The different types of ETFs

What are ETFs and their benefits?

Exchange Traded Funds (ETFs) are a popular diversification method that was first introduced in 1993. An ETF is a basket of open-funded pooled securities traded on stock exchanges managed by brokerage firms.  An ETF tracks commodities, indices, other assets, or even specific investment strategies. One ETF can be compromised of stocks from one industry or from several ones. Moreover, most ETFs are index funds in which they hold the same securities in the same proportions as a specific stock or bond market index. In 2021, the total amount of cash invested in ETFs totaled $9.94 trillion.  

Like any other investment, ETFs have pros and cons. Unlike mutual funds, they can be traded intraday, and they are also cost-effective in that they are provided at lower commission and expense ratios and are tax-efficient. In addition, they are more liquid than mutual funds. They are also transparent, as the investor knows exactly what securities are included in the ETF. Also, they are less risky as a means of portfolio diversification, and market orders can be executed. On the other hand, one con is that ETF settlement is T+2, which means it takes 2 days after the trade to settle it to cash, while mutual settlement is T+1. 

Types of ETFs

ETFs can either be managed actively or passively. When first developed, passive ETFs refer to those that mimic the performance of a broader index, and their price changes vis a vis the index. Examples of passive ETFs are SPDR S&P (SPY), and Invesco QQQ (QQQ). 

However, the performance of an active ETF, firstly introduced by Bear Stearns in 2008, depends on the portfolio manager who decides upon which securities to add to the ETF to seize profitability from short-term investment. There are more than 500 actively managed ETFs in the US, accounting for around $193 billion in assets. Some examples include First Trust North American Energy Infrastructure ETF (EMLP), ARK Innovation ETF (ARKK), and SPDR Blackstone Senior Loan ETF (SRLN). Most ETFs are passively managed. 

There are different types of ETFs, including synthetic and physical ETFs, Smart Beta ETFs, fixed income (also known as bonds), stocks and sectors, commodities and currencies, and specialty ETFs including inverse and leveraged ETFs.  

The physical ETFs hold the physical underlying funds of the index, while the synthetics use financial derivatives in an attempt to replicate the returns of the selected index. 

Smart Beta ETFs choose predetermined specific financial metrics to choose the securities of the fund from a specific index. They are both active and passive ETFs. Stocks in a Smart Beta ETF can be of different weights, meaning it might include more than one share of a stock, and only one of another based on different metrics; such as value or earnings growth, the stock's momentum, dividends, etc. There are different types of smart beta ETFs such as equally weighted which factors are equally weighted, fundamentally weighted considering factors such as growth and profitability, factor-based including certain criteria such as small growing companies, underpriced valuations, and low volatility focusing on stocks that have low price fluctuations over the years. An example of a Smart Beta ETF is The Vanguard Dividend Appreciation Index Fund ETF Shares (VIG). 

Bond ETFs depend on the performance of underlying bonds; they include municipal, government, and corporate bonds; they do not have a maturity date, and they trade at a premium or discount from the bond's face value. Examples of bond ETFs are the Vanguard Long-Term Bond ETF (BLV), and SPDR Barclays High Yield Bond ETF (JNK). 

Stock (Equity) ETFs, such as the Fidelity NASDAQ Composite Index Tracking Stock ETF (ONEQ), include a basket of stocks tracking a specific industry's performance including established and new entrant companies to ensure diversification, while the Sector ETFs include all of the stocks in a specific industry and mimic the performance of the industry. Examples of a Sector ETF are the Financial Select Sector (XLF) and the Energy Select Sector (XLE). There is also the real estate investment trust (REIT) ETFs in which an investor chooses to invest in a specific type of real estate. Investors are attracted to REIT ETFs because they pay attractive yields, and they pay about 90% of their taxable income to shareholders; they are good investments at times of low inflation and interest rates. 

The commodities ETFs are comprised of commodities such as gold and natural gas, and they are considered safe havens at times of turmoil. Examples of such ETFs are the GLD ETF and the GLTR ETF. While the currency ETF exposes investors to the FOREX in which it tracks the relative performance of a currency or a basket of currencies; such as the CurrencyShares Euro Trust (FXE), PowerShares DB US Dollar Index Bullish Fund (UUP), and UltraShort FTSE- Xinhua China 25 Proshare CFD (FXF). 

Finally, two types of specialty funds are the leveraged and the inverse ETFs. The leveraged ETFs seek to provide a multiple of the investment returns or losses of a certain index daily such as the Direxion Daily Energy Bull 2X Shares ETF (ERX). However, Inverse ETFs, also known as short or bearish ETFs, provide the opposite of the investment returns or losses; if the index falls 3%, the ETF rises by 3% and vice versa; such as the ProShares UltraShort Silver ETF(ZSL). Leveraged and inverse ETFs are not meant to be traded for the long term, as their strategies are reset after the market closes.  

What are the best types of ETFs?

The most appealing ETFs vary based on the investor's specific goals and strategies, whether the objective is to trade with a short-term time frame or invest in the long run. It can also depend on the investor's risk appetite. 

Therefore, the best type of ETF changes from one investor to another. However, it is important to consider several factors when dealing with ETFs, such as the cost, risk, benefits, investment strategies associated, the level of assets held by the ETF. Also, an investor should consider the trading volume, the underlying securities, the tracking error, and the market position of the ETF. 

What is the difference between an ETF and a mutual fund? 

Firstly, a mutual fund is an investment vehicle made of a pool of securities. Like the ETFs, there are different types of mutual funds; the open-ended funds with unlimited shares can be issued and the closed-end funds where there is no new issuance of shares as the fund grows. There are also money market funds, bond funds, stocks funds, target-date funds (also known as lifecycle funds) etc. An investor can earn money from a mutual fund by receiving interest on bonds or dividends on stocks if any, or from capital gains distributions, and from increased current net asset value (NAV) which is the market value of the portfolio.

Mutual Funds and ETFs might seem similar in some sense; however, there are significant differences between both; one of which is that ETFs are traded intraday, while mutual funds' orders are traded only once after the market closes, also mutually funds are mostly actively managed by fund managers, while ETFs are mostly passive and pegged to a certain index. Furthermore, ETFs do not have a minimum investment where an investor can buy it at the market price. Mutual funds meanwhile require a higher minimum initial investment that is normally a flat dollar amount and is not based on the fund's share price. For example, the Vanguard 500 Index Investor Fund requires a $3000 minimum investment. An investor can also set up an automatic deposits and withdrawals in and out of a mutual fund. However, this is not available for ETFs. Finally, ETFs generate fewer capital gains compared to mutual funds, hence, they are more tax efficient.  

How can so many ETFs tracking the same index coexist?

Sheer Breadth of ETFs can track the same index showing different share prices. Therefore, there are different factors to compare similar ETFs such as cost, risk, liquidity issues in the underlying index, management actions, and performance. Some ETFs are traded more than the others and hence the market price differs.

In conclusion, ETFs are investment vehicles that act as a basket of different securities that track an underlying asset or index. Like everything else, they have both pros and cons. Therefore, an investor should consider carefully which type to invest in according to his own personal preferences and investment strategies to avoid high risk.