9 types of ETFs: How do ETFs work and different types of ETFs to know
Exchange-traded funds (ETFs) are the cornerstone of many investor portfolios. If youāre new to ETFs, youāll want to know more about the types of ETFs and how ETFs work for different investment goals. Hereās a closer look at the different types of ETFs you should know about and how they may fit into your portfolio strategy.
What is an ETF?
Exchange-traded funds (ETFs) are a type of investment where you can buy a basket of stocks or other assets with one transaction.
9 types of ETFs explained
While ETFs work similarly, they come in many forms. ETFs can give you ownership of stocks, bonds and many other assets. Each type of ETF is helpful for different financial goals, and knowing how to navigate your options can help you build an ideal portfolio. Hereās a closer look at the types of ETFs you should know about as an individual investor.
1. Equity ETFs (Stock ETFs)
Equity ETFs are a type of investment fund that gives investors the ability to buy a group of stocks all at once. Equity ETFs typically follow a specific index or category. You can buy a diverse portfolio of stocks in a single trade with equity funds. For example, popular S&P 500 index funds give you ownership of the 500 large companies included in the S&P 500 index. Equity ETFs are the most common type of ETF and can hold a mix of many different types of companies.
Who are they for?
Equity ETFs are an excellent choice for nearly any investor. Diverse index funds typically come with low fees and outperform actively managed funds or personally selected stock portfolios. Whether youāre investing for retirement or any other long-term goal, equity ETFs may make up a large portion of your holdings.
Pros
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Buy diverse groups of stocks with a single purchase
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May track indexes or specific categories of the stock market
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Typically lower fees than mutual funds
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Near instant trades
Cons
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Less control over which stocks you own
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Management fees apply
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Research required to find the best fit for your portfolio
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Actively managed funds typically underperform
2. Bond and fixed-income ETFs
Bond and fixed-income ETFs hold corporate bonds, government bonds, certificates of deposit (CDs) and other income-producing securities. While individual bonds are unsuitable for the typical investor, many benefit from holding an array of bonds that provide predictable and stable income. Municipal bonds offer tax-free benefits, and major agencies rate corporate bonds, so you know its risk level when investing.
Who are they for?
Traditionally, bonds become a larger part of investorsā portfolios as they move toward retirement. Because those near the end of their careers may not have as much time to ride out the ups and downs of the stock market, investing in bonds provides a more reliable outlook. While bond prices typically decrease when interest rates rise, they remain an important part of most long-term investment strategies.
Pros
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Stable income-producing asset class
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Buy into a certain type of bond or the entire bond market at once
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Tax benefits in some situations
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Quickly buy and sell without owning full bonds
Cons
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Some opacity compared to owning individual securities
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Management fees take from returns
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No granular control over cash flow from specific bonds
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Can be challenging to understand and manage risk across your bond portfolio
3. Real estate ETFs
Real estate ETFs invest in stocks from the real estate sector, offering investors a path into the real estate markets without directly buying properties or meeting accredited investor requirements imposed by many online real estate investment platforms. With real estate ETFs, youāre buying a diverse portfolio of companies that own real estate, not specific properties owned by the ETF.
Who are they for?
Real estate ETFs are suitable for investors looking to diversify their portfolios beyond traditional stocks and bonds but not ready to dive directly into managed real estate funds or purchase investment properties outright. If you believe real estate is going to perform well, buying a diverse portfolio of real estate stocks through a low-fee ETF can be a good way to dip your toes into real estate with relatively low risk.
Pros
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Buy the stock of multiple real estate-focused companies at once
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Less risk than buying individual properties
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No accredited investor requirements
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Low fees with many real estate index ETFs
Cons
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Less granular control and visibility into real estate holdings
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Profitability is subject to successful management
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Real estate stocks have less direct real estate market exposure
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May follow stock market and real estate market trends and volatility
4. Commodity ETFs
Commodities are raw physical goods, including precious metals, oil and gas, agricultural products and others. Commodity ETFs typically buy options and futures related to a broad set of commodities or specific underlying assets. One popular broad market commodity ETF holds gold, copper, crude oil, natural gas, soybeans, sugar, silver, coffee, corn and much more. If you believe raw goods or the entire commodity market will perform well, a commodity ETF gives you a diversified portfolio managed by an investment professional.
Who are they for?
Commodities are generally riskier than more traditional investments. Commodity prices can experience wild swings based on demand, government policies, economic conditions and production volumes. Commodity ETFs are best for someone who doesnāt want to actively manage an ETF portfolio but can handle the risk of these volatile investments.
Pros
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Quickly gain exposure to raw goods
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No need to actively manage commodities options and futures
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Invest in a broad commodity fund or specific category
Cons
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Highly volatile and risky underlying investments
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Can have higher fees than common stock and bond index funds
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Fast-moving markets that can be difficult to follow
5. Currency ETFs
Currencies are the money we use every day around the world. Compared to the United States dollar, foreign currencies rise and fall in value in the foreign exchange (FX) markets. You can buy a basket of foreign currencies in your brokerage account with currency ETFs. Currency ETFs may hold a wide array of currencies or focus on specific regions or economies. A subset of currency ETFs holds cryptocurrencies, such as Bitcoin and Ethereum.
Who are they for?
Like commodity ETFs, currency ETFs are not suitable for many investors. Due to the risks involved, you may decide to skip foreign currency holdings. If youāre an expert investor and fully understand the risks, currency ETFs could make up a small portion of your portfolio. If you donāt comprehend the risks and potential benefits, you may want to skip this type of ETF.
