What is an ETF? A complete guide for beginner investors

A Brief History: How ETFs Were Born

Before understanding what an ETF is today, it’s worth knowing its origin. It all began in 1973 when Wells Fargo created the first index funds for institutional clients. But the real revolution came in 1990 with the TIPs 35 in Toronto, which laid the groundwork for what was to come.

The definitive change occurred in 1993 with the launch of the S&P 500 Trust ETF, popularly known as SPY. This revolutionary product combined the best of two worlds: the diversification of traditional funds with the trading flexibility of stocks.

Since then, the industry has experienced spectacular growth. We went from fewer than 10 ETFs in the 1990s to over 8,754 products in 2022. In terms of capital, Assets Under Management (AUM) grew from $204 billion in 2003 to $9.6 trillion in 2022, with approximately $4.5 trillion coming from North America.

What exactly is an ETF?

An ETF (Exchange Traded Fund) is an investment fund that trades on the stock exchange like a regular stock. The key difference is that an ETF does not represent a single company but a basket of diversified assets.

What makes an ETF special is that it combines three characteristics:

• Liquidity like a stock: you can buy or sell during market hours at prices that fluctuate in real time
• Diversification like a fund: access to multiple assets with a single purchase
• Low costs: generally offers lower commissions than traditional investment funds

The ETF replicates the performance of a specific index, sector, geographic region, or asset class. For example, if you buy SPY, you are investing in the 500 large companies of the S&P 500 without having to buy each stock separately.

The different types of ETFs available

The universe of ETFs is broad and diverse. Here are the main categories:

Index ETFs: track broad stock indices (SPY, VTI). They allow full exposure to market segments.

Sector ETFs: focus on specific industries such as technology, energy, or finance. They are useful when you want to bet on a particular sector.

Commodity ETFs: offer exposure to gold, oil, silver, and other commodities without physically purchasing them.

Currency ETFs: access to foreign exchange markets.

Geographic ETFs: invest in assets from specific regions, facilitating international diversification.

Inverse or Bear ETFs: profit when the market falls. Tools for protection or short-term speculation.

Leveraged ETFs: amplify gains and losses through derivatives. They are for experienced traders, not long-term investors.

Passive vs. Active ETFs: the former simply replicate an index (very low costs), the latter have managers trying to outperform the market (higher costs).

How ETFs work in practice

When you decide to invest in an ETF, the process is simple:

1. Open a brokerage account (as you would to buy stocks)
2. Search for the ETF you want (by ticker symbol)
3. Place your buy order at market price
4. Receive ETF units in real time

Behind the scenes, something more sophisticated happens. Authorized participants (large financial institutions) act as intermediaries. They create new ETF units when there is demand and withdraw them when there is excess. This mechanism continuously adjusts the ETF’s price to match the actual value of the assets it contains (called NAV - Net Asset Value).

If the market price diverges from the NAV, an arbitrage opportunity arises. Investors can buy low and sell high to correct the difference. This process keeps prices fair and efficient.

Advantages: why millions choose ETFs

Extraordinarily low costs

Typical expense ratios range from 0.03% to 0.2% annually. Compare this with investment funds that charge 1% or more. Scientific studies show that this difference can reduce your wealth by 25-30% over 30 years.

Tax efficiency

ETFs use a mechanism called “in-kind” redemption. Instead of selling assets and generating capital gains taxes, they simply transfer physical securities. This minimizes your tax bill over time.

True intraday liquidity

Unlike mutual funds (which close at 4 PM), you can buy or sell an ETF at any time during market hours. The price fluctuates in real time based on supply and demand.

Total transparency

Most ETFs publish the exact composition of their portfolio daily. You know exactly what assets you own at any moment, making informed decision-making easier.

Instant diversification

With a single purchase, you access dozens, hundreds, or even thousands of assets. Replicating this diversification individually would be complex and costly.

Disadvantages: what you should know

Tracking error

Occasionally, an ETF’s performance does not perfectly match its benchmark index. A low tracking error is desirable, but no ETF is perfect.

Hidden costs in specialized ETFs

Although many ETFs are cheap, niche or small ETFs may have higher expense ratios that affect your returns.

Extreme risks in leveraged ETFs

Leveraged products amplify both gains and losses. A 20% drop in the index can mean much larger losses. They are suitable only for experienced traders with a short-term horizon.

Liquidity issues in small ETFs

ETFs with low trading volume can have large bid-ask spreads, increasing your trading costs.

Dividend taxes

Although ETFs are tax-efficient, they still distribute dividends that may be subject to taxes depending on your jurisdiction.

How to choose the right ETF for you

Analyze the expense ratio

Look at the total cost of holding the ETF. Lower ratios generally mean better net performance over the long term.

Check liquidity

Observe daily trading volume and the bid-ask spread (the gap between buy and sell prices). High volume and narrow spreads are signs of healthy liquidity.

Review historical tracking error

Compare the ETF’s performance with its benchmark index over several years. Consistently low error is a good sign.

Understand your goal

Do you want global exposure? Focus on a sector? Hedge against downturns? Choose an ETF that aligns with your strategy.

Advanced ETF strategies

Multi-factor portfolios

Combine ETFs emphasizing different factors (value, size, growth) to create a more robust portfolio, especially in turbulent markets.

Hedging strategies

Use inverse or bearish ETFs to protect your gains when volatility is expected. For example, a Treasury bond ETF can balance a heavily stock-oriented portfolio.

Price mismatch arbitrage

When the ETF price diverges temporarily from its NAV, sophisticated traders exploit these differences until they return to equilibrium.

Bull and Bear trading

Speculate on market direction with bullish (Bull) ETFs when expecting rises or bearish (Bear) ETFs when anticipating declines.

Conclusion: Are ETFs right for you?

ETFs represent one of the greatest advances in democratizing the financial market. They allow anyone to access diversification, transparency, and low costs, previously exclusive to institutional investors.

However, they are not a silver bullet. Diversification reduces risks but does not eliminate them. Tracking error and hidden costs can erode returns. Leveraged products carry extreme risks.

The key is to select ETFs that align with your risk profile, time horizon, and financial goals. A deliberate and well-researched strategy maximizes the advantages of these instruments while mitigating their limitations.

Whether as the core of your portfolio or as a strategic complement, understanding what an ETF is and how to use it positions you better in financial markets.