What is an ETF and how does it work?

What is an ETF?

What is an ETF?
An exchange-traded fund (ETF) holds a variety of securities in one category or class. Most ETFs are passively managed, meaning they are designed to track the performance of a particular index.

What is an Index?
An index is made of a big cross-section of stocks or bonds, and bigger indexes are commonly used as benchmarks for the overall stock market.

ETFs allow you to invest in a broad segment of a market, like the S&P 500 or the Dow, or in the market as a whole.

Because they are designed to mimic an index, passively managed ETFs offer potentially lower expenses and greater tax efficiency.

If you want the chance to outperform an index, you might want to look into actively managed mutual funds.

Are ETFs right for me?
ETFs may be appropriate for many kinds of investors, especially the traditional, more broadly diversified and passively managed ETFs that provide exposure to multiple securities and sectors.

Your local Edward Jones financial advisor is ready to help you determine if ETFs are right for you.

The video above offers a brief overview about exchange-traded funds (ETFs). An ETF can be used as a building block of your portfolio or as a complement to other investments you own, providing further diversification. It all depends on your individual goals and circumstances.

An ETF is an investment fund through which investors can pool their money to invest in a preselected basket of securities that are traded as a package on a stock exchange – which is how it gets its name. It has specific characteristics.

• ETFs offer investors a way to combine their money and invest as a group in a basket of securities.
• ETF shares are bought and sold throughout the day on an organized market, such as the New York Stock Exchange.
• Most ETFs are passively managed investments designed to track the performance of a particular index by investing in the same securities as the index.
• ETFs are easy to track because investors can look up their trading price by checking their tickers.
• Since ETFs trade on an exchange, they may experience price changes throughout the day.
• ETFs track the performance of a market-capitalization-weighted (market-cap) index, such as the S&P 500.

If you are new to investing, it may still be a bit confusing as to what exactly an ETF is. Don’t worry, you’re not alone. Sometimes it helps to just break it all down.

And if you are already an experienced investor, you may want to skip ahead to “How does an ETF work?”

As an exchange-traded investment fund, an ETF offers investors the opportunity to pool their money and invest in a preselected basket of securities. This fund is made up of tradeable financial assets, such as stocks, bonds, currencies, futures contracts and/or commodities, or some combination of these investments. An ETF can own thousands of securities.

You are investing in a basket (group) of securities that are tradeable financial assets. As mentioned above, an ETF is an exchange-traded investment fund through which investors can pool their money to invest in a preselected basket of securities, which are tradeable financial assets, such as stocks (shares of a company), bonds (loans to a company or government), currencies (various forms of money, including foreign currency), futures contracts (legal agreements to buy or sell something in the future) and/or commodities (such as crops or natural gas), or some combination of these investments.

When you invest in an ETF, you are joining other investors in pooling your money to invest in multiple securities simultaneously. Each share you purchase gives you a little piece of every security (asset) included in the ETF.

The process all starts with an ETF sponsor, usually a fund manager, who creates an investment management strategy based on studying various securities and their performance. The plan is submitted to the Securities and Exchange Commission (SEC) for approval.

Once the plan is approved, the securities that align with the strategy for the newly approved ETF are obtained and placed in a trust. Then, creation units (large blocks of shares – typically 50,000 or more) are formed, based on the value of the ETF. The creation units, which represent the value of the securities in the ETF, are divided into shares. These shares are then sold to investors on an exchange.

After an ETF’s shares have been created, you can buy and sell them via a brokerage firm/broker (including online brokers and robo-advisors) throughout the day on the ETF’s chosen stock exchange. Thus, the ETF’s share price can fluctuate from hour to hour. Because ETFs can create shares when they are needed or redeem them when they are not, the number of available shares each day can vary, as well.

In addition to your initial investment, you will typically pay an administrative fee for administrative costs, possible brokerage commissions (depending on your broker) and transaction fees (required by the SEC) for the sale of ETF shares. In return, as an investor, you will get a share of the fund (based on what you purchase), possibly entitling you to dividend payments, capital gains distributions or other benefits. You can learn details about how your specific ETF works by reviewing its respective prospectus, which you can request from your financial advisor.

Before investing in an ETF, keep these key considerations in mind:

Assess your financial goals: Understand the fund’s investment strategy and evaluate if it is right for you.

Determine your tolerance for risk: All investments carry risk . Securities held by a fund can go up and down in value. Be aware, as with many other investments, you could lose some or all of the principal amount you are investing.

Understand how your specific ETF works: ETFs are sold by prospectus, which provides important information, such as the fund’s investment objectives. Request the prospectus from your financial advisor and fully read it before making an investment decision.

