What Is an ETF?

Diversification is an important component of long-term success in markets, and perhaps no other financial product has helped everyday investors and major institutions alike easily reap the benefits of diversification like exchange-traded funds (ETFs) have.

So, what, exactly, are ETFs, and why are they so popular these days?

What is an ETF?

ETFs, or exchange-traded funds, are essentially hybrids of market-based investments and mutual funds. Like mutual funds, ETFs allow investors to buy an entire basket of securities: stocks, bonds, commodities—just about any asset these days—in a single transaction. But like market-based investments, ETFs can be bought and sold during market hours, and their prices fluctuate through the day (mutual fund prices are set daily and can be traded only once a day at the end of the day).

Therefore, ETFs are lauded for their liquidity, ease of trading and ease of access to diversification. You can get ETFs that track just about anything you’d like. There are ETFs that hold every single stock in the S&P 500 or in the entire U.S. stock market, or they can hold a basket of Treasury bonds. Some ETFs focus on a single sector, such as industrials, and there are ETFs that hold stocks of companies based in Europe or in emerging markets.

A brief history of ETFs

Technically, the first ETF was launched in Canada back in 1990, although a typical retail investor wouldn’t recognize that product. Those early relatives were largely used by large, institutional investors to purchase and sell pooled assets. The first ETF that retail investors would recognize was the SPDR S&P 500 Trust ETF (ticker: SPY) launched in 1993 here in the U.S. It first traded on Jan. 29 of that year and amassed $461 million in assets. Today, SPY, nicknamed the “spider,” has more than $403 billion in assets and is the largest ETF on the market.

SPY ushered in a vibrant industry of ETFs, and the iterations and types of ETFs have exploded. There are now thousands of ETFs with a combined $9 trillion held within them, according to Morningstar research.

How ETFs work

ETFs can be bought and sold through a brokerage firm. ETF providers outline the rules, or investing philosophy, that their ETFs will adhere to. A market cap-weighted ETF that uses the S&P 500 (or a host of others) as its benchmark will buy every stock in the S&P 500, proportional to its weighting in the index. If Apple represents 6 percent of the S&P 500 market cap, the ETF will seek to have Apple represent 6 percent of its holdings.

However, not all indexes are as liquid, and some contain thousands of constituents. For broader and more complex market indexes, like the Wilshire 5000, an ETF may buy securities in an index that provides the most representative sample of the index based on correlations, exposure and risk—often referred to as optimization or sampling.

The ETF’s fund provider owns the underlying assets in the fund, while ETF investors technically own a share of that fund. The price of an ETF generally tracks the underlying value of the fund (although it isn’t always exact). However, the fund’s price can also be affected by market demand for the ETF. When more money flows into an ETF, its price will rise (demand rises), and the fund provider will then buy more of the underlying assets in proportion to the amount of money that’s come in the door. The same is true when investors sell an ETF.

Do ETFs pay dividends?

An ETF will pay dividends as long as the underlying stock within the ETF is paying dividends. Based on the number of shares an investor owns, they can expect to receive dividends on a quarterly basis. In fact, there are some ETFs, called dividend ETFs, that are created and constructed with the intent to maximize dividend income.

Do I need to pay taxes on my ETF?

While an ETF is still subject to tax on capital gains and tax on dividends, the structure of an ETF minimizes taxable events, making them quite tax efficient. Rather than constantly rebalancing by selling securities (as a mutual fund manager would), an ETF manager balances with baskets of assets that are relative to the ETF’s entire investment exposure, which limits exposure to in-fund capital gains events. However, if you sell an ETF, you will be subject to short- or long-term capital gains tax.

How long do you have to hold an ETF?

How long you hold onto an ETF will depend on your investment strategy and long-term goals. But an ETF can be bought or sold at any time during a trading day.

What types of ETFs are there?

There are many different types of ETFs on the market today. Depending on your risk tolerance and your overall financial strategy, it’s possible you’ll want to integrate different types of ETFs with other assets in your portfolio.

Active or passive ETFs

Passive ETFs are essentially operated on autopilot. They simply follow a set of rules or a benchmark, such as the S&P or NASDAQ, and underlying assets are rebalanced to reflect that index. Active ETFs have a fund manager at the helm making decisions about what assets and in what proportions the fund should hold. These funds will have an overarching philosophy, but fund managers have more leeway to buy and sell using their expertise. Typically, an actively managed ETF will have higher fees than passive funds.

Equity ETFs

Equity ETFs select an index of equities to track, be it large businesses, small businesses or international stocks. Equity ETFs also include thematic ETFs (or sector ETFs), which track investing themes, such as artificial intelligence, “dogs of the DOW,” founder-run companies—the list goes on. These ETFs may hold stocks of all asset classes in any part of the world, so long as they align with an overarching theme.

