Investing Classroom

Course 101: Exchange-Traded Funds
In this course
1. Introduction
2. What Are Exchange-Traded Funds?
3. How Do ETFs Work?
4. The Pros of ETFs
5. The Cons of ETFs
6. Are ETFs for You?
7. Do ETFs Perform Better?
8. Conclusion
Quiz
Course Catalog

What Are Exchange-Traded Funds?

Like mutual funds, ETFs are baskets of securities. Like stocks, ETFs trade on an exchange. Unlike regular mutual funds, ETFs can be bought and sold throughout the trading day. They can also be sold short and bought on margin. Anything you might do with a stock, you can do with an ETF.

There are a number of different equity ETFs on the market, including SPDRs, Select Sector SPDRs, MidCap SPDRs, HOLDRs, and Diamonds. ETFs have also branched out into the bond arena with scores of bond ETFs now on the market. ETFs also come in more-exotic flavors. While conventional mutual funds still vastly outnumber ETFs, funds that drill down into specific sectors, industries, regions, countries, and asset classes make up a greater percentage of the ETF universe, offering relatively inexpensive access to investments, such as currencies, precious metals, or emergent industries, that heretofore have been the sole province of larger institutional and wealthy investors.

ETFs are largely passively managed, which means that each tracks a sector-specific, country-specific, broad-market, or other index. A manager isn't actively choosing which stocks to buy and sell.

Why has indexing been the strategy of choice for ETFs? ETFs rely on an arbitrage mechanism to keep the prices at which they trade roughly in line with the net asset values of their underlying portfolios. For the mechanism to work, potential arbitragers need to have full, timely knowledge of a fund's holdings. So, many ETFs have chosen the indexed route because active managers rarely disclose their portfolio holdings more frequently than the Securities and Exchange Commission requires (which currently is four times a year).

Although ETFs are largely index-based, more actively managed or enhanced-index ETFs are gaining visibility. For example, the WisdomTree ETFs follow indexes that are weighted based upon stock dividend metrics rather than a more-traditional market-cap weighting. WisdomTree's research shows that a dividend weighting has provided stronger returns in the past, but the jury's still out on future performance.

In addition, applications have been filed with the SEC to launch actively managed ETFs, but they still have much to prove to regulators, money managers, and investors about their portfolio transparency, fee structures, and real-world operations before they’d become widely available.

Next: How Do ETFs Work? >>


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ETFs are baskets of securities that may track a sector-specific, country-specific, or a narrow/broad-market index. ETFs trade on an exchange like a stock. ETFs are subject to risk similar to those of their underlying securities, including, but not limited to, market, sector, or industry risks, and those regarding short-selling and margin account maintenance. Commission fees typically apply.

Asset allocation and diversification do not eliminate the risk of experiencing investment losses.

Risks of Commodity ETFs
Commodity ETFs may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity. Commodity ETFs may be subject to greater volatility than traditional ETFs and may not be suitable for all investors. Unique risk factors of a commodity fund may include, but are not limited to the fund's use of aggressive investment techniques such as derivatives, options, forward contracts, correlation or inverse correlation, market price variance risk and leverage.

Risks of Currency ETFs
The value of the shares of a currency exchange traded product relates directly to the value of the foreign currency held by the particular product. This creates a concentration risk associated with fluctuations in the price of the applicable foreign currency. Unique risk factors of a foreign currency include national debt levels and trade deficits, domestic and foreign inflation rates, domestic and foreign interest rates, investment and trading activities of institutions and global or regional political, economic or financial events and situations. Currency products may not be suitable for all investors. Many currency products are not investment companies registered under the Investment Company Act of 1940.For a more complete discussion of risk factors applicable to each currency product, carefully read the particular product's prospectus.

Risks of Bond ETFs
Investments in bond funds are not insured or guaranteed by the Federal Deposit Insurance Corporation (FDIC) or any other government agency. Bonds and bond funds will typically decrease in value as interest rates rise.

Risks of Leveraged and Inverse ETFs
Leveraged and inverse ETFs entail unique risks, including but not limited to: use of leverage; aggressive and complex investment techniques; and use of derivatives. Leveraged ETFs seek to deliver multiples of the performance of a benchmark. Inverse ETFs seek to deliver the opposite of the performance of a benchmark. Both seek results over periods as short as a single day. Results of both strategies can be affected substantially by compounding. Returns over longer periods will likely differ in amount and even direction. These products require active monitoring and management, as frequently as daily. They are not suitable for all investors.

Research and planning tools are obtained by unaffiliated third party sources deemed reliable by TD Ameritrade.
However, TD Ameritrade does not guarantee accuracy and completeness, and makes no warranties with respect to results to be obtained from their use. ETFs are baskets of securities that track recognized indexes and trade on an exchange like a stock. Commission fees apply.