There are many types of ETFs, each varying in terms of asset type, tax implication, and expense ratio. The following is a list of the most common ETF categories.

Equity ETFs

Equity ETFs invest in various stock assets, usually tracking stocks in a particular industry or in an entire index of equities, such as the Dow Jones Industrial Average (DJIA) or the S&P 500 Index. Equity ETFs may own stocks, generally selected based on company location, sector or size.

Fixed-income ETFs (bond ETFs)

Fixed-income ETFs (bond ETFs) invest in bonds, which are fixed-income securities. Most bond ETFs focus on a specific subset of bonds, such as government bonds or corporate bonds, and are generally lower risk, which helps to reduce your portfolio’s volatility. Bond ETFs trade throughout the day on a centralized exchange, as opposed to individual bonds, which are sold by bond brokers.

Commodity ETFs

Commodity ETFs invest in physical commodities, such as natural resources or precious metals. Commodity ETFs give you either ownership in the fund’s physical stockpile of a commodity or give you equity in companies that produce a commodity or commodities.

Currency ETFs

Currency ETFs track a single currency or a basket of currencies and are often backed by bank deposits in a foreign currency. Having investments in non-dollar currency can provide your portfolio with even more diversification.

Broad stock ETFs

Broad stock ETFs are diversified, often giving you exposure to multiple sectors (energy or real estate, for example), individual securities and — in the case of international ETFs — several countries. Broad stock ETFs generally don’t rely too heavily on the performance of a certain type of company or a specific country.

Broad bond ETFs

Broad bond ETFs invest in different areas of the fixed-income market, such as corporate and government securities, which generally makes their returns less dependent on the performance of specific sectors. Examples of broad bond ETFs include government and corporate ETFs.

ETFs offer benefits such as low costs and diversification, which can make them attractive investments. But you should consider your goals, risk tolerance and the types of investments you prefer to own when determining whether ETFs are appropriate for you.

The benefits of investing in ETFs may include:

• Low costs: Most ETFs track broad market indexes, so they don’t have to pay portfolio managers to analyze and trade shares for the fund. This generally makes owning an ETF less costly than owning an actively managed mutual fund.
• Diversification: Instead of holding just one investment in an individual company, ETFs invest in a diversified portfolio of individual stocks or bonds, and you buy shares in that fund, which can help even out the ups and downs in the market.
• Fewer broker commissions: Because ETFs invest in a diversified portfolio including multiple securities, usually only one trade is needed compared to individual stocks or bonds.
• Tax efficiency: Because ETFs often mirror index mutual funds, they generally trade less often and generate fewer transactions that are taxable, which means fewer expenses for investors.

ETFs also have disadvantages, which are important to understand and consider.

• Lack of control: Investors cannot directly control or influence which securities are included in the fund’s portfolios.
• Extra costs: ETF shares trade on stock exchanges; so, every time an ETF share is bought or sold, the fund may incur a broker’s commission. ETFs also have bid-ask spreads, in which shares are purchased at the ask price and sold at the bid price, with the spread between the prices adding to the ETF’s transaction costs. The wider the bid-ask spread, the higher the cost to trade.
• Overtrading: The potential ease of trading in and out of ETFs may tempt some investors to overtrade instead of following a more appropriate long-term investment strategy.
• Liquidity: Some ETFs may be more difficult to sell, making them less liquid than you’d like – especially if you need the money quickly.

There are ETFs that should be carefully considered and discussed in detail with your financial advisor before considering them as investment possibilities for your portfolio.

Narrowly focused ETFs: An ETF that’s more narrowly focused is more dependent on a certain kind of company or individual country. Narrowly focused ETFs can also have large allocations to single companies. This can lead to higher volatility over time, with more downside than investors may expect. Broad-based ETFs can be held for a longer term and offer investors more diversification.

Leveraged and inverse ETFs: Leveraged ETFs seek to provide a return that’s a multiple (such as two or three times) of the benchmark index’s return. Inverse ETFs aim to provide a return that’s the opposite, or the inverse, of the benchmark index return. Returns for these types of ETFs can lead to unexpected performance results over longer periods, which make them less suitable for long-term investments.

Track record: Assess an ETF’s track record to evaluate whether it has met its performance objective. In general, you should review at least one year of actual performance history, as most ETFs should perform similarly to the underlying benchmark index. You should also review how the benchmark index itself has changed over time, as this can cause the ETF to perform differently.