Factor ETFs—another type of equity ETF—use certain valuation methods or technical analysis to include stocks with certain defining characteristics. Typical factor ETFs include those that target growth stocks, value stocks, dividend payers, high-yield corporate debt, momentum stocks or quality.

Non-equity ETFs

Non-equity ETFs hold securities in non-equity entities like bonds, commodities and currencies. Generally, non-equity ETFs can be helpful in diversifying a portfolio by providing some lower-risk stability.

Bond ETFs can include government bonds, municipal bonds or corporate bonds. Commodity ETFs that invest in commodities (like gold or oil) are also good diversification tools, as they can provide stability during down markets. Currency ETFs that track the performance of currencies in other countries are another option that can hedge against inflation.

How are ETFs different from mutual funds?

ETFs and mutual funds both have a similar structure: They represent collections (“baskets” or “pools”) of individual securities like stocks or bonds. They both also offer opportunities for diversification among a variety of asset classes and markets. The biggest differences between the two lie in their cost and when they can be traded.

Generally speaking, ETFs often have lower fees than mutual funds. The average expense ratio (fees associated with managing the asset) for an ETF is around 0.16 percent, whereas the average expense ratio for a mutual fund is somewhere around 0.47 percent (plus additional fees).

ETFs are also able to be traded throughout the day when the market is open, just like a stock is. Mutual funds, on the other hand, are able to be purchased only at the end of the trading day, when a price has been calculated after the market has closed.

Is owning an ETF a good investment?

ETFs can be useful in a portfolio because they’re relatively simple, inexpensive and typically diverse. Here are some of the benefits of investing in an ETF:

High liquidity

Popular ETFs tend to have plenty of market participants buying and selling, which makes it easy for you or an advisor to rebalance your portfolio or use ETFs to dynamically overweight or underweight certain assets as part of a long-term investing strategy.

Instant diversification

Buying one share in an ETF can provide access to thousands of stocks, bonds, etc. in a single transaction. This is beneficial for young investors just getting started or experienced investors looking to plug a hole in a portfolio (e.g., to gain exposure to municipal bonds or international markets). Northwestern Mutual portfolio managers and advisors often use ETFs to help their clients diversify their portfolios as well.

Low cost, low effort

Fees for ETFs tend to be lower than mutual funds, although that’s not always the case. And it’s easier and more cost effective than buying the assets individually—particularly for more complex asset classes, such as bonds or commodities.

ETF terms to know

Prospectus

Every ETF has a prospectus, or a comprehensive document that outlines the fund’s strategy, performance, fees, risks, the fund’s owner and other important information. It’s not exactly a thrilling read, but it’s worthwhile for investors doing their due diligence. Make sure you read the prospectus carefully before deciding to purchase any investment.

Net expense ratio

This, in a nutshell, is the annual fee a fund manager charges to pay for portfolio management, administration and marketing and distribution, among other expenses. Fees range from as low as 0.16 percent to a few percentage points.

Tracking error

This describes how closely an ETF follows its intended benchmark. A high tracking error indicates a fund is diverging from the benchmark, and it may be worth a deeper dive as to why. Northwestern Mutual’s investment team looks closely at this metric when researching funds to include in client portfolios.

Discount/premium to net asset value (NAV)

ETFs don’t always match the value of their underlying assets one to one. Sometimes, the share price (multiplied by total shares outstanding) is lower than the value of its underlying assets. When this is the case, the ETF is said to be trading at a discount to NAV. When the price is higher than the underlying assets, the ETF is trading at a premium to NAV.

Net assets

This is the combined value of all assets held in the ETF, but it’s not to be confused with the ETF’s price.

Net flows

This measures how much money has flowed into an ETF and is measured on a daily, weekly or monthly basis.

Fitting an ETF into your financial strategy

While ETFs offer certain benefits for investors, they’re simple tools. But tools alone don’t build a house—doing so requires a plan and skilled craftsmen to use the proper tools to do it. While some investors are financially handy, others may benefit by working with a financial advisor who knows how to use a variety of financial tools to get them where they want to be. A financial advisor can incorporate ETFs into a broader financial plan that’s designed to give you confidence that you’re on track to reach your financial goals.

Exchange-traded funds (ETFs) have risks and trade similarly to stocks. Shares of ETFs are bought and sold in the market at a market price; as a result, they may trade at a premium or discount to the fund's actual net asset value. Investors selling ETF shares in the market may lose money, including the original amount invested.

No investment strategy can guarantee a profit or protect against loss. All investments carry some level of risk, including the potential loss of principal invested. No investment strategy can guarantee a profit or protect against loss in a down market. This is for information purposes only and not a solicitation to purchase any security.