Exchange-traded funds (ETFs) have become a common way to approach diversification in investment portfolios. Yet, with thousands of ETFs on the market today, how do you keep track of the differences? Learn more about the types of ETFs available that can be used in an investment strategy.
- What Are ETFs?
- Choosing an ETF
- 9 Types of ETFs
- See All 17 Items
What Are ETFs?
An ETF is a fund, tradeable on an exchange, that holds a group of investments, such as stocks and bonds. This group of investments often tracks a sector, theme or entire market. By owning ETF shares, investors can diversify their portfolios without holding each of the relevant individual stocks. Spreading investments over multiple stocks, industries or sectors aims to reduce portfolio risk. However, ETFs are still subject to market fluctuations and can decline if the market or sector invested in performs poorly.
Choosing an ETF
Choosing an ETF often depends on your financial goals and how much risk you are willing to take. You can build your investment portfolio with active or passive ETFs.
Active ETFs focus on beating market indexes to generate higher returns. Active ETFs have a fund manager who regularly monitors ETF performance. A fund manager actively changes investments within the portfolio to adapt to market fluctuations. So, a low-performing stock may be swapped out for stock providing higher returns. Active ETFs can be riskier and charge higher fees as they require more oversight from the fund manager.
Passive ETFs seek to match the performance indexes. Since the goal is to replicate the performance, passive ETFs don't have fund managers. Passive ETFs generally cost less than active ETFs. However, a passive ETF tracks the market and does not actively adapt to market conditions.
9 Types of ETFs
A vast number of ETF investments trade 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 exclusively invests in assets that generate fixed income or dividends, such as bonds or preferred shares. The mix ranges from corporate debt to traditional government bonds. Fixed-income and bond ETFs can be less risky but provide lower returns. However, fixed income and bond ETFs are more likely to provide a regular 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 asset; 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 of many other assets, such as stocks and bonds. When stock and bond values drop, commodities can also increase in value. This negative correlation gives commodity ETFs the ability to diversify your portfolio.
3. Currency ETFs
A currency ETF gives you exposure to changes in foreign exchange rates between currency pairs. Returns are generated based on how the price of one currency compares with another.
Currency ETFs make it easy to participate in the foreign exchange market. You can make trades during the day. Plus, you don’t have to place individual trades.
4. Equity ETFs
Equity ETFs hold a variety of stock investments. The collection of securities may 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, an equity ETF holds shares in multiple technology entities. Or you may prefer an equity ETF that holds securities across different industries. When you invest in equity ETFs as opposed to shares of stock in a company, you can use the diversification of the fund to help manage the risk of loss.
5. Industry or Sector ETFs
Through an industry or sector ETF, your investment portfolio gains exposure to an entire industry or sector. Sector or industry ETFs make investments based on a particular industry or sector. The collection of securities exposes your portfolio to a whole industry, not just one company. Common industry and sector ETFs may focus on industries like technology, health care and energy.
6. Inverse ETFs
Inverse ETFs are designed to benefit from price drops. With these short-term investments, the fund borrows and sells securities with the intent to repurchase them at a lower price. Inverse ETFs can offer decent returns when the market falls. Still, you may need to devote a lot of time to monitoring these investments and should be utilized only by sophisticated investors due to risks involved in these products and should be utilized only by sophisticated investors due to the risks involved in these products..
7. Leveraged ETFs
A leveraged ETF uses debt and financial derivatives, like options and futures contracts, to increase returns over a specific index. The leveraged ETF uses debt to buy shares that are performing well, which increases its earnings. As such, leveraged ETFs have the potential for significant returns on your investment.
Similarly, they have the potential for large losses. Leveraged ETFs are intended for sophisticated investors who are aware of the risks and have a very short investment timeline.
8. Real Estate ETFs
Real estate ETFs offer a low-cost way to invest in the real estate industry. Real estate ETFs invest in securities and trusts that manage real estate properties. Investing in real estate without buying property is an attractive benefit for some.
9. Specialty ETFs
Specialty ETFs typically 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 features. Specialty ETFs provide the opportunity to invest money in companies focused on financial returns and social causes.
How to Invest in ETFs
Here are five steps to learn how to invest in ETFs:
- Determine your financial goals and tolerance for risk
- Research ETF investments·
- Open a brokerage or investment account
- Purchase ETFs
- Rebalance ETF positions in your portfolio over time
ETFs vs. Mutual Funds vs. Stocks
Diversifying your portfolio helps mitigate investment risk. A mix 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 share prices. A critical difference between the two lies in how they are purchased. You can trade an ETF on the exchange at any time, whereas a mutual fund may only be sold at specific times.
Like stocks, ETFs trade on the exchange. ETF prices vary as they can be bought and sold throughout the day. However, when you buy stock, you invest in only one company. ETFs invest in stocks from different companies to help spread investment risk.
Things to Remember Before Investing
You always face risk when you invest your money. While ETFs generally offer a low-risk, low-cost way to diversify your portfolio, you could still lose money in the market.
Pick 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 align with your financial goals and investment strategy.
Frequently Asked Questions
Which type of ETF is best?
Your financial preferences and personal objectives help determine which type of ETF is best for you. A fixed-income ETF offers a monthly source of income. Instead of buying gold, you can invest in a commodity-based ETF. Or you can choose an ETF with investments in multiple industries to expand your portfolio.
Do ETFs pay dividends?
Whether an ETF pays dividends depends on its investments. If the assets held by the ETF pay dividends, the payments are distributed to ETF shareholders.
Which type of ETF is best for beginners to buy?
The type of ETF to buy when you are a novice is an investment that aligns with your financial goals. It is helpful to thoroughly research ETFs and choose one that fits your trading style.
About Anna Yen
Anna Yen, CFA is an investment writer with over two decades of professional finance and writing experience in roles within JPMorgan and UBS derivatives, asset management, crypto, and Family Money Map. She specializes in writing about investment topics ranging from traditional asset classes and derivatives to alternatives like cryptocurrency and real estate. Her work has been published on sites like Quicken and the crypto exchange Bybit.