Pros
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Invest in foreign currencies without directly holding them
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No need for a foreign exchange trading account
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Build diversified currency portfolios quickly
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Access traditional fiat currencies or cryptocurrencies
Cons
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High-risk and highly volatile investments
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Less control compared to holding individual currencies
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Potential high fees for actively traded ETFs
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Not suitable for many investors
6. Alternatives ETFs
In the investment world, alternatives are nontraditional assets beyond stocks and bonds. They commonly include private equity, venture capital, real estate, commodities, hedge funds, antiques and collectibles and more. Weāve already looked at real estate and currency ETFs, for example, but you can also find more diverse alternative ETFs investing across different types of alternatives or in other alternative markets.
Who are they for?
Alternative ETFs are best for investors with a strong understanding of market dynamics and already have a sizable portfolio of more traditional assets, like stock and bond ETFs. If youāre looking to diversify your portfolio further and can tolerate the added risks that come with less traditional assets.
Pros
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Diversity beyond stocks and bonds
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Potential hedge against losses from other assets
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Increase cash flow or growth potential
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Professionally managed for optimal returns
Cons
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Higher risk than traditional assets
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Can be difficult to understand for less experienced investors
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Potential for higher fees than equity and bond ETFs
7. Sustainable ETFs
You should know about sustainable ETFs if you want environmentally and socially conscious companies in your portfolio. As the name suggests, sustainable ETFs generally include stocks that put environmental and business sustainability at the forefront of operations. If youāre familiar with ESG stocks, companies with a strong focus on environment, social and governance practices, youāll come across many such companies in sustainable ETFs.
Who are they for?
According to some research, sustainable stocks outperform the market as a whole, so thereās a good argument that many investors would benefit from sustainable ETFs. If you are comfortable with portfolio management and have your long-term needs, such as retirement, well covered by traditional index funds, adding a sustainable section to your portfolio is a reasonable decision.
Pros
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Potential for returns above the market as a whole
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Add environmentally conscious companies to your portfolio
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Stocks picked by a professional fund manager
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Feel good about the stocks in your accounts
Cons
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Some investors donāt believe sustainable companies will outperform
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Investment fees required
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No granular control over sustainability standards
8. Speciality ETFs
Specialty ETFs focus on unique investments, such as leveraged funds and funds focused on unique methodologies. For example, QQQ (Invesco QQQ Trust, Series 1) aims to hold innovative stocks. Leveraged ETFs work to give investors 2x or 3x the results of what happens in the markets. Funds like VIX reward investors when markets are highly volatile. These funds are focused on highly specialized investments and strategies, so make sure you understand how the fund works before buying shares.
Who are they for?
Most specialty ETFs are best reserved for experienced investors who already understand market dynamics and are comfortable with potential losses. With higher risk comes higher potential returns, so risk-takers looking to maximize their return on investment may do well. But if youāre skittish about losses, you may want to skip specialty ETFs altogether.
Pros
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Potential for above-average returns
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Make multiples of what you would with leveraged funds
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Invest in highly specialized strategies
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Managed by expert investors
Cons
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Higher risk than traditional ETFs
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Potential for higher fees than most index funds
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Often more volatile than index fund ETFs
9. Factor ETFs
Factor ETFs are a type of stock ETF where professional fund managers choose a portfolio of stocks or follow an index based on the companyās unique factors, which can include financial, market momentum and other factors. While the term factor ETF is fairly new, the concept of owning a portfolio of similar stocks based on varying criteria is as old as mutual funds and ETFs. You may find some overlap between factor ETFs and other types of ETFs described above.
Who are they for?
Factor ETFs are best for investors who are well-versed in the stock market. If you already have a sufficient portfolio to meet your long-term goals, adding factor ETFs can boost your returns, albeit with more risk. You can use factor ETFs to add specific areas of the market to your investment makeup that you believe will outperform.
Pros
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Access specific areas of the market you believe will perform well
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Professionals pick the best stocks based on the chosen factor
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Maintain diversification based on different company factors
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Many different factors supported by ETF managers
Cons
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Management fees apply
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Higher risk than broad market ETFs
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Higher potential for losses or poor performance
Where to buy ETFs?
To buy ETFs, youāll need to open a brokerage account, search for the ETF by its ticker symbol and place a buy order. Find the broker thatās right for you.
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What is cap in ETFs?
Cap is short for capitalization in ETFs and the stock market. A companyās market capitalization, or market cap, is how much the company is worth in total. To calculate market capitalization, multiply the number of shares outstanding by the current stock price. For example, a company with one million shares and a $5 share price would be worth $50 million. The same applies to ETFs, as it also has a market price and number of shares.
FINRA, an investment industry organization, defines market caps based on the following tiers:
- Mega-cap: Market value of $200 billion or more
- Large-cap: Market value between $10 billion and $200 billion
- Mid-cap: Market value between $2 billion and $10 billion
- Small-cap: Market value between $250 million and $2 billion
- Micro-cap: Market value of less than $250 million
How to choose an ETF?
When choosing an ETF, itās important to consider your financial situation and long-term goals. I have the vast majority of my investments in long-term accounts, including several retirement accounts (IRAs), a health savings account (HSA) and a taxable investment account.
With my long-term goals, I have my investments primarily in broad market ETFs, mostly made up of low-fee index funds. I hold S&P 500 index funds, total stock market funds, dividend-focused funds and a target date fund, among others.
A small portion of my assets is in specialized ETFs, which focus on different aspects of companies and parts of the market. I like to follow a rule I call the 80/15/5 allocation. It means 80% of my investments are in low-fee index funds, 15% are in individual stocks and 5% is reserved for alternatives and higher-risk investments.
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Eric Rosenberg is a finance, travel and technology writer in Ventura, California. He is a former bank manager and corporate finance and accounting professional who left his day job in 2016 to take his online side hustle full time.
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