The exchange-traded fund (ETF) is a type of pooled investment security (usually a stock) that functions similarly to a mutual fund. ETFs typically track an index, sector, commodity or other asset, but unlike mutual funds, ETFs can be bought or sold on an exchange (with a broker) just like a regular stock.
What is an ETF?
An ETF can be structured to track anything from the price of a single commodity to a large and diverse collection of securities. ETFs can even be structured to track specific investment strategies, but this is not that common.
The first ETF was the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 index and is still an actively traded and popular ETF today.
ETF stands for exchange-traded fund because it is traded on an exchange just like a stock. An ETF most often combines the shares of many companies in a particular index or sector – this diversifies your investment. The price of ETF shares changes during the trading day as shares are bought and sold in the market. This is a major difference from mutual funds, which are not traded on an exchange and only trade once a day after the markets close. In addition, ETFs tend to be more cost-effective and liquid compared to mutual funds.
Compared to investing in individual stocks, ETFs are a much safer choice. Most active investors seek to outperform the index and ETF performance through appropriate stock selection. Figures show that only 30% of professional investors manage to beat ETFs over the long term.
💡 Tip: If you are only marginally interested in stocks and want to invest more safely with less risk, you should have your portfolio dominated by ETFs and not bet on individual stock titles. As you can see above, even professional investors can’t beat ETFs and the index.
How do ETFs work?
An ETF is a type of fund that holds multiple underlying assets, not just shares of a few companies. Because ETFs hold multiple assets, they are a great choice for diversification. When you buy an ETF, you’re often betting on the success of a market or a particular sector. Thus, ETFs can contain many types of investments, including stocks, commodities, bonds. An ETF can own hundreds or thousands of stocks across different sectors, or it can be isolated to one particular industry or sector.
With investment brokers, you can find the ETF of your liking. If you don’t understand much about investing, putting your money in an S&P 500 ETF is a pretty good choice.
In the image below, you can see XTB broker interface, with the S&P 500 ETFs from iShares and Vanguard highlighted in green. In the next columns, which show one-year, three-year and five-year appreciation, you can see that the performance of these two ETFs is nearly identical. You can see that over the past five years, this ETF has made an average of 12.5% each year, which is well above where inflation has been over the past five years.
Below, you can see what companies are listed with what holdings in the iShares CORE S&P 500 ETF. The companies in this ETF generally have a percentage representation replicating their market capitalization. This means that the moves of the largest companies, Apple and Microsoft, can stack up the most with the ETF.
Dividends and ETFs
Although ETFs provide investors with the opportunity to gain as stock prices rise and fall, they also benefit companies that pay dividends. Dividends are the portion of profits that companies allocate or pay to investors for holding their shares. ETF shareholders are entitled to a portion of the profits, such as interest earned or dividends paid, and may receive the residual value in the event of the fund’s liquidation.
Distribution and Accumulation ETFs
You can see the abbreviations Dist and Acc in parentheses next to the thumbnails. These abbreviations tell you what the ETF will do with the accumulated dividend of the ETF’s stock portfolio.
Distributive, Dist (dividend) – With Distributive, you will receive a dividend periodically in your account that is made up of the dividends of the given stock that makes up the ETF. For ETFs focused on dividend stocks, the dividend will be higher. For technology companies, the dividend will be lower. At XTB, this dividend will come into your investment account like dividends from traditional stock titles. Since a compound ETF is made up of many titles that pay dividends at different rates, the ETF accumulates and pays dividends annually or quarterly. The downside of distribution ETFs is their withholding tax, which you can’t avoid.
Accumulative, Acc (reinvestment) – With these ETFs, nothing goes into your investment account, but the ETF in question continues to reinvest the funds. All without any additional costs. So the ETF in question grows in price faster than a distribution ETF.
What types of ETFs do we have?
