A variety of spices on a table

You’ve probably heard the old adage “variety is the spice of life.” But what about its lesser known counterpart, “variety is the spice of investing”?

Ok, we might’ve made that one up, but that doesn’t make it any less true. Holding a mix of investments in your portfolio (a.k.a. diversification) is not only the spice, but the key ingredient in the recipe for a strong investment strategy.

The thing is, purchasing multiple individual spices — or stocks, bonds, and other securities — can be more time consuming when you’re aiming to create a perfectly diversified portfolio. Fortunately, there’s a way to achieve a blend of spicy, sweet, and smoky investments through one single allspice purchase: exchange-traded funds.

Read on or select a section to learn about ETF basics.

  1. What are exchange-traded funds?
  2. A brief history of ETFs
  3. Differences between ETFs and mutual funds
  4. Who can buy ETFs?
  5. Types of ETFs
  6. Advantages of ETFs
  7. Disadvantages of ETFs
  8. How to evaluate an ETF
  9. How to get in on ETFs

What are exchange-traded funds?

Exchange-traded funds (ETFs) are funds that pool together the money of many investors to invest in a basket of securities that can include stocks, bonds, commodities, etc.

ETFs are typically passively managed, meaning instead of having a portfolio manager who uses their best judgment to select specific securities to buy and sell, they attempt to replicate the performance of a specific index. An ETF might do this by tracking a certain index (like the S&P 500) and holding a collection of securities from that index. Or it might track an industry (like technology) by investing in stocks from a range of companies within that sector.

At first glance, ETFs can look quite similar to mutual funds. The big difference between the two? How they’re priced and traded. ETFs are actually a lot like stocks. That’s because they’re traded on an exchange. Since they can be bought and sold throughout the day, their price may fluctuate more often. Mutual funds, on the other hand, are only priced once per day — after the market closes.

Keep in mind, while you can usually expect an ETF to perform similarly to the index it tracks, factors like supply and demand in the market may cause its price to vary from the values of its underlying securities.

ETFs can be a great investment for the home-chef level investor, but also the most experienced, Michelin-starred one. Not only do they inherently provide a level of diversification in a portfolio, they offer the chance to invest in a variety of stocks or other securities that may be too expensive to invest in individually. And since they’re most often (though not always) passively managed, ETFs usually have lower expense ratios or fees associated with their management.

If you’re interested in cooking up an ETF portfolio but want to learn more about the individual ingredients in these funds — like where they come from, how they work, and how they can benefit you — read on.

A brief history of ETFs

Before there were exchange-traded funds, there were mutual funds. Mutual funds follow the rules set by the Investment Act of 1940, which includes that they cannot actively be traded throughout the day. But when Congress passed these laws, it granted exemption powers to the Securities and Exchange Commission (SEC), which oversees all U.S. investment activity. Now, investment companies intending to offer ETFs must apply to the SEC in writing for the necessary exemptions.

In 1989, the Toronto Stock Exchange introduced Toronto Index Participation Units — the first ETFs to be traded on any exchange. A few years later in 1993, the American Stock Exchange entered the ETF game with its own: Standard and Poor’s Depositary Receipts (SPDRs, pronounced “spiders”). SPDRs track the performance of the Standard & Poor’s 500 index. Other major investment firms quickly followed suit, and today investors can trade hundreds of passive and active ETFs on the market.

Technical differences between ETFs and mutual funds

Though they have their similarities (and may contain the same securities), the recipes for an ETF and mutual fund are quite different — even those that track the same indexes.

Mutual funds essentially buy and sell securities for cash on the open market, but the process for how an ETF works is more complex.

An ETF is created when a large institutional investor (like a bank, broker, or other financial services firm) assembles large holdings of securities, like stocks or bonds, into a portfolio, which might then track a specific market index — for example, the Nasdaq 100.

That financial institution is known as an authorized participant (AP). It exchanges those securities with the exchange-traded fund’s manager, and in return, receives large blocks of shares, called creation units, from that ETF.

