Exchange-traded funds (ETFs) have become a common way to approach investment portfolio diversification. Yet with thousands of ETFs on the market today, how do you track the differences? Learn more about the types of ETFs available that can be used in an investment strategy.
What are ETFs?
An ETF is a fund, traded on an exchange, that holds a group of investments, such as stocks and bonds. This group of investments often follows an entire sector, theme, or market. By owning ETF shares, investors can diversify their portfolios without owning each of the individual stocks involved. Spreading investments across multiple stocks, industries or sectors aims to reduce portfolio risk. However, ETFs remain subject to market fluctuations and may decline if the market or sector in which they invest performs poorly.
Choosing an ETF
Choosing an ETF often depends on your financial goals and the level of risk you are willing to take. You can build your investment portfolio with active or passive ETFs.
Active ETFs aim to beat market indices to generate higher returns. Active ETFs have a fund manager who regularly monitors the performance of the ETFs. A fund manager actively changes investments within the portfolio to adapt to market fluctuations. Thus, a poorly performing stock can be replaced by one offering higher returns. Active ETFs can be riskier and charge higher fees because they require greater oversight from the fund manager.
Passive ETFs seek to match performance indices. Since the goal is to replicate performance, passive ETFs do not have fund managers. Passive ETFs generally cost less than active ETFs. However, a passive ETF follows the market and does not actively adapt to market conditions.
9 types of ETFs
A large number of ETF investments are traded on the market. Consider these common types of ETFs to narrow down investment choices for your portfolio.
1. Bond/Fixed Income ETFs
A fixed income ETF invests exclusively in assets that generate fixed income or dividends, such as bonds or preferred stocks. The mix ranges from corporate debt to traditional government bonds. Fixed income and bond ETFs may be less risky but offer lower returns. However, fixed income and bond ETFs are more likely to provide a steady income stream.
2. Commodity ETFs
With commodity ETFs, the fund invests in physical assets, such as precious metals or natural resources. You do not own the physical property; instead, the commodity ETF is a set of contracts backed by the commodity itself.
The value of commodity ETFs tends to move in the opposite direction to many other assets, such as stocks and bonds. When the value of stocks and bonds falls, the value of commodities may also rise. This negative correlation gives commodity ETFs the ability to diversify your portfolio.
3. Currency ETFs
A currency ETF gives you exposure to changes in exchange rates between currency pairs. Returns are generated based on comparing the price of one currency with another.
Currency ETFs make it easier to participate in the foreign exchange market. You can transact during the day. Additionally, you are not required to make individual transactions.
4. Stock ETFs
Stock ETFs hold a variety of stock investments. The collection of titles can be based on specific industries, sectors or themes. If you want to invest in technology but don’t like putting all your money in one company, a stock ETF holds shares in multiple technology entities. Or you may prefer a stock ETF that holds securities from different sectors. When you invest in stock ETFs rather than shares of a company, you can use the fund’s diversification to help manage the risk of loss.
5. Sector or sector ETFs
With an industry or sector ETF, your investment portfolio has exposure to an entire industry or sector. Sector or industry ETFs make investments based on a particular industry or sector. Stock collecting exposes your portfolio to an entire industry, not just one company. Common industry and sector ETFs may focus on sectors such as technology, healthcare and energy.
6. Inverse ETFs
Inverse ETFs are designed to benefit from price declines. With these short-term investments, the fund borrows and sells securities with the intention of buying them back at a lower price. Inverse ETFs can offer decent returns when the market falls. Nevertheless, you may need to spend a significant amount of time monitoring these investments and should only be used by sophisticated investors due to the risks involved in these products and should only be used by sophisticated investors due to the risks involved in these products.
7. Leveraged ETF
A leveraged ETF uses debt securities and financial derivatives, like options and futures, to increase returns relative to a specific index. The leveraged ETF uses debt to buy stocks that are performing well, increasing its profits. As such, leveraged ETFs have the potential to generate significant investment returns.
Likewise, they can lead to significant losses. Leveraged ETFs are intended for sophisticated investors who are aware of the risks and have a very short investment time frame.
8. Real estate ETFs
Real estate ETFs offer an inexpensive way to invest in the real estate sector. Real estate ETFs invest in securities and trusts that manage real estate properties. Investing in real estate without buying a property is an attractive advantage for some.
9. Specialized ETFs
Specialized ETFs generally track the performance of an index of stocks or bonds issued by companies with socially responsible characteristics. These companies may focus on environmental, social or governance characteristics. Specialty ETFs offer the opportunity to invest money in companies focused on financial returns and social causes.
How to invest in ETFs
Here are five steps to learning how to invest in ETFs:
- Determine your financial goals and risk tolerance
- Investing in research ETFs ·
- Open a brokerage or investment account
- Buy ETFs
- Rebalance your portfolio’s ETF positions over time
ETFs, mutual funds and stocks
Diversifying your portfolio helps mitigate investment risk. A combination of ETFs, mutual funds and stocks helps diversify your holdings.
Mutual funds and ETFs share many similarities. Both investment options hold a portfolio of securities and have stock prices. A key difference between the two is how they are purchased. You can trade an ETF on a stock exchange at any time, whereas a mutual fund can only be sold at specific times.
Like stocks, ETFs trade on stock exchanges. ETF prices vary because they can be bought and sold throughout the day. However, when you buy stocks, you are investing in a single company. ETFs invest in shares of different companies to help spread investment risk.
Things to remember before investing
You always face risks when you invest your money. Although ETFs generally offer a low-risk, low-cost way to diversify your portfolio, you could still lose money in the market.
Choose the right ETF for your portfolio
Adding an ETF to your portfolio can be an effective way to generate returns and diversify your investments. The right ETF should match your financial goals and investment strategy.
Frequently asked questions
Your financial preferences and personal goals help determine which type of ETF is best for you. A fixed income ETF provides a source of monthly income. Instead of buying gold, you can invest in a commodity-based ETF. You can also choose an ETF with investments in multiple sectors to expand your portfolio.
Whether an ETF pays dividends depends on its investments. If the assets held by the ETF pay dividends, the payments are distributed to the ETF’s shareholders.
The type of ETF to buy when you’re new to investing is one that fits your financial goals. It helps to research ETFs thoroughly and choose one that fits your trading style.