What Is a Stock Exchange-Traded Fund (ETF)?

The term stock exchange-traded fund (ETF) refers to a security that tracks a particular set of equities. These ETFs trade on exchanges the same way normal stocks do and track equities just like an index. They can track stocks in a single industry or an entire index of equities. Investors who purchase shares of stock exchange ETF can gain exposure to a basket of equities and limited company-specific risk associated with single stocks, providing them with a cost-effective way to diversify their portfolios.

Key Takeaways

  • A stock exchange-traded fund tracks a set of stocks.
  • These ETFs provide investors with immediate diversification within a low cost, easily tradable vehicle.
  • Research suggests that passive-investment vehicles like ETFs tend to return more than actively-managed vehicles like mutual funds over the long run.
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4 Reasons To Invest In ETFs

Understanding Stock Exchange-Traded Funds (ETFs)

An exchange-traded fund is an asset that allows investors to track any number of things, such as indexes, commodities, sectors, or even stocks. Investors can purchase shares in these securities, which trade on stock exchanges. Prices change regularly through the course of a trading day, just like stocks. They are generally considered a more cost-effective and more liquid investment compared to mutual funds. 

As mentioned above, ETFs can also track stocks. These are called stock exchange-traded funds. These securities allow investors to gain exposure to a basket of equities in a specific sector or index without purchasing individual stocks. For instance, these ETFs can track stocks in the energy sector or an entire index of equities like the S&P 500. Other tracking methods include the Stochastic Oscillator and the Stochastic Momentum Index.

There is also a group of ETFs that bet against the success of an index or sector, meaning the asset performs well when the underlying asset struggles. Unlike a mutual fund, a stock ETF charges minimal management fees and carries low expense ratios. This makes it an ideal tool for investors of any skill level looking to maintain low costs and generate consistent returns

The original purpose of investing in ETFs was to meet long-term goals, but they can be traded like any other stock in that investors can short or buy on margin.

Since they give investors access to a broad range of equities or indexes makes these (and others), stock ETFs are generally considered very diversified assets. This instant diversification limits some of the unsystematic risk associated with company stocks and comes in a simple, low-cost, and tax-efficient tool that can be accessed through most online brokerages.

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The number of ETFs that are trading in the United States, as of 2020, giving investors a huge number of potential funds to choose from.

Benefits of Stock Exchange-Traded Funds (ETFs)

Stock ETFs offer investors a wealth of benefits so it makes sense that fund inflows have increased. In fact, as of Nov. 2020, the ETF market in the United States topped a record $5 trillion in assets.

The broad advantages cannot go understated. They are an excellent option for investors who want to diversify their portfolio in a flexible, low cost, and tax-efficient manner. In fact, a growing body of research suggests passive investments like stock ETFs tend to outperform actively managed funds over a long time frame.

Types of Stock Exchange-Traded Funds (ETFs)

The more popular stock ETFs track benchmark indexes like the S&P 500 or Dow 30. For instance, the SPDR S&P 500 (SPY) is consistently the most active asset with an average daily volume exceeding 85 million shares in the three months preceding Feb. 28, 2021. 

Other styles of stock ETFs adopt a factor-based strategy that accounts for specific attributes like market capitalization, momentum, and value. This subset is a popular strategy known as Smart Beta, which attempts to deliver better risk-adjusted returns than a conventional market capitalization-weighted index.

Sector funds are another popular ETF category that tracks the stocks of a specific industry like energy, financials, and technology.