Each creation unit may include anywhere from 10,000–100,000 ETF shares. The AP may hold those creation units in its portfolio(s) or break them up and sell the ETF shares in smaller quantities to other investors — including individual investors, like you, who buy and sell on the open market as you might any other security.

A gif detailing how ETFs are created, as outlined in this section

The original basket of securities is held at a custodial bank for safekeeping and monitored by the ETF’s manager. When an authorized participant wants or needs the individual securities rather than the large ETF creation units, it simply assembles enough ETF shares to make up a creation unit. Then, it returns the creation unit to the ETF in exchange for the equivalent securities (based on the creation unit’s net asset value, or price per share), plus cash accumulated from dividends.

A gif on ETF redemption, as outlined in this section

Those individual securities can then once again be sold on the open market, or if they were borrowed by the AP, returned to individual owners who loaned them.

Creation units are constantly created and redeemed by an ETF, depending on supply and demand. The authorized participant’s decision about whether to hold creation units or the shares they represent may be determined by their relative values.

The AP may be able to profit by using an investment strategy called arbitrage, which is the process of purchasing a security in one market and simultaneously selling it in another for a higher cost. This takes advantage of any difference between the value of the creation unit and the collective value of the underlying securities.

However, due to competition, ETF prices often stay relatively close to the NAV (or net asset value) of the underlying securities.

The exchange of creation units for the securities that make up the ETF’s index involves no cash and is considered an in-kind trade, because securities are traded for securities. As a result, it doesn’t trigger any capital gains. This means the fund does not grow in worth from its purchase price.

Because the in-kind exchange of creation units for the underlying securities minimizes or eliminates internal capital gains for an ETF, you are protected from the tax implications of those large trades if you have a smaller portfolio.

This differs from a mutual fund. If you sell shares of a mutual fund, you may incur capital gains and will be responsible for the tax bill.

Who can buy ETFs?

When they were first introduced, ETFs were primarily made available to large investors. Today, any investor can add these funds to their portfolios, purchasing them through a broker, just as they would purchase stocks.

Ally Invest offers commission-free ETFs to self-directed traders and low-cost ETFs via its robo-advisor Managed Portfolio platform.

Types of ETFs

Like spices come in a range from sweet to hot to salty, the securities within ETFs span a wide variety of asset classes and industries — making them a great investment vehicle for portfolio diversification.

Here are a few of the most common types:A visual representation of the types of ETFs listed below

Stock ETF: Stock ETFs track a particular set of stocks. They can track these equities based on their index or industry. Because stocks are subject to market volatility, these can be a good option for long-term investors, since a longer investment horizon allows securities more time to recover should the market see a periodic downturn.

Bond ETF: Bonds ETFs may be attractive for investors interested in fixed income ETFs. This is because they pay regular interest dividends from corporate or government bonds. Bonds are typically a less risky investment.

Commodity ETF: These ETFs invest in commodities like precious metals, agricultural goods, or natural resources.

Sector or Industry ETF: These ETFs track particular industries, like biotech, health care, energy, etc.

Currency ETF: Currency ETFs trade foreign currencies and can provide investors exposure to the forex market.

Leveraged ETF: Leveraged ETFs aim to amplify returns, typically by 2 or 3 times more than that of a typical ETF tracking the same index. They’re most often used as a short-term investment strategy. While they can provide significant returns when the underlying index is on the rise, losses are also magnified — making them a higher-risk investment.

Inverse ETF: Also known as short ETFs or bear ETFs, inverse ETFs aim to deliver returns on the decline of the indexes they track. Meaning if the underlying index decreases by 1%, the inverse ETF increases by 1%. Like leveraged ETFs, they’re often a short-term investment and can result in significant losses should the market fluctuate.

Advantages of ETFs

You can enhance almost any portfolio by sprinkling ETFs into your investment strategy.