If a simple guide on how you can invest in ETFs isn’t enough, the following lines will explain how ETFs are divided and their differences. Investors have different types of ETFs that can be used to generate income, speculate and increase prices, and to hedge or partially offset risk in an investor’s portfolio.
Passive ETFs – Passive ETFs aim to replicate the performance of a broader index. A diversified index, such as the S&P 500, or a more specific industry, sector or trend. An example of the latter category is gold mining stocks. There are now approximately 8-9 ETFs that focus on gold mining companies, excluding inverse, leveraged and low asset under management funds. If you invest in these ETFs, you believe that gold mining is currently undervalued or will experience an upturn in the future. You are not betting on a specific company, but on an entire sector made up of the biggest players in the market. So if company A significantly outperforms company B, you will also partly benefit. Of course, the investor who holds Company A’s shares will benefit more.
Active ETFs – Actively managed ETFs typically do not focus on an index of securities, but the portfolio managers decide which securities to add to the portfolio. These funds have advantages over passive ETFs but tend to be more expensive for investors to manage. We discuss actively managed ETFs below.
Bond ETFs – are used to provide investors with regular income. The distribution of their returns depends on the performance of the underlying bonds. They can include government bonds, corporate bonds, and state and local bonds – called municipal bonds. Unlike their underlying instruments, bond ETFs do not have a maturity date. They typically trade at a premium or discount to the actual price of the bonds.
Stock ETFs – include a basket of stocks that track a single industry or sector. For example, a stock ETF might track stocks of technology companies. If you’re interested in the individual composition, you can search for each ETF to see what titles are included and in what specific amounts. The goal is to provide diversified exposure to a single sector that includes high performing companies and new entrants with growth potential. Unlike stock mutual funds, stock ETFs have lower fees and do not involve actual ownership of securities.
Commodity ETFs – As the name implies, commodity ETFs invest in commodities, including oil or gold. Commodity ETFs provide several benefits. First, they diversify a portfolio, making it easier to hedge against downturns. For example, commodity ETFs can provide a cushion during a downturn in the stock market. Second, a very important point, holding shares of a commodity ETF is cheaper than physical ownership of the commodity. This is because there are no insurance and storage costs associated with the former.
How to invest in ETFs?
- What is your timeframe for investing? How long do you want to hold the investment? An important question to ask yourself right from the start. Quite simply, the longer you invest, the more likely you are to properly value your funds. If your investment horizon is two years, you may find yourself withdrawing money at the wrong stage of the economic cycle. As you can also see above, the iShares core S&P 500 ucits ETF has made an average of 12.47% per year over the previous 5 years, but is down 4.9% over the past year.
- Are you investing for income or growth? What is your strategy? Do you plan to withdraw money slowly or do you want to add money regularly over the long term?
- Are there particular sectors or segments you believe in?
- Choosing an investment platform or broker. If you want to invest with less fees, you can choose XTB, but if you want to invest without worrying about ETFs, you can try Porto where the platform takes care of everything important. However, there is an extra fee for this service .
Advantages and disadvantages of ETFs
ETFs provide a lower average cost because it would be costly for an investor to buy all the stocks held in an ETF portfolio individually. In fact, it is almost impossible. Investors only have to make one transaction to buy and one transaction to sell, which results in lower fees to brokers and investment platforms because investors only make a few trades. Fees for ETFs are typically only 0.25% per year and you pay nothing to hold an ETF with broker XTB, for example.
Investment platforms usually charge a commission for each trade, but ETFs are particularly suitable for longer-term holding as a more conservative type of investment in the capital markets.
The cost of an ETF is the finances to run and manage the fund. ETFs typically have low costs because they track and replicate a given index. For example, if an ETF tracks the S&P 500 index, it may contain all 500 stocks in the S&P index, making it a passively managed fund that is less time-consuming to humanly manage and also accumulates a huge amount of finances in the case of iShares or Vanguard. However, not all ETFs track the index in a passive manner and therefore may have a higher expense ratio.