Low expenses: Many ETFs have lower expenses because they’re passively managed. Passively managed ETFs representing a certain asset class tend to be similar, so costs can be an important difference. The following represents a general guideline for ETF expenses:

^{Source: Morningstar}

The expense ratio measures what percentage of a fund’s assets are used to pay for the operating and administrative expenses of that fund, which reduce an investor’s return. The expense ratio of a particular ETF may be higher or lower than the guidelines noted in the chart above. You should carefully review the prospectus for the ETFs expense ratio.

More than $100 million in assets under management (AUM): Hundreds of ETFs have been launched in the past few years, and many still have marginal assets under management. Edward Jones suggests investing in ETFs that have at least $100 million in AUM, which is the level we believe is helpful to sustain their operations.

Share price premium or discount relative to net asset value (NAV): The NAV of the fund’s underlying holdings primarily determines an ETF's price, along with the supply of and demand for shares in the market. This may cause an ETF to trade at a premium or discount to its NAV. Edward Jones suggests seeking funds trading at minimal premiums or discounts to NAV. Most broad-based ETFs trade within 2% of the fund’s NAV - although this spread could widen in periods of market volatility. The premium or discount could also be more significant for more narrowly focused ETFs.

Additional Considerations

• Tax implications: An ETF’s holdings may affect capital gains or dividend distribution taxes. While most ETFs are legally structured as open-ended funds, meaning there is no limit to the number of shares the fund can offer, some may not be. Certain ETFs may generate a K-1 tax form, which may be undesirable for some investors. You can find the details on fund structure and tax implications in an ETF’s prospectus. Talk to your qualified tax professional about your situation.
• Underlying holdings: Understanding an ETF’s underlying holdings can help identify significant weightings to individual securities, industries, sectors or geographic locations, which may indicate the ETF is not as diverse as it seems. Knowing how the ETF is invested can lead to fewer performance surprises.
• How to invest in ETF funds: Like stocks, ETFs trade on an exchange. This means you can place different types of orders, and the time of day you place an order can affect the price you receive. ETF prices may be more volatile near the market’s opening and closing. Talk with your financial advisor to understand order types and their implications.

Broad-based ETFs can make up the core building blocks of your portfolio. If you’re interested in investing in a specific asset class, such as large- or small-cap equity, international equity or fixed income, chances are there’s an ETF for you.

You can also incorporate ETFs representing various investment styles — for example, dividend income or capital appreciation — into your portfolio.

ETFs can provide lower-cost, broad exposure to asset classes that can help further diversify your portfolio. Do you already own several individual large-cap domestic stocks? You may wish to speak to your financial advisor about how an international or small-cap ETF may fit into your portfolio. Similarly, if you own many individual bonds, consider speaking to your financial advisor about how a broad intermediate or short-term fixed income ETF may benefit your portfolio.

You can use ETFs with mutual funds to achieve even more diversification.

For example, an ETF could fill a gap in your portfolio of mutual funds. If you already own several large-cap domestic equity and international equity as well as fixed-income mutual funds, you may further diversify by adding exposure to the mid- or small-cap asset classes. If the mutual fund family doesn’t have a fund that meets your needs, you may consider adding a mid- or small-cap ETF instead.

ETFs also can provide exposure to certain asset classes with a more limited number of fund choices, such as emerging markets or international small-cap.

If you already have a well-diversified portfolio of mutual funds with different investment categories and asset classes, ETFs may not be necessary. Remember, before you supplement your portfolio with other investment types, you should speak with your financial advisor and read the fund's prospectus documents as you may be eligible for break points — or lower fees — if you invest a certain amount with a specific mutual fund family.

When combined, ETFs and mutual funds can complement your investment portfolio by adding diversification. They also have specific characteristics that set them apart from one another.

There are three key factors to consider when comparing ETFs and mutual funds, performance objectives, sensitivity to costs and taxes.

Performance objectives: Mutual funds and other active strategies (including active ETFs) invest differently from their benchmarks, often leading to returns that can be above or below the benchmark’s returns. If you are comfortable with the degree of risk in pursuit of generating a higher return, an active management strategy could be a good choice. However, if you prefer to match the returns of the market more closely, then an ETF may be a better fit.

Sensitivity to costs: While it is difficult to forecast the returns of an investment strategy, its fees are known. If your objective is to keep your costs as low as possible, you may consider an ETF or other passively managed strategies. They are generally less expensive than actively managed strategies within the same asset class.

Taxes: Taxes are an important consideration for investments held in taxable accounts. Passively managed investment strategies like ETFs tend to trade less frequently than mutual funds, leading to less portfolio turnover and lower capital gains. If the potential for greater tax efficiency appeals to you, an ETF, may be appropriate.