What are ETFs and why can't investors ignore them

When we talk about what ETFs are, we refer to financial instruments that trade on the stock exchange as if they were stocks, but contain a diversified basket of assets inside. Their official name is Exchange-Traded Funds, and although the concept may seem complex, their operation is more straightforward than many believe.

The main feature that makes ETFs attractive is that they combine two worlds: the instant trading flexibility of traditional stocks with the security of diversified investment provided by conventional funds. To understand what ETFs are well, it is essential to know that you are not buying a single asset, but a participation in a complete portfolio.

The evolution of ETFs: from idea to reality

The history of Exchange-Traded Funds begins in the 1970s with index funds created by Wells Fargo and American National Bank. But the true revolution came in 1990 with the Toronto 35 Index Participation Units (TIPs 35) on the Toronto Stock Exchange, which set the precedent for modern ETFs.

In 1993, the SPY (SPDR S&P 500) emerged, which remains one of the most traded ETFs on the planet. Since then, expansion has been exponential: from fewer than 10 products in the early 1990s to over 8,754 ETFs in 2022.

The growth figures of the sector are overwhelming. Assets Under Management (AUM) went from $204 billion in 2003 to $9.6 trillion in 2022. Of that total, approximately $4.5 trillion corresponds to North America, demonstrating the concentration of this market in the region.

How do ETFs really work?

Understanding what ETFs are also involves knowing their operational mechanics. When a management company decides to launch an ETF, it collaborates with authorized market participants (generally large financial institutions) to create units that are listed on stock exchanges.

The interesting part is that these authorized participants act as guardians of value. They constantly adjust the number of units in circulation so that the ETF price reflects the Net Asset Value (NAV) of the underlying assets. If the market price deviates too much from the actual NAV, market arbitrators take advantage of that difference to buy or sell, automatically correcting any distortion.

To invest in ETFs, the requirements are minimal. You only need an account with a broker, and you can buy or sell units just like any stock. The process is identical: press buy or sell, and you’re done.

The different flavors of ETFs

There is no single type of ETF. The variety is immense, and each responds to different strategies and investor profiles.

Stock index ETFs: Replicate the performance of complete indices. The SPY, for example, gives you exposure to the 500 largest companies in the United States with a single investment.

Currency ETFs: Offer access to forex markets without the need to trade directly in currency pairs. You can invest in euros, yuan, or any other currency effortlessly.

Sector ETFs: If you believe technology will take off, you can buy a tech ETF. If you prefer robotics and artificial intelligence, there is an ETF for that too. Specialization is the strong point.

Commodity ETFs: From gold to oil, access to commodities is greatly simplified. The GLD replicates the gold price without you having to store it in a safe.

Geographic ETFs: Allow investing in specific markets. Asia, Europe, emerging markets: all available with a click.

Inverse and leveraged ETFs: Here is where things get more extreme. Inverse ETFs profit when the market falls (short positions). Leveraged ETFs amplify gains but also multiply losses. They are tools for sophisticated strategies, not for beginner investors.

Passive vs active ETFs: Passive ETFs simply follow an index and have low costs. Active ETFs are managed by professionals trying to outperform the market, which generally involves higher fees.

ETFs versus other investment options

When considering where to invest, it’s common to compare ETFs with individual stocks. The fundamental difference is risk. An individual stock concentrates all risk in a specific company. An ETF diversifies that risk across dozens or hundreds of companies.

With individual stocks, you can gain or lose much faster. With ETFs, movements are smoother because you are invested in multiple companies.

ETF vs CFD: Contracts for Difference allow leverage, which amplifies both gains and losses. ETFs, on the other hand, are traditional investments that you buy and sell on the exchange. CFDs are for active traders handling high risk. ETFs are for investors seeking diversified exposure without extreme leverage.

ETF vs Traditional Investment Funds: Both offer diversification, but here are the critical differences. ETFs are traded throughout the trading day at real-time prices. Traditional funds are valued only once at market close. ETFs usually have fees between 0.03% and 0.2% annually. Active funds often exceed 1%. This fee difference can erode your portfolio by 25% to 30% over 30 years, according to academic studies.

Why investors choose ETFs: the real advantages

Extremely low costs: This is perhaps the most convincing argument. While traditional investment funds eat up 1% or more of your assets annually, ETFs average 0.1% or less. Over the long term, that difference is huge.

Tax efficiency: ETFs use a special mechanism called “in-kind” redemption. Instead of selling assets and generating taxable capital gains, they transfer the physical assets directly. This significantly minimizes your tax bill compared to traditional funds.

Intraday liquidity: You can buy or sell at any time the market is open, at current market prices updated every second. This contrasts with traditional funds where you can only operate at the close.

Absolute transparency: ETFs publish their holdings daily, sometimes multiple times a day. You always know exactly what’s inside your investment.

Instant diversification: Instead of buying 50 different stocks incurring high commissions, you buy an ETF containing those 50 stocks. Diversification is achieved with a single transaction.

The cracks in the armor: disadvantages of ETFs

Although ETFs sound like the perfect solution, they have limitations.

Tracking error: Not all ETFs perfectly replicate their index. There is a discrepancy between what the ETF should earn and what it actually earns. For specialized ETFs or those with low trading volume, this error can be significant.

Variable costs depending on specialization: While broad index ETFs are cheap, highly specialized ETFs can have much higher expense ratios, eating into your returns.

Extreme risk in leveraged products: Leveraged ETFs can quickly lose your investment if the market moves against you. They are designed for short-term operations, not long-term investing.

Limited liquidity in certain niche ETFs: Some highly specialized ETFs have low volume, meaning wide spreads (difference between bid and ask) and difficulty entering or exiting positions.

Dividend taxes: Dividends paid by ETFs are subject to taxes, though generally less than in individual stocks.

How to select the right ETF for your portfolio

Choosing an ETF should not be random. There are specific criteria that smart investors evaluate.

Expense ratio: Always compare fees. 0.03% vs 0.3% may seem small, but over 30 years it makes a colossal difference.

Trading volume: An ETF with low volume means buying or selling can be costly. Check that the daily volume is sufficient.

Tracking error history: Review whether the ETF has faithfully replicated its index in recent years. A low tracking error is a sign of good performance.

Portfolio composition: Ensure that the included assets align with your strategy. Don’t buy a dividend ETF if you seek aggressive growth.

Advanced strategies with ETFs

Sophisticated investors use ETFs in ways beyond “buy and hold.”

Multifactor strategies: Combining ETFs that track different factors (size, value, momentum, quality) can create a more balanced and resilient portfolio.

Hedging and hedging: Use inverse ETFs to protect against market downturns. If you hold tech stocks, you can buy an inverse tech ETF as insurance.

Arbitrage: When the ETF price deviates from its NAV, traders can exploit that difference.

Directional positioning: Bull and Bear ETFs allow speculation on whether a sector will rise or fall without individual company risk.

Final reflection on what ETFs are

Exchange-Traded Funds represent a democratization of investing. What was once accessible only to institutional investors with multimillion-dollar portfolios is now available to anyone with a brokerage account.

However, the diversification offered by ETFs does not eliminate all risks. Markets can fall, sectors can plummet, volatility always exists. Diversification mitigates risks but does not erase them.

Therefore, building a portfolio with ETFs should be deliberate and based on analysis. It’s not just “buy 10 ETFs and forget.” It requires careful selection, periodic monitoring of tracking error, review of fees, and alignment with your long-term financial goals.

ETFs are powerful tools when used correctly. Ignoring them in the context of modern investing would be a mistake.