Definition
An exchange-traded fund pools a group of securities into a fund and can be traded like an individual stock on an exchange.
Like individual stocks, exchange-traded funds (ETFs) are investment vehicles that hold a range of underlying assets and are traded on stock exchanges. ETFs are made to replicate the performance of various assets, including stock indexes, commodities, and particular investment strategies. They are used for a number of things, such as risk management, speculation, portfolio diversification, and income generation. ETFs come in a variety of forms to accommodate various investment objectives. The SPDR S&P 500 ETF (SPY), which mimics the S&P 500 Index, was the first exchange-traded fund (ETF) to be introduced in the United States.¹
     KEY:-
- An exchange-traded fund is a basket of securities that trades on an exchange just like a stock.
- ETF share prices fluctuate throughout the trading day unlike mutual funds, which only trade once a day after the market closes.
- ETFs offer low expense ratios and fewer brokerage commissions than buying stocks individually.
How ETFs Work
The Securities and Exchange Commission (SEC) requires an ETF to be formally registered. The majority of ETFs in the United States function as open-ended funds and adhere to the Investment Company Act of 1940, though some of their legal requirements may have been modified by more recent regulations. There is no cap on the total number of investors that can participate in open-ended funds.
The Vanguard Consumer Staples ETF (VDC) has a $1 minimum investment requirement and tracks the MSCI US Investable Market Consumer Staples 25/50 Index. It comprises all 104 of the index’s listed businesses, many of which are well-known names in the consumer goods industry. Procter & Gamble, Costco, Coca-Cola, Walmart, and PepsiCo are among the companies in VDC’s portfolio.
Ownership doesn’t change hands directly because investors are purchasing shares of the ETF, which in turn holds the actual shares of the companies. Unlike mutual funds, ETF share prices fluctuate throughout the trading day. Mutual funds, by contrast, are priced only once daily after the market closes.
    Important:-
  Volatility is limited with an ETF because its holdings are diversified. Industry ETFs are also used to rotate in and out of sectors during economic cycles.
Types of ETFs
- Passive ETFs: These funds are designed to mirror the performance of a specific index—either a broad-based index like the S&P 500 or a more niche market segment. They aim to provide investors with exposure to the market’s overall movement without active management.
- Actively Managed ETFs: Rather than following an index, these ETFs rely on fund managers to make real-time decisions about which assets to buy or sell. While they often have higher fees, they can offer more flexible investment strategies and potentially higher returns than passive ETFs.
- Bond ETFs: Created to offer consistent income, bond ETFs invest in fixed-income assets such as government, corporate, or municipal bonds. These ETFs trade like stocks and do not have a maturity date, unlike the bonds they hold, making them a liquid alternative for income-focused investors.
- Industry or Sector ETFs: These ETFs focus on specific sectors such as healthcare, technology, or energy. By holding a basket of stocks from a single industry, they offer diversified exposure within that space. For instance, iShares U.S. Technology ETF (IYW) tracks the Russell 1000 Technology RIC 22.5/45 Capped Index.
- Commodity ETFs: Designed to invest in physical commodities like oil or gold, these ETFs allow investors to gain exposure to commodity price movements without owning the asset. They are cost-effective tools for diversifying portfolios and managing risk in volatile markets.
- Currency ETFs: These ETFs follow currency pairs and are often used for speculation or hedging purposes. Investors, importers, and exporters use them to manage risk from currency fluctuations driven by global economic or political changes.
- Bitcoin ETFs: In 2024, the SEC approved spot Bitcoin ETFs, which give investors direct exposure to bitcoin’s price within traditional brokerage accounts. Earlier, in 2021, Bitcoin futures ETFs launched, tracking futures contracts traded on the Chicago Mercantile Exchange.
- Ethereum ETFs: Spot Ethereum ETFs offer exposure to ether, Ethereum’s native cryptocurrency, without requiring direct ownership. As of May 2024, the SEC authorized several U.S. exchanges like Nasdaq and NYSE to list them. Nine such ETFs were approved for trading in July 2024.
- Inverse ETFs: These ETFs aim to profit when stock prices fall. They use derivatives to move opposite to the underlying index’s performance. Most inverse ETFs are structured as exchange-traded notes (ETNs), which are debt instruments backed by issuers such as banks.
- Leveraged ETFs: Aimed at amplifying returns, leveraged ETFs attempt to deliver 2× or 3× the return of a target index. For example, if the S&P 500 gains 1%, a 2× leveraged ETF would rise 2%. They use derivatives and borrowing to magnify gains and losses alike.
Pros and Cons of ETFs
Exposure to many stocks across various industries
Low expense ratios and commissions
Risk management through diversification
Can focus on targeted industries or commodities
Actively managed ETFs have higher fees
Single-industry-focused ETFs limit diversification
Lack of liquidity hinders transactions
How to Invest in ETFs
ETFs can be bought through online platforms or traditional brokerage firms. Numerous reliable sources offer lists of vetted brokers specializing in ETFs. Investors also have the option to purchase ETFs within their retirement portfolios. Another modern choice includes robo-advisors such as Betterment or Wealthfront, which automate investing.
The expense ratio of an ETF reflects the annual cost of managing the fund. ETFs usually feature lower expense ratios since they passively follow a market index, reducing operational costs.
Most online investing platforms, retirement account websites, and apps like Robinhood support ETFs. These platforms generally offer commission-free trades, allowing investors to buy or sell ETFs without extra transaction charges.