For most investors, the most attractive feature of ETFs is the diversification they offer to a portfolio. For example, if you’re interested in investing in technology, an ETF allows you to invest in hundreds of technology stocks at once (typically for a much lower cost), rather than investing in just a few individual companies. Typically, the more diversification across holdings in your portfolio, the more balanced your investments will remain, even during market volatility.

Another advantage ETFs offer over mutual funds is their liquidity. While traditional mutual funds are bought and sold at the close of business each trading day, investors can trade ETFs at any point throughout the day from market open to market close.

ETFs also often have lower expense ratios, or costs to manage and operate, than actively managed mutual funds. Because of the passive management and structure of ETFs, they may also have lower annual taxable distributions, too.

Unlike traditional mutual funds, but similar to stocks, ETFs can be sold short by investors. Short selling is the process of selling a share of a stock that is borrowed (for a fee) from a brokerage, rather than owned. You may short sell if you believe a stock will decline in value. If the value does go down, you make money — but if its value increases, you will lose money.

Because short selling has potential for unlimited losses, it’s important to remember it can be a risky investment move.

Disadvantages of ETFs

Being too heavy-handed with any spice may overwhelm a dish — just as too many of any single investment, including ETFs, usually isn’t great for your portfolio.

Investors must purchase ETFs through a broker and might have to pay a brokerage commission when buying shares of an ETF. We offer hundreds of commission-free ETFs with no minimum investment.

(If you are incurring trading costs, ETFs could be less suited to popular investment strategies like dollar cost averaging.)

While an ETF offers a less expensive way to diversify among many securities, one of the big risks of these funds is that an individual ETF tends to be made up of securities in a given asset class (like the same industry or commodity), which may share similar behavior.

For example, if you invest in a sector ETF that tracks the energy sector industry and it experiences a major market downturn, it’s likely that all the securities within the ETF will be negatively affected.

To create a broadly diversified portfolio, consider investing in different types of ETFs, across industries, as well as other types of investments. This will ensure you aren’t reliant on a single investment or industry’s success.

It’s also important to note that an ETF doesn’t necessarily trade at its NAV, and bid-ask spreads (or the difference between what buyers are willing to pay and what sellers are willing to accept) may be wide for thinly traded issues or in volatile markets.

How to evaluate an ETF

Like any investment, it’s important to do some research before you invest in ETFs. Consider these factors when evaluating an exchange-traded fund:

  • Its investment objectives, risks, charges and expenses, which are included in the prospectus available from the fund.
  • The index it tracks. Understand what the index consists of and what rules it follows in selecting and weighting the securities in it.
  • How long the fund and/or its underlying index have been in existence, and if possible, how both have performed in good times and bad.
  • The fund’s expense ratio. The more straightforward its investing strategy and the more widely traded the securities in its index are, the lower expenses are likely to be. For example, an actively managed ETF is likely to have higher expenses than one that simply replicates the S&P 500.
  • How the fund’s returns will be taxed. Depending on what it invests in and how the ETF is structured, returns may be taxed in a variety of ways. For example, an ETF that invests directly in gold bullion will be subject to the 28% maximum tax rate for collectibles. An ETF that uses futures contracts, as many commodity ETFs do, may distribute both long-term and short-term capital gains. A bond ETF pays interest, which is taxable as ordinary income.

Want in on ETFs?

ETF investing can be an essential component to add flavor and depth to a robust investment strategy.

If your investment palette is more mild, we offer a range of ETFs through our Managed Portfolios. Whether you’re interested in socially-responsible investing or are looking to reduce the amount of taxes you pay, your professionally managed portfolio will contain a mix of ETFs to help you reach your financial goals. And you can enhance your portfolio with a 30% cash buffer to protect further against market volatility — and avoid any advisory fees.

For those more comfortable taking the heat of the kitchen in the market, we offer more than 500 commission-free ETFs across a range of types of ETFs through our Self-Directed Trading platform. You can get started today with no minimum investment.

Now that you know ETF basics, are you ready to incorporate this spice into your investment strategy?

Invest in ETFs with us.

Learn more at Ally Invest.