What is an ETF?

Exchange-traded funds (ETFs) have soared in popularity in recent years, but what exactly are they? Let's take a closer look.

What is an ETF?

Similar to a mutual fund, an ETF is a pooled investment vehicle that owns a basket of underlying securities and divides ownership of those securities into shares. A pooled investment vehicle is simply an investment fund formed by pooling small investments from a large number of individuals.

Quick ETF Facts:

• ETF shares, or units, can be bought and sold on a stock exchange throughout the trading day, like a stock.
• An ETF's underlying securities are largely determined by the investment objective of the ETF. Some common underlying assets include stocks, bonds, commodities and currencies.
• ETFs are open-ended, meaning units can be created or redeemed based on investor demand. This process is managed by market makers. A market maker is a trader at a bank or brokerage tasked with making firm bids or offers to ensure liquidity is maintained in the market.
• ETFs can be managed a few ways: passively, actively, or a blend of the two.

Active and Passive Management

Passive index ETFs, which offer broad-market exposure by tracking a market index such as the S&P 500, were one of the first types of ETFs created and still represent the majority of ETFs you'll find.

Passive 101

In short, passive investing means tracking the market rather than actively trying to beat the market.

• Passively managed ETFs are constructed to track a benchmark or replicate its performance by holding the same securities as an index in proportionate amounts. They don't seek to exceed the returns, but rather to follow them as closely as possible.

Active 101

Actively managed ETFs look to outperform market returns.

• Actively managed ETFs are those where a manager makes the investment decisions to achieve an objective. Ongoing decisions regarding portfolio construction are made to attempt to outperform the market's return. There are many specialty ETFs that provide unique active management strategies.

Types of ETFs

ETFs can be divided into many categories.

• Index ETFs can include a broad range of securities, such as stocks (domestic and foreign), bonds and commodities like oil and gas or gold.
• Equity ETFs invest in stocks of Canadian, U.S. or international companies. Much like buying stocks and owning shares, equity ETFs have a proportionate claim of ownership on the underlying businesses.
• Sector and industry ETFs include major sectors or segments of the market representing certain industries, such as financials, technology, health care and more.
• Commodity ETFs include specific commodities, such as oil or gold.
• Fixed-income ETFs include broad markets or sectors of the bond market (corporate, government or international, for example).
• Currency ETFs include individual currencies or baskets of currencies from a particular region of the world.
• Real estate ETFs include multiple real estate investment trusts (REITs).
• Thematic or specialty ETFs: The former includes securities based on a theme, and the latter may be leveraged funds, inverse funds or other types.
• Leveraged ETFs use derivatives to achieve daily returns of the underlying asset, multiplied usually by two or three. Similar to any leveraged investment, these types of higher-risk ETFs are designed to magnify gains, which means they also magnify losses.

Remember, there are risks and benefits associated with any investment. It's a good idea to weigh both the risks and benefits when determining if any type of investment is right for you and your situation.