One of the notable advantages of exchange-traded funds or ETFs is that there is a huge selection of different categories and types of ETFs. Each has its defining characteristics and appeals to the investment objective, risk profile, and even investment time horizons of each investor. This means that it is important for all interested investors to understand the different types of exchange-traded funds for comparison purposes, as well as to ensure that a particular ETF is aligned with the particular purpose of a specific investor.
Selecting Exchange-Traded Funds: Explaining and Understanding the Different Categories and Types of Exchange-Traded Funds
There is a huge selection of ETFs to choose from. This can be confusing for first-time investors or those who are not familiar with how pooled funds work. It is worth mentioning that these ETFs are categorized based on a set of criteria. Most are categorized based on the composition of their securities and assets. Others are categorized according to the investment strategy employed. This same naming convention has also been used in the different types of mutual funds and even in the different selection unit investment trusts. Take note of the following:
• By Investment Strategy: There are two broad types of exchanged traded funds based on investment strategy. These are Index ETFs and Actively Managed ETFs. The former are the most common types of ETFs and are based on passive investing. The goal of these funds is to track and mirror a specific market index like S&P 500 and Nasdaq 100. The latter are based on active investing. Their portfolios are reconfigured or rebalanced more frequently to outperform a benchmark or market index.
• By Securities and Assets: ETFs are also labeled according to the composition of their portfolios. Equity ETFs are composed of stocks of publicly traded companies while Bond ETFs include fixed-income securities or different types of bonds like government bonds and corporate bonds. Commodity ETFs include commodities like precious metals and oil and Currency ETFs include currencies and cryptocurrencies. There are also hybrid funds like Balanced ETFs that are composed of stocks and bonds.
• By Investment Style: Some labels are based on the underlying investment style. Value ETFs are based on value investing and include value stocks and other relevant securities. Growth ETFs adhere to the principles of growth investing and invest in growth stocks, small-cap and mid-cap stocks with growth potential, and other securities. Defensive ETFs are comprised of defensive securities and assets like defensive stocks and are based on defensive investing that is aimed at weathering through market cycles.
• By Industries and Markets: Other types of ETFs are labeled based on their industry or market focus. These are also called Thematic ETFs. There are funds with portfolios that are focused on securities or investments in artificial intelligence, fossil fuel or hydrocarbon companies, clean or alternative energy, other disruptive technologies and market trends, climate change, defense industries, consumer retail, specific commodities like gold or oil, and a selection of cryptocurrencies, among others.
Investing in Exchange-Traded Funds: The Importance of Understanding the Different Categories and Types of Exchange-Traded Funds
Remember that understanding the different types of exchange-traded funds or ETFs is important for investors to ensure that their choice and investment are aligned with their respective investment objectives, risk profiles or risk tolerance, and investment time horizons. It is important to note that each type of ETF has its defining features or set of characteristics that can appeal to a particular investor or his or her profile. These characteristics also come with inherent advantages and disadvantages. Furthermore, because of the wide selection of ETFs to choose from, understanding which categories or types they belong to is also critical for making comparisons and making informed investment decisions. Take note of the following pointers:
• Risk and Return: Different types of ETFs have different levels of risk and return profiles. Equity ETFs are riskier and more suitable for aggressive investors than Bond ETFs. The same is true for Growth ETFs or Cryptocurrency ETFs. An industry-focused ETF is riskier than a Broad-Market ETF. Index ETF might be less riskier and more suitable for moderate investors but the return potential is lower than an Actively Managed ETF. A Broad-Market ETF might also expose an investor to lower return potential because poor-performing securities and assets can dilute the gains from better-performing ones.
• Diversification: It is important to note that investing in a single ETF can help an investor have a diversified portfolio from the get-go. Further investments in other types of ETFs can also help in the further diversification of the portfolio. A particular portfolio with the right mix of investments in equity funds, fund bonds, commodity funds, and several thematic funds can help spread the risk that comes from investing in a single security or a particular industry or market. An understanding of the different types of ETFs can help an investor decide which one he or she needs to add to his or her portfolio.
• Cost Implications: The different types of ETFs also have different cost implications. Actively Managed ETFs have higher costs than Index ETFs and other Passively Managed ETFs because of fund management fees placed on top of other fees. Some ETFs are also more tax-efficient due to their structures. Examples include Bond ETFs or more specific Municipal Bond ETFs, Broad-Market ETFs, and Fundamental Index ETFs. These ETFs tend to have lower tax implications because either the income that they generate is exempted from taxable sources by law or their turnovers are lower.
• Time Horizon: It is also worth mentioning that Equity ETFs are suited for both short-term and long-term investment horizons. This depends on the composition of their portfolios. Currency ETFs and Cryptocurrency ETFs are ideal for both investing and trading. Note that These ETFs are suitable for trading because their volatile price movements can help traders generate profits from the difference between buy prices and sell prices. Bond ETFs and Dividend ETFs are suitable for wealth preservation and long-term investing because they are income-generating investments and have lower volatility.
