d3sign / Getty Images One popular ETF is the Vanguard S&P 500 ETF (VOO), which invests in the stocks of the 500 companies listed on the S&P 500 index. The ETF is a passively managed fund, meaning that there is no active trading in and out of stocks. Instead, the VOO mirrors the S&P 500 by owning all of its holdings at the same percentage weighting as the index. For instance, the financial sector made up 11.50% of the S&P 500, and so too did it make up 11.50% of the VOO ETF, as of February 2022. Other examples of ETFs include the following:
Schwab U.S. Large-Cap ETF (SCHX)Global X Robotics & Artificial Intelligence ETF (BOTZ)iShares Global Clean Energy ETF (ICLN)
How ETFs Work
Buying and selling ETFs can be as easy as buying a stock and can be done through a brokerage account during normal trading hours. When placing an ETF trade, you’ll have to choose a certain number of shares to buy or sell, just like with a stock. For example, if you want to buy $1,000 of a particular ETF and it trades at $100 per share, you’ll need to place a buy order for 10 shares, using the ETF’s ticker symbol. While ETFs trade on an exchange like stocks, they have a unique process of share creation and redemption. A third party, known as authorized participants (APs), handles the buying and selling of the ETF’s underlying securities, generally in large chunks of shares known as creation units. That way, the ETF doesn’t absorb those trading costs, and the price of the fund stays closely tied to that of the underlying index, regardless of supply and demand.
Pros and Cons of ETFs
ETFs can be smart investment tools for all types of investors. However, they might not be ideal for everyone. Before investing in ETFs, it’s wise to know the pros and cons.
Pros Explained
Diversification: Investors can gain access to dozens, or even hundreds, of stocks or bonds in one ETF. Holding multiple investment securities in one fund reduces volatility, compared to buying just one or a few individual securities. Low cost: Most ETFs are passively managed, so there is no need for costly research or analysis, which reduces management costs. ETFs’ expense ratios, on average, are significantly lower than those of mutual funds. Many ETFs have expenses below 0.25% ($25 for every $10,000 invested). By contrast, the expense ratio for the average mutual fund is about 0.76%. Tax efficiency: Actively managed mutual funds trade their holdings, which creates capital gains distribution that is often taxable to the shareholder. While ETF gains are also taxable, their structure generally makes them more tax-efficient than mutual funds. Market orders: Since ETFs trade throughout the day on exchanges, an investor can place market orders, such as stop-loss orders and limit orders.
Cons Explained
Trading costs can add up: ETFs sometimes generate a small trading commission every time an investor buys or sells shares. Although the commission fees are low, they add up quickly if you’re making frequent trades. May be too narrowly focused: Many ETFs track a particular sector benchmark or similar niche area of the market, such as technology. Those types of ETFs tend to have wider swings in price than a broader market index, such as the S&P 500. Temptation to trade: The ability to buy and sell quickly can make it tempting to dabble in market-timing, which can be more harmful than good. It causes people to speculate on price changes instead of investing for the longer term.
