oil, wheat, gold or other raw materials or products. Some ETFs hold physical commodities like gold or silver while others attempt to match the market price using future contracts. Commodities ETFs often use leverage to meet their investment objectives, so these funds are usually meant for experienced investors.

Currency ETFs

The forex market is the largest in the world, and currencies are traded 24 hours per day during the week. Currency ETFs allow investors to gain forex exposure through securities traded on major stock exchanges. Currencies are traded in pairs, meaning gains or losses occur when one currency appreciates in value versus another. Currency ETF shares are also complex instruments and aren’t usually advised for novice investors.

Sector ETFs

Sector ETFs are a variation of equity ETFs with an investment focus on particular market sectors. A sector ETF holds stocks based on a single industry, like information technology, healthcare or consumer staples. Sector ETFs are riskier than broad market ETFs because the stock holdings are more concentrated and more susceptible to volatility.

International ETFs

The definition of an international ETF can vary depending on who you ask. Most investors think of international equity ETFs, which hold stocks from developed or emerging markets. However, international ETFs can also hold fixed-income securities like foreign government debt or international corporate bonds. International ETFs tend to have higher expense rates than domestic ones since the holdings are more challenging to maintain.

Key Factors to Consider When Choosing an ETF

How do you decide which ETFs to invest in? The answer depends on your own investment goals and risk tolerance. However, when evaluating similar funds, a few important elements help you make a smart comparison.

Selecting and Evaluating ETFs

When picking ETFs, keep these three factors in mind:

  • Liquidity: ETFs are traded on exchanges like stocks, meaning buyers and sellers constantly move shares during market sessions. An illiquid ETF is one with limited shares available or minimal trading volume. The more liquid an ETF is, the lower the spreads will be and the easier it will be to enter and exit positions.
  • Expense ratio: The expense rate is the percentage of assets under management a fund takes to cover operating expenses. Large index ETFs tend to have the lowest expense ratios, while smaller funds or those with more targeted strategies have higher ratios.
  • Tracking error: ETFs usually attempt to match the performance of an index, like the S&P 500 or Russell 2000. But not every fund will match their index penny for penny. This factor is known as tracking error, and it becomes more likely to occur as fund objectives become more complex.

Researching and Analyzing ETF Performance and Holdings

Past performance doesn’t guarantee future performance, but reviewing the price history of various ETFs and comparing it to the index is still a good idea. Does your S&P 500 ETF track the index within acceptable parameters? Are the holdings in line with your investment goals? Be sure to review the prospectus and make sure you and the fund have aligned objectives.

Common Mistakes to Avoid When Investing in ETFs

ETFs are reasonably easy to understand, but investors can still make mistakes with them. Here are a few snafus to avoid when buying ETFs.

  • Paying too much: Ensure the expense ratio is fair compared to other funds with similar themes or styles.
  • Not understanding the objectives: Many investors need help understanding how complex ETFs work, especially inverse daily funds that use leverage and derivatives to track their benchmark. Be sure you know how the fund is constructed and what's actually in the portfolio.
  • Mismatching risk: How risky is your particular ETF investment? Funds have various risks (interest rate risk with fixed-income ETFs or tax risk with commodity ETFs). You won’t escape market risk, but you can manage other risks by investing in appropriate vehicles.

Comparing ETF Brokers

Here are a few of Benzinga’s favorite brokers for ETF investing.

ETFs Provide Diversification, But Investors Must Still Understand Fund Expenses and Goals

Index ETFs make it easy for investors with minimal experience or capital to build a diversified long-term portfolio. But funds like 3x leveraged ETNs are meant for short-term trading, so investors must be cautious about what they purchase. With over 2,700 ETFs in the U.S. alone, with different investment styles, costs and risks, it’s on the individual investor to understand how their capital is put to work inside an ETF. Just because it's a group of assets doesn’t mean it won’t carry substantial investment risks. Know what you own and why you own it.

Frequently Asked Questions

Q

Are ETFs a type of mutual fund?

A

While ETFs share some similarities with mutual funds, they are a different investment vehicle and trade on a stock exchange.

Q

Are ETFs best for beginners?

A

ETFs can be a good asset class for beginners because they provide diversification, but investors should still research each fund before putting capital to work. It is important for beginners to do their own research and understand ETF basics and the specific ETF they are investing in, as not all ETFs are created equal.

Q

How many types of ETFs are there?

A

There are dozens of different types of ETFs tracking all kinds of asset prices, including some that use leverage to achieve their results. Make sure your goals align with the fund’s objectives before investing.

About Dan Schmidt

Dan has written about a wide range of topics including stocks and investing, cryptocurrencies, banking, student loans, and credit cards.