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Index ETFs Explained

Exchange-traded funds (ETFs) have quickly become a popular way to invest in stocks, bonds, and commodities. They combine the convenience of trading stocks with the broad diversification available to index funds. ETFs are traded daily on public exchanges to allow investors to take advantage of various price points throughout the day for buying and selling. Individual investors can make their own trades on public stock exchanges, thus making ETFs easy and more desirable. All you need to start trading is an account and an app for your smartphone.

Key Takeaways

  • There is a variety of ETFs available to investors.
  • The market offers several popular index ETFs to diversity your investment portfolio.
  • ETFs have low expense ratios for investors.
  • Index ETFs may have higher fees, less liquidity, and lower overall yield.

What Is an Index ETF?

An index exchange-traded fund (ETF) is a fund traded on the public stock exchange that tries to replicate and track a benchmark index. Indexed ETFs are funds similar to normal index mutual funds with a portfolio that replicates a specific index or industry sector basket of securities. The main difference between an index ETF and index fund is that while they offer the diversification of a mutual fund, ETFs instead trade like common stock shares. Secondly, you can make trades on ETFs during market hours, while index funds are priced at the end of the trading day. ETFs are often less costly than index funds.

These funds are good for those beginning to learn about investing, as they offer diversification and less risk than other types of index funds. Index ETFs are relatively less risky than stock trades. While being very similar to a mutual fund, ETFs offer more opportunities and can be purchased throughout the day. Exchange-traded funds can be purchased on margin and be sold short.

The annual expenses of exchange-traded funds are generally low. Just like a common stock, commissions are charged on each transaction. Sales loads are not applicable to an ETF. Dividend payments are possible, but not typical. A settlement for an exchange-traded fund is T+3 business days with options available on most ETFs.

Various Types of ETFs

There are various types of ETFs available to investors, and learning about them can help an investor diversify and offset risk in their portfolio. Here’s a brief overview of the various types of ETFs available:

  • United State Market ETFs
    • The market index ETFs are some of the most active ETFs on the exchange floor.
  • Foreign Market Index ETFs
    • There are many foreign ETFs to choose from. These are valuable to an investor seeking international exposure or wishing to hedge against foreign investment risk.
  • Foreign Currency ETFs
    • These ETFs help investors gain exposure to foreign currencies without completing complex transactions. This would include such currencies as the Euro or the Canadian dollar.
    • Currency exchange-traded funds are simple investment vehicles that track foreign currency. This type of ETF sometimes tracks a basket of currencies, allowing investors access to multiple foreign currencies.
  • Sector and Industry ETFs
    • An industry ETF generally tracks a sector index representing a certain industry. This is an opportunity for inventors to gain exposure to a certain market sector like pharmaceuticals or home-building without having to purchase in multiple companies.
  • Commodity ETFs
    • Commodity exchange-traded funds are similar to industry exchange-traded funds in that they target certain areas or sectors of the market. These are often industries such as technology, banking, oil, or gas.
    • When you purchase a commodity ETF you invest in derivative contracts to follow the price of the underlying commodity. You aren’t actually purchasing the actual physical commodity.
    • Investments in commodities include things like gold, crude oil, or energy.
  • Style ETFs
    • Style exchange-traded funds track a certain investment style or market capitalization.
    • This type of ETF is most actively traded in the United States. If your investment goal is based on market-cap style, this style of exchange-traded fund may help you reach your target.
  • Bond ETFs
    • Bond ETFs include government, corporate, state, and local bonds, also called municipal bonds.
    • Bond exchange-traded funds track low-liquidity investment products.
    • Bonds are not actively traded in secondary markets as they are typically held to maturity. However, Bond ETFs are actively traded products.
    • Debt-based ETFs like the SPDR Capital Long Credit Bond ETF offer investors opportunities in the bond market while still maintaining the benefits of an exchange-traded fund.
  • ETNs (Exchange-Traded Notes)
    • Exchange-traded notes are technically not true ETFs but are often lumped into the same category.
    • Exchange-traded notes are issued by a major bank as senior debt notes. In purchasing an ETN, you receive a debt investment similar to a bond.
    • ETNs are considered a secure investment as they are backed by high-credit rating banks, however, they’re not totally absent of credit risk.
  • Inverse ETFs
    • Inverse exchange-traded funds create short positions when an investor purchases them, providing inverse reactions to the direction of the underlying index or asset.
    • These are used in attempts to earn gains from stock declines by shorting stocks. Shorting is selling a stock, expecting a decline in value, and turning around to repurchase at a lower price.
  • Leveraged ETFs
    • This style of exchange fund is best suited for advanced ETF trading strategies. It is a common misconception that leveraged ETFs produce exponential annual returns.
    • The goal of this type of fund is to offer leveraged daily returns on underlying indexes and assets.
    • However, this cannot be assured. Therefore, if adding leveraged ETFs to a portfolio, it would be best to conduct thorough research.
  • Actively Managed ETFs
    • These exchange-traded funds combine the benefits of mutual and exchange-traded funds into one asset while eliminating some of the disadvantages.
  • Dividend ETFs
    • A dividend ETF tracks a dividend index, consisting of a diverse range of dividend-paying stocks.
  • Innovative ETFs
    • With a growing ETF popularity, there’s a rise in the development of an innovative crop of funds such as volatility ETFs and tax-deferred ETFs.

