Exchange-traded funds (ETFs) were launched in 1993 with the first U.S. fund, Standard & Poor's Depositary Receipts, better known as spiders (SPDRs). This first ETF tracked the S&P 500 and its popularity with investors led to the introduction of ETFs based on other indexes, such as the Dow Jones Industrial Average and the Nasdaq 100.
Key Takeaways
- Exchange-traded funds (ETFs) were launched in 1993.
- Investing in ETFs can be a low-cost strategy to build an optimal portfolio.
- Several tools help investors find the right ETFs based on cost, asset class, or index.
Investing in ETFs
As of Nov. 2023, over 3,000 ETFs were listed on U.S. exchanges with combined assets exceeding $7.6 trillion. ETFs range from traditional index ETFs based on U.S. and international equity indexes and subindexes, and others that track benchmark indices in bonds, commodities, and futures.
There are ETFs based on investing style and those that focus on market capitalization. Leveraged ETFs provide returns or losses based on the underlying index's movements, as well as inverse ETFs that rise when the market falls and vice-versa.
Investors can narrow their choices using an asset screener typically available on brokerage trading platforms for free or through subscription-based services.
ETF Examples
Funds that track the S&P 500 index include SPDR (SPY), Vanguard S&P 500 ETF, or iShares S&P 500 ETF. Some ETF issuers have developed products with a specific focus. The Range Cancer Therapeutics ETF (CNCR) tracks the Range Cancer Therapeutics Index and invests in stocks that focus on the research and development of drugs and technology to fightcancer using immunotherapy.
ETFs based on new investment trends include the Robotics & Artificial Intelligence ETF (BOTZ) or the Drone Economy Strategy ETF (IFLY). The Obesity ETF invests in companies developing ways to fight obesity and related diseases.
In Jan. 2024, the Securities and Exchange Commission (SEC) approved eleven new spot bitcoin ETFs listed on the NYSE Arca, Cboe BZX, and Nasdaq exchanges.
How to Choose an ETF
Given the number of ETF choices that investors have, it's important to consider the following factors:
- Level of Assets: An ETF should have a minimum level of assets, with a common threshold being at least $10 million. An ETF with assets below this threshold is likely to have a limited degree of investor interest, which translates into poor liquidity and wide spreads.
- Trading Activity: Trading volume is an excellent indicator of liquidity, regardless of the asset class. Generally speaking, the higher the trading volume for an ETF, the more liquid it is likely to be and the tighter the bid-ask spread.
- Underlying Index or Asset: Consider the underlying index or asset class on which the ETF is based. From the point of view of diversification, it may be preferable to invest in an ETF that is based on a broad, widely followed index.
- Tracking Error: While most ETFs track their underlying indexes closely, some do not track them as closely as they should. An ETF with minimal tracking error is preferable to one with a greater degree of error.
- Market Position: The first ETF issuer for a particular sector often garners the lion's share of assets before others jump in. It is prudent to avoid ETFs that are imitations of an original idea.
When Do ETF Investors Pay Taxes?
When the ETF shares are sold and if the ETF was held in a taxable account, the investor will owe taxes on any capital gains.
What Is a Bid-Ask Spread?
A bid-ask spread is the difference between the highest price that a buyer is willing to pay for an asset and the lowest price that a seller is willing to accept.
What Happens During ETF Liquidation?
The ETF issuer will notify investors when the ETF will stop trading. The investor has to decide on the best course of action to protect the investment and determine whether to sell the ETF shares before the "stop trading" date or hold on to the ETF shares until liquidation.
The Bottom Line
When selecting an ETF, investors should consider factors such as its level of assets, trading volume, and underlying index. In the event that an ETF is to be liquidated, an investor has to decide whether to sell the ETF shares before it stops trading or wait until the liquidation process is completed, with due consideration given to the tax aspects of the ETF sale.
The comments, opinions, and analyses expressed herein are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or adopt any investment strategy. Though we believe the information provided herein is reliable, we do not warrant its accuracy or completeness. The views and strategies described in our content may not be suitable for all investors. Because market and economic conditions are subject to rapid change, all comments, opinions, and analyses contained within our content are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment, or strategy.
FAQs
If a fund has the right strategy and is well-run, you then decide if you can buy it. Trading costs can eat into your returns if you're not careful. The three things you want to look for are the fund's liquidity; its bid/ask spread; and its tendency to trade in line with its true net asset value.
How to know what ETF to choose? ›
Before purchasing an ETF there are five factors to take into account 1) performance of the ETF 2) the underlying index of the ETF 3) the ETF's structure 4) when and how to trade the ETF and 5) the total cost of the ETF.
