Guide to ETFs

Welcome to the ETF Education Center. We've prepared a complete series of articles that walks you through the basics of ETFs, teaching you everything you need to know to get started with these powerful investment tools.

In a hurry? Just watch the webinar.


In this 30-minute pre-recorded webinar, ETF.com's Director of Research, Dave Nadig, explains what ETFs are, how they work and how you can use them in a portfolio. Pick up powerful tips on how to trade ETFs, and how to avoid any potholes. This webinar is a powerful supplement to the articles listed below.


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Investors typically use the term "ETF" to mean a lot of things that aren't technically "exchange-traded funds": commodity pools, grantor trusts and debt securities. We're guilty of this too: After all, this is ETF.com, but we cover all types of products. It's the term of art, so we'll roll with it.
 

This website is called ETF.com. As you might expect, we like ETFs. For a variety of reasons outlined below, we think ETFs are the right investment choice, much of the time, for many investors.

ETFs are great. But how do you choose?

With more than 1,500 ETFs on the market today, and 150+ launching each year, it can be tough to determine which product will work best in your portfolio. How should you evaluate the ever-expanding ETF landscape?

The first thing people talk about when they talk about ETFs is their low fees. And it’s true: While the average U.S. equity mutual fund charges 1.42 percent in annual expenses, the average equity ETF charges just 0.53 percent. If you look at where the bulk of ETF money is actually invested, the average fee is an even-lower 0.40 percent.

The key to understanding how ETFs work is the "creation/redemption" mechanism. It's how ETFs gain exposure to the market, and is the "secret sauce" that allows ETFs to be less expensive, more transparent and more tax efficient than traditional mutual funds.

Two of the great, under-appreciated advantages of ETFs are their transparency and tax efficiency. Compared with mutual funds, ETFs are light years ahead in these two critical categories.

What risks are there in ETFs?

When you talk about trading ETFs, you have to talk about two kinds of trades.

As explained in Critical Concepts: ETF Tradability, ETFs operate at two levels of liquidity.

Authorized participants (APs) are one of the major parties at the center of the ETF creation/redemption mechanism and as such, play a critical role in ETF liquidity.

The homebuilder who constructs sturdy houses that stand for hundreds of years does a better job than one whose homes collapse after a short period.

When selling a car, people don't accept the first price a used-car salesman quotes as its actual value. Instead, most attempt to arrive at a more independent assessment of actual value.

Confusing as it seems, ETFs have more than one "price."

ETF investing has often been lauded for its transparency. After all, what investor doesn't want to know what they own and how much it's worth?

How do you know if an ETF is doing its job well?

Securities lending is a fairly simple process that can generate extra returns for ETF investors, but it also introduces extra risk—however minimal.

Like any business, even low-cost ETFs need to generate revenue to cover their costs. Plenty of ETFs fail to garner the assets necessary to cover these costs and, consequently, ETF closures happen regularly. In fact, a significant percentage of ETFs are currently at risk of closure.

ETFs trade like stocks. ETFs trade nothing at all like stocks.

For individual stocks, liquidity is all about trading volume and its regularity—more is better. For exchange-traded funds (ETFs), however, there's more to consider.

We believe most investors choose an ETF to express an investment opinion, and to access the pattern of returns expected from that opinion, e.g., gold will rise, large-cap U.S. stocks will fall, Treasury bonds will provide a certain level of risk-adjusted return. The proliferation of ETFs has made it both possible and daunting for investors to find the fund that best expresses their precise views.

Passive investing. It sounds, well, worse than boring. "Passive" sounds uninterested and maybe a bit lazy—two adjectives that are hardly desirable in an investing approach.

The goal of most ETFs is to track the performance of an index. Fund managers have two ways they can do this:

Investors spend hours researching funds for expense ratios and spreads, trying to save a few basis points here and there. But often, not enough time is spent researching a fund's structure and the associated tax implications, which can translate into hundreds or even thousands of basis points.

The breadth of investment opportunities available to investors has never been greater—the range of opportunity can be intimidating at times. The purpose of this article is to briefly explain each "category" of investment securities and the rationale for investing in them.

There are now more than 25 China-focused ETFs to choose from. As if sifting through expense ratios, liquidity and holdings isn't enough, China investors have another big, fundamental factor to consider: Chinese share classes.

You've probably heard us at ETF.com say numerous times, "not all ETFs are created equal." As an investor, it's imperative to understand how the ETF's underlying index works, since the name of an ETF can be deceiving … or, at least, not fully representative of the exposure you think you're getting.