Popular Index ETFs On The Market Today

Image via Flickr by investmentzen

Index ETFs have become popular with investors looking for alternatives to investing in mutual funds. Learning the pros and cons of exchange-traded funds when comparing to other types of investments can help to create a strong portfolio by making decisions based on risks and rewards. A few popular stock index ETFs on the market today include:

  • SPDR S&P 500 (SPY): The oldest and surviving and most widely known ETF. It tracks the S&P 500 Index.
  • iShares Russell 2000 (IWM): Tracks the Russell 2000 small-cap index
  • InvescoQQQ (QQQ): Indexes the Nasdaq 100, which is typically technology stocks
  • SPDR Dow Jones Industrial Average (DIA): Represents 30 stocks of the Down Jones Industrial Average
  • Sector ETFs: Track individual industries such as oil (OIH), energy (XLE), financial services (XLF), REITs (IYR), and Biotech (BBH)
  • Commodity ETFs: Represent commodity markets, including crude oil (USO) and natural gas (UNG)
  • Physically-Backed ETFS: SPDR Gold Shares (GLD) and iShares Silver Trust (SLV) hold physical gold and silver bullion in the fund.

Noting the differences among the various styles of index ETFs will lead to greater success among investors making decisions, such as whether these securities are appropriate for a portfolio.

Advantages Of Index ETFs

Index ETFs give access to many stocks across various industries. Because there is a variety offered, there’s greater opportunity in risk management through diversification. ETFs tend to have low expense ratios. Only one transaction is needed to buy and only one transaction to sell, which reduces the number of broker commissions based on only a few trades being made by investors. ETFs focus on targeted industries. The expense ratio of an ETF is the cost to operate and manage the fund. ETFs typically have lower expenses because they track an index, and they tend to be more tax-efficient.

Disadvantages Of Index ETFs

W hile most exchange-traded funds have lower expense ratios, actively managed ETFs often have higher fees. Intra-day pricing may not be beneficial to those with long term investments. A single industry exchange fund limits diversification. In some types of ETFs, there’s a lack of liquidity, which hinders transactions. Yields from ETFs may not be as high as owning a high-yielding stock. This type of fund tracks a broad market, so the overall yield tends to be lower. Leveraged ETFs need to be carefully monitored if held for a long period of time as a loss could multiply quickly.

Index ETFs can cover U.S. and foreign markets, specific sectors, or different asset classes. Each asset incorporates a passive investment strategy, meaning the provider only changes the asset allocation when changes occur in the underlying index. Exchange-traded funds can contain all types of investments, including stocks, commodities, bonds, and U.S. holdings as well as international. These unique funds have become popular especially among new investors, with trillions of dollars invested in index exchange-traded funds worldwide.