7 Questions to Ask Before Investing in ETFs

State Street launched the first US-listed ETF in 1993, and the $9.9 trillion global ETF industry has boomed even since.¹ The rapid growth of ETFs can be attributed to their efficient, cost-effective, and diversified access to most of the world’s listed investment markets.

Whether you’re new to ETFs or looking for more information, check out our answers to some of the most commonly asked questions about ETFs:

1. What Is an ETF?

An ETF (exchange traded fund) is a pooled investment vehicle of shares that can be bought or sold throughout the day on a stock exchange at the prevailing market price.

There are many types of ETFs, including those that invest in broad market indices, market sector indices, active strategies, smart beta strategies, themes, factors, and physical assets (like real estate and infrastructure).

ETFs issue shares that can be traded on the stock exchanges where they are listed — each share of an ETF represents an interest in the underlying assets of the fund. Most ETFs are regulated, meaning they provide investors with certain protections, including oversight by an independent board of directors and the requirement that fund assets be held separately from the assets of the advisor.

2. What Kinds of ETFs Are Available? 

ETFs cover every asset class and almost every global market. With ETFs, investors can also access almost any investment strategy, including:

This list is not comprehensive and many ETFs combine a number of strategies listed above. That said, the majority of ETFs are index-based, meaning they are designed to track the performance of a designated index.

3. How Can I Evaluate an ETF’s Objective — and Risks?

Index-based ETFs typically seek to track the performance of an index, and so the construction of the index matters. For example, an index might weight its holdings equally, by market capitalization, by dividends, or through another mechanism.

Actively managed ETFs seek to outperform a particular benchmark or index by making active decisions to accept and reject securities and assets, rather than invest in the overall market.

An ETF may invest in the underlying securities in the index it tracks, known as physically-backed ETFs. Alternatively, it may invest in a representative sample of securities in the index. Some ETFs also employ derivative instruments to track an index, rather than the underlying securities or assets. The chosen approach may affect how well the ETF tracks the index (tracking difference), and its overall risks.

Like All Investments, ETFs Are Subject to Risk

The principal risks are typically those associated with the ETF’s investment objective and the assets it acquires to meet these objectives. Risks can also include currency, interest rates, the impact of economic growth, and other factors that impact the market and the assets.

One risk of index-based strategies is tracking error (the difference between the return of the ETF and the return of the index it tracks).

Another risk for all ETFs is premium/discount volatility, or the disparity between the market price of ETF shares and the market value of the underlying assets — the net asset value (NAV).

Disparity can occur because shares are traded on the exchange, and temporary sentiment and market volatility can drive prices beyond the NAV. But with most ETFs, the price should usually correct again toward the NAV over time. Generally, the longer the investment term, the less relevant these types of movements are for the investor.

4. How Do Investors use ETFs? 

There are a myriad of ways to use ETFs in portfolios. Investors commonly use ETFs to:

• Build diversified portfolios
• Pursue long-term compound returns
• Create core-satellite portfolio strategies
• Access hard-to-reach markets 
• Implement regular investment plans
• Diversify across return and risk sources
• Reduce portfolio concentration

5. What Are the Costs Associated with ETFs?

While the list below may not be comprehensive, it does discuss the majority of associated expenses when investing in ETFs.

6. How Do You Measure ETF Performance?

While past performance is not an indication of how an ETF may perform in the future, investors may wish to evaluate an ETF’s performance against its stated objective or benchmark.

• For an index-based ETF, performance is measured against its benchmark by the ETF’s tracking difference (which shows how closely it has been able to replicate the benchmark).
• For an actively managed ETF, an investor might look at how the ETF has performed, based on the outperformance objective and the benchmark.

Tracking difference is the extent to which the ETF’s return deviates from the return of its benchmark index. Tracking difference can be influenced by a number of factors, such as how an ETF seeks to track the index (i.e., investing in every security in the index versus a representative sample of the index’s securities), the ETF’s operating expenses, and how the manager handles index rebalancing and corporate actions.

Tracking error is this difference expressed in standard deviations.

7. How Do Investors Buy and Sell ETFs? And Why Is Liquidity Important?

Most investors buy and sell ETFs on the stock market at a market-determined price, typically trading through a brokerage account, just like trading a stock.

As with buying and selling shares, there are two basic options when trading ETF shares:

Market Orders

A market order is an order to buy or sell a security at the best available price, at the price that has been created on the market by the supply and demand. Generally, this type of order will be executed immediately.

Although placing a market order usually ensures that a trade will be executed, the price at which the order will be executed is not guaranteed to be an optimal price. It is important for investors to remember that the last-traded price is not necessarily the price at which a market order will be executed.

Limit Orders

A limit order is an order to buy or sell a security at a specific limit price or better. A buy limit order can only be executed at the limit price or lower, and a sell limit order can only be executed at the limit price or higher.

A limit order is not guaranteed to execute — it can only be filled if the security’s market price reaches the limit price, with the right amount of stock demand to meet the trade. While limit orders do not guarantee execution, they allow the investor to control the price at which they are willing to buy or sell.

The Importance of Liquidity

Liquidity refers to how easily shares can be bought or sold without moving the market for those shares. Securities with high trading volumes are generally considered more liquid.

ETF liquidity should be considered with respect to both the ETF shares and the underlying securities the ETF holds. Highly liquid ETFs and ETFs that have highly liquid underlying securities — even if the ETF shares do not have high trading volumes — typically have narrower bid/ask spreads than ETFs that trade less or hold less liquid securities.