The MLP ETP space has gotten very crowded very quickly, with 16 MLP ETPs launching in the past three years. The products have been a success, too: Thanks to a wholesale compression of yields across every asset class, investors have flooded the segment with more than $17 billion in assets. Although more than half of that tally is invested in just two products—the Alerian MLP ETF (AMLP) and the JPMorgan Alerian MLP ETN (AMJ)—there are nine different products in all that have cumulative assets of more than $100 million each.

Fixed-income securities are a mainstay of investor portfolios. While they come in many shapes and sizes, bonds and other fixed-income securities are simple in principle—they're loans from the investing public to an institution that needs money. Issuers of the bonds are the borrowers, and investors are the lenders. Investors who lend the money expect to be repaid, and they expect to be compensated for the use of their money and the risk they take in making the loan. Investors' compensation—the interest on the loan—often takes the form of a regularly paid coupon, say, 5 percent per year. It's this coupon payment—a consistent, repeating cash flow—that gives fixed income its name.

"Bond prices go down when interest rates go up." That's the oft-repeated maxim in fixed-income investing, and mathematically, all else equal, it's true. But prices for some bonds fall more than others given the exact same change in interest rates. Understanding the basic drivers of interest-rate risk can help you identify which bonds make the most sense for you, and can help you identify which bonds are best to own—or best to avoid—if you think interest rates will increase.

Senior bank loans are a form of debt financing issued by a private institutions. The "senior" in their name refers to their place in the capital structure of a firm. Senior loans are typically the highest-priority credits on a firm's balance sheet, meaning in the event of a bankruptcy or liquidation, they're repaid before any other type of financing. That means senior loan holders expect to be paid before bond and note holders as well as general creditors and equity shareholders.

ETFs typically trade at something close to "fair value." That is, if you calculated the intraday value of all the securities that an ETF holds, that would roughly align with the price of the ETF.

Without a doubt, exchange-traded funds have revolutionized the way investors buy and sell commodities, but not all ETFs are created equal. There are a number of different ways that ETFs provide commodity exposure to investors, and in this article, we explain one popular method.

Investors buying commodity exchange-traded funds naturally focus on the prices of the commodities themselves.

In our previous article, we discussed why—for many commodities—you can’t buy the physical commodity itself, and while futures may be an imperfect way to get exposure, it’s oftentimes the only option. In that article, we also specified three components of futures returns: changes in the spot price; the roll cost or yield; and interest income.

One of the age-old debates when it comes to commodity investing is whether to buy the actual raw material itself or the stocks of the producers of said raw material. Exchange-traded funds have made it easier than ever to get exposure to the whole spectrum of commodities, and that includes investments in commodity producers.

An ETF's taxation is ultimately driven by its underlying holdings. Since funds are structured differently according to how they gain exposure to the underlying asset, an exchange-traded fund's tax treatment inherently depends on both the asset class it covers and its particular structure.

For U.S.-based investors, choosing the right currency ETF for your investment objectives comes in two steps: choosing the exposure you want; and choosing the right structure.

An ETF's taxation is ultimately driven by its underlying holdings. Since funds are structured differently according to how they gain exposure to the underlying asset, an exchange-traded fund's tax treatment inherently depends on both the asset class it covers and its particular structure.

On the surface, picking the right target-date fund couldn't be easier: Simply identify the year in which you'll turn 65 and pick the fund closest to that date. Done. After all, the whole point of target-date funds is to make the allocation process easy for the end investor. Unfortunately, there's a lot more to consider when selecting the best target-date fund for you, especially considering the funds' ambitious goals.

The VIX index attracts traders and investors because it often spikes way up when U.S. equity markets plunge. Known as the fear gauge, the VIX index reflects the market's short-term outlook for stock price volatility as derived from options prices on the S&P 500.

Hedge funds and ETFs have little in common on their face. Hedge funds are typically accessed only by wealthy individuals or institutions, are illiquid in the short run and charge very high fees. In contrast, ETFs can be accessed by anyone, are highly liquid in the short run and charge low fees, typically.

Leveraged and inverse ETFs are powerful tools that allow investors to magnify the returns on an investment. While higher returns always sound better, leveraged and inverse ETFs are highly specialized tactical tools that should be implemented with caution. These products are primarily intended for professional traders. Advisors and individuals can use inverse funds as hedging tools, but they must know how the products really work and rebalance their positions.

Most leveraged/inverse ETFs reset their leverage daily, but some have monthly reset periods. In that case, the ETF provides leveraged or inverse returns to an index over a month-long period, rather than over one day. While this seems like an attractive alternative to the challenges created with daily reset products, the monthly reset option is "different" rather than "better" for most investors.