Once a brokerage account is opened and funded, users can easily search and trade ETFs. A practical method to filter ETF choices is by using a screening tool, applying filters like volume, expense ratio, historical returns, portfolio holdings, and associated fees.
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Popular ETFs
ETFs are popular investment tools. Some offer broad exposure by tracking major stock indexes, while others focus on specific sectors or themes.
SPDR S&P 500 (SPY): The first and most recognized ETF, it mirrors the performance of the S&P 500.
iShares Russell 2000 (IWM): Tracks small-cap U.S. stocks in the Russell 2000 index.
Invesco QQQ (QQQ): Often called “cubes,” it follows the tech-heavy Nasdaq 100.
SPDR Dow Jones Industrial Average (DIA): Called “diamonds,” it tracks the 30 stocks in the Dow Jones.
Sector ETFs: Cover industries like oil (OIH), energy (XLE), finance (XLF), REITs (IYR), and biotech (BBH).
Commodity ETFs: Track assets like gold (GLD), silver (SLV), oil (USO), and gas (UNG).
Country ETFs: Track global markets like China (MCHI), Brazil (EWZ), Japan (EWJ), Israel (EIS), and broader regions like emerging (EEM) or developed (EFA) economies.
ETFs vs. Mutual Funds vs. Stocks
Most stocks, exchange-traded funds (ETFs), and mutual funds can be bought and sold without paying any commissions. However, while stocks generally have no ongoing charges, ETFs and mutual funds may involve management fees—though these costs have been steadily decreasing. Notably, ETFs usually charge lower fees compared to mutual funds.
| Type | Exchange-Traded Funds (ETFs) | Mutual Funds | Stocks |
|---|---|---|---|
| Definition | Track a collection of assets like securities or commodities | Pool investor funds to invest in securities and bonds | Represent ownership in a specific listed company |
| Pricing | Can trade above or below the fund’s net asset value (NAV) | Always trade at NAV at market close | Reflect the company’s actual stock market value |
| Trading Method | Bought/sold throughout the day like stocks | Traded only once daily after the market closes | Traded during standard market hours |
| Fees | Generally low-cost, often commission-free | May charge management and load fees; costlier than ETFs | Often commission-free; no ongoing charges |
| Security Ownership | Retail investors don’t directly own the underlying assets | Fund holds actual securities | Investors directly own the company’s stock |
| Risk Profile | Provides diversification across sectors and assets | Also offers diversification across multiple instruments | Risk is tied to one company unless diversified |
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Dividends and Taxes
Investors can profit from businesses that pay dividends by purchasing exchange-traded funds (ETFs). A portion of a business’s profits that are distributed to investors is known as a dividend. Investors who own ETFs are entitled to dividend payments or interest income, and they may also profit from any money left over in the event that the ETF is closed or liquidated.
In general, ETFs outperform mutual funds in terms of tax efficiency. This is due to the fact that the majority of ETF transactions occur on an exchange, which means that the fund provider does not have to redeem shares whenever an investor wishes to sell.
The creation and redemption process is how an Exchange-Traded Fund (ETF) manages the quantity of shares that are available. Authorized Participants (APs) are big, specialized investors who handle this process. The AP buys the underlying stocks in the index the ETF tracks, like the S&P 500, and transfers them to the ETF when an ETF provider chooses to issue additional shares. Newly created ETF shares of equal value are given to the AP in exchange, and these shares are subsequently sold on the open market to generate profit.
A creation unit is the collection of shares used in this transaction. For instance, the ETF is considered to be trading at a premium if its closing share price is $101 but the net asset value (NAV) of the stocks it owns is $100 per share. The total value of all the assets in the ETF is reflected in the NAV.
In exchange for individual stock shares, APs also purchase ETF shares from the market and give them back to the ETF provider. The number of ETF shares in circulation is decreased by this procedure, known as redemption. Market demand and whether the ETF is trading at a premium or discount to its NAV determine creation and redemption activity.
ETFs in the United Kingdom
One of the largest and most diverse ETF markets in Europe is the UK market. A variety of asset classes, including stocks, bonds, commodities, currencies, real estate, and alternative investments, are accessible through exchange-traded funds (ETFs) that are listed on the London Stock Exchange (LSE).
One benefit of buying ETFs in the UK is that they are held in Individual Savings Accounts (ISAs). Individuals can invest up to £20,000 a year in these tax-efficient investment vehicles without having to pay income or capital gains tax on their profits. Another benefit is that ETFs are not subject to stamp duty, which is a tax that is normally imposed on ordinary share transactions in the UK.
hile UK investors can purchase shares of U.S.-listed companies, they are restricted from buying U.S.-listed ETFs due to regulatory limitations. However, many UK ETFs mirror U.S. markets by being labeled as UCITS (Undertakings for the Collective Investment in Transferable Securities). These funds are fully regulated in the UK and authorized to follow U.S. investment benchmarks.
Several ETFs track the FTSE 100 index, offering broad exposure to top UK equities. This index includes the country’s 100 largest publicly traded companies. A notable example is the HSBC FTSE 100 UCITS ETF, trading under the ticker HUKX on the London Stock Exchange. As of April 2025, it features a low ongoing charge of 0.07% and delivers a dividend yield of 3.56%.
FAQs
What Was the First Exchange-Traded Fund?
The distinction of being the first exchange-traded fund is often given to the SPDR S&P 500 ETF (SPY) launched by State Street Global Advisors on Jan. 22, 1993.1 There were, however, some precursors to SPY, including Index Participation Units listed on the Toronto Stock Exchange (TSX), which tracked the Toronto 35 Index and appeared in 1990.
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