What are ETFs? An exchange-traded fund, or ETF, is an investment vehicle that tracks a basket of related assets, such as stocks and bonds. Unlike a typical mutual fund, which must be purchased directly from the issuing company or through your broker, ETFs trade on stock exchanges just like individual stocks.

What Are ETFs

ETFs are a type of investment that allows you to invest in multiple companies at once through one transaction. The acronym stands for the exchange-traded fund, and it's bought and sold on an exchange just like stocks.

There are many different ETFs available, but they all work the same way. An index is used as a benchmark for the performance of the ETF. For example, if you want exposure to the S&P 500 index, you can buy an ETF that tracks it. You can also use other benchmarks such as Dow Jones Industrial Average or Nasdaq Composite Indexes.

The value of an ETF is represented by its net asset value (NAV). NAV is calculated by considering all assets held by the fund minus any outstanding liabilities against those assets and dividing that number by the number of outstanding shares. Price of an ETF may differ from its NAV based on supply and demand.

Types of ETFs

The ETF market is growing rapidly, with new products added almost daily. There are now more than 2,000 ETFs listed in the U.S., with more being created every day.

ETFs come in all shapes and sizes, from broad-market indexes to niche sectors and strategies.

Here are some of the most common types of ETFs:

Index Funds: These funds track a specific index such as the S&P 500 or the Russell 2000, which mimic the performance of their underlying benchmarks. They can be bought or sold throughout the trading day like individual stocks.

Strategic Beta: Strategic beta funds use alternative weighting schemes to enhance returns and diversify risk beyond traditional market-cap weighting. For example, a fund might overweight small-cap stocks or underweight specific sectors like energy or utilities. Strategic beta funds may also use other factors such as momentum investing or relative value to determine weights instead of market cap alone.

Exchange-Traded Notes (ETNs): ETNs are debt securities issued by banks that track a benchmark but trade like stocks on an exchange. Unlike ETFs, they aren't required to replicate the holdings of the benchmark they track; instead, they're subject to credit risks.

How To Select an ETF

The first decision you need to make is whether you want to invest in a passive or an active ETF. Once you've made that decision, it's time to learn how to select the right ETF for your investment goals.

Passive vs. Active ETFs

Passive ETFs track indexes like the S&P 500 Index or the Dow Jones Industrial Average (DJIA). The goal of these funds is to match the performance of their benchmark as closely as possible, which means they don't make any adjustments based on market conditions or other factors. Passive index funds are top-rated because they offer investors the opportunity to get exposure to various assets at a low cost with minimal risk.

On the other hand, active ETFs use professional traders and investment managers who try to beat their benchmark by making trades based on their market analysis. Active funds carry more risk due to their active management strategies.

Tax Considerations for ETFs

ETFs are often more tax-efficient compared to their mutual fund rivals. When an investor wants to redeem shares, they can sell it to another investor on the exchange. In contrast, a mutual funds has to sell securities to raise cash for the redemption. Even when the redemption happens directly through the ETF, the fund still doesn’t have to sell securities and can do an in-kin transaction with the investor, so it does not create a taxable event.

Income from ETFs are taxable just like the income from the underlying securities in the fund. Also selling an ETF creates a taxable event and the rate at which it is taxed, long-term capital gains or ordinary income rate, depends on how long the ETF was held.

There are many reasons to consider buying an ETF, but most boil down to making it easier to afford to invest in the stock market. Whether you're a beginner investor looking for a new way to participate in the market or a more experienced investor looking for alternative options, there is a lot to learn about ETFs.