An exchange traded fund (ETF) is a security that can be bought and sold on stock exchanges and trades similarly to a stock. Unlike stocks, ETFs don't represent ownership in a single company. Instead, an ETF is an investment fund with a defined objective – whether that's diversifying across a particular sector or focusing on a specific set of companies. The fund company is directly in pursuit of that objective, and investors in the ETF benefit if the fund succeeds.
ETFs have become a popular alternative to mutual funds because they typically charge a much lower management expense ratio (MER) while still offering the diversification a mutual fund provides. They're also simpler to trade: unlike mutual funds, which can only be bought or sold once a day, ETFs can be traded during market hours like any stock.
Diversification
Buying individual stocks has its limits. Some stocks are expensive, and with a limited budget it can be difficult to spread your holdings across sectors and countries. Researching and rebalancing a portfolio of 100-plus individual investments is also genuinely time-consuming.
With an ETF, a team of portfolio managers handles that research. They determine what goes into the fund and rebalance when necessary, whether that means tracking a popular index or managing a complex mix of countries and asset classes.
All ETFs are transparent about their holdings, with that information available on the fund's website. ETF owners also receive a fund facts document within 48 hours of purchase, as well as annual financial statements – both are typically available electronically through your brokerage, though some funds will mail physical documents regardless.
Buying an ETF
Buying and selling an ETF works exactly like buying and selling a stock. Once you've decided how many shares you want, you place an order through your brokerage. ETFs can be traded during regular market hours as well as extended hours.
Like stocks, some ETFs pay distributions to shareholders – similar to a dividend, and often a result of the dividends or income generated by the fund's underlying investments. Some investors specifically look for ETFs with a track record of paying consistent, high distributions.
Specialized ETFs
While ETFs became popular as a diversification tool, not all of them are built for that purpose. Some are designed to take advantage of specific market situations. A few examples:
- Leveraged ETFs aim to double or triple the returns of their underlying investments. The flip side: double or triple the losses if the market moves against them. These are typically used for short-term trading.
- Covered Call ETFs run covered call option strategies on behalf of investors, sparing them the effort of setting these up themselves. They can generate high income, but limit how much you can profit if the underlying holdings rise significantly in value.
- Commodity or Crypto ETFs provide easy exposure to investments that are otherwise difficult to access. The tradeoff is that they tend to offer little diversification.
All ETFs display their MER on their website. For specialized ETFs, that fee tends to be higher.
Summary
ETFs are a cost-effective way to diversify within an investment account, typically at a much lower management fee than a mutual fund. They trade like stocks on the stock exchange and can serve a range of purposes, from broad diversification to highly specialized strategies. Fund details, including holdings and MER, are publicly available on each fund's website.