How do you assess a good ETF? ›
The two ways to see how closely an ETF matches the index performance are 'tracking error' and 'tracking difference'. Tracking difference addresses how closely the ETF tracks the index returns, while tracking error reflects how consistent over time the tracking quality is.
How many ETFs should I own as a beginner? ›
The majority of individual investors should, however, seek to hold 5 to 10 ETFs that are diverse in terms of asset classes, regions, and other factors. Investors can diversify their investment portfolio across several industries and asset classes while maintaining simplicity by buying 5 to 10 ETFs.
What is the optimal number of ETFs? ›
How to build an optimally diversified portfolio? Experts agree that for most personal investors, a portfolio comprising 5 to 10 ETFs is perfect in terms of diversification.
How do ETFs work for dummies? ›
ETFs or "exchange-traded funds" are exactly as the name implies: funds that trade on exchanges, generally tracking a specific index. When you invest in an ETF, you get a bundle of assets you can buy and sell during market hours—potentially lowering your risk and exposure, while helping to diversify your portfolio.
What 3 ETFs should I invest in? ›
7 Best ETFs to Buy Now
| ETF | Assets under management | Expense ratio |
|---|
| Invesco S&P SmallCap Momentum ETF (XSMO) | $1.2 billion | 0.39% |
| iShares 20+ Year Treasury Bond ETF (TLT) | $57.5 billion | 0.15% |
| iShares Bitcoin Trust ETF (IBIT) | $21.7 billion | 0.12% |
| iShares Gold Trust (IAU) | $30.1 billion | 0.25% |
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Morningstar excels in its ability to provide a holistic analysis of ETFs. Investors can access detailed information on a fund's historical performance, risk metrics, and expense ratios.
How do I choose an S&P 500 ETF? ›
Other Factors in Choosing an S&P 500 Index ETF
The first is its liquidity. While S&P 500 ETFs would be considered very liquid by their nature, some might have more daily trading volume and tighter bid-ask spreads than others. A second consideration would be the index's tracking error.
What are the best indicators for ETFs? ›
Trading Activity: Trading volume is an excellent indicator of liquidity, regardless of the asset class. Generally speaking, the higher the trading volume for an ETF, the more liquid it is likely to be and the tighter the bid-ask spread.
A three-fund portfolio is an investment strategy that involves holding mutual funds or ETFs that invest in U.S. stocks, international stocks and bonds. The strategy is popular with followers of the late Vanguard founder John Bogle, who valued simplicity in investing and keeping investment costs low.
What is the 70 30 ETF strategy? ›
This investment strategy seeks total return through exposure to a diversified portfolio of primarily equity, and to a lesser extent, fixed income asset classes with a target allocation of 70% equities and 30% fixed income. Target allocations can vary +/-5%.
How do I choose my first ETF? ›
Ultimately, investors choosing an ETF need to ask 3 questions: What exposure does this ETF have? How well does the ETF deliver this exposure? And how efficiently can I access the ETF? Look at the ETF's underlying index (benchmark) to determine the exposure you're getting.
What is the 4% rule for ETF? ›
It's relatively simple: You add up all of your investments, and withdraw 4% of that total during your first year of retirement. In subsequent years, you adjust the dollar amount you withdraw to account for inflation.
How to pick a good ETF? ›
The key liquidity factors are:
- The underlying securities of the ETF - highly tradable are better.
- Fund size - larger tends to be better.
- Daily trading volume - more tends to be better.
- Market makers - more is better.
- Market conditions - liquidity can decline when the markets are very volatile.
Diversification: A well-diversified portfolio should include ETFs that cover different asset classes (stocks, bonds, commodities, etc.), sectors, industries, and geographical regions. This spreads risk and reduces the impact of any single investment on the overall performance.
How do I choose between ETF and index funds? ›
ETFs are generally better for frequent trading because you can buy and sell shares throughout the trading day. Index mutual funds only let you buy and sell at the very end of each trading day. ETFs also give you up-to-date information on the fund investment value throughout the trading day.
What order type should I use to buy ETFs? ›
Market orders are the simplest and represent the default order at most brokerages. It is simply an order to buy or sell an ETF at the best available price in the market at that moment. Pro: You can buy or sell as quickly as possible, because market orders prioritize speed of execution.
What's the best ETF to buy right now? ›
The best ETFs to buy now
| Exchange-traded fund (ticker) | Assets under management | Expenses |
|---|
| Vanguard Dividend Appreciation ETF (VIG) | $79.1 billion | 0.06% |
| Vanguard U.S. Quality Factor ETF (VFQY) | $344.1 million | 0.13% |
| SPDR Gold MiniShares (GLDM) | $7.8 billion | 0.10% |
| iShares 1-3 Year Treasury Bond ETF (SHY) | $24.2 billion | 0.15% |
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