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.
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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.
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