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What are Stock ETFs?
In 2019 the total value of US-listed ETFs crossed the $4 trillion mark. Approximately 75% of these funds hold stocks. Furthermore, the 10 largest ETFs in the US market are stock ETFs. Around the world, the picture is similar, with equity ETFs dominating the industry.
So, what exactly are stock ETFs and what are the pros and cons of investing in them?
Exchange traded funds are funds that pool capital, with the capital then invested to replicate an index. In the case of stock ETFs, the fund will be designed to track the value of an existing stock index, or an index specifically created for the fund. Either way, in the case of a stock ETF, only shares of listed companies will be held by the fund.
Types of Stock ETFs
While most exchange-traded funds fall into the stock ETF category, there are lots of very different types of stock ETFs.
Headline index ETFs
Many of the largest ETFs track well-known stock market indexes. These indexes are often used as benchmarks for the performance of the broad stock market, and so it makes sense that ETFs should track them. Examples include the SPDR S&P 500 index fund (SPY) and the QQQ Trust (QQQQ) which tracks the Nasdaq 100 index.
Market Cap ETFs
Some stock ETFs track companies according to their market value. Headline index funds typically track the largest companies, but there are some funds that narrow the list down further to the very largest companies. The iShares Global 100 ETF tracks the S&P Global 100 Index which includes the world's 100 most valuable companies.
There are also lots of funds that invest in midcap, small-cap, and microcap stocks. The iShares Micro-Cap ETF (IWC) holds over 1,300 companies, but all with a value below $300 million.
Some stock ETFs track sector indexes. The best example is the SPDR Select series of ETFs which includes 10 funds that invest in the 10 sectors that make up the market. Some of these funds, like the Financial Select Sector SPDR (XLF), have themselves become benchmarks for the daily performance of their respective sectors.
To invest in even more focused baskets of stocks, ETFs that invest in industry indexes are available. For example, within the technology sector there are various industries like cloud computing, software, hardware and cybersecurity. The Global X Cloud Computing ETF (CLOU) tracks the Indxx Global Cloud Computing Index of 37 companies around the world that are involved in cloud computing.
Investment style ETFs
An important part of the stock ETF universe is the funds that follow specific investment styles. These are still passively managed funds, but the indexes they track filter for stocks that have certain characteristics related to growth, value, momentum, or other factors.
An example is the iShares MSCI EAFE Growth ETF which tracks an index developed-market growth stocks from Europe, Australia, and Asia. Stock is selected for the index using a blend of growth metrics.
Smart Beta and Factor ETFs
Slightly more complex are ETFs that use a combination of factors to select and weight holdings. Indexes are typically based on empirical research and aim to improve on the performance of market cap weighted indexes. The goal is not just to create higher returns but take risks and volatility into account. This can be done by excluding stocks with high debt, falling margins, or very high valuations.
Equal weight ETFs
Another approach to risk management is the equal-weighted fund. In this case, an exiting index is altered so that all stocks are weighted equally. This approach removes the risk when the most valuable companies in an index are overvalued.
The Invesco S&P 500 Equal Weight ETF (RSP) includes all stocks in the S&P500 index, with each stock making up 0.2% of the fund. These funds do require regular rebalancing.
Income or dividend funds
Some investors are more concerned with the income their investments generate than with growth of capital. A large number of ETFs cater to these investors with dividend and income ETFs. The funds track indexes of stocks with high, sustainable, or growing dividend yields. These funds typically also invest in real estate investment trusts (REITs) and preference shares.
International and regional ETFs
ETFs are a useful tool for diversifying a portfolio with exposure to overseas markets. These funds typically hold a large number of equities from specific regions or stages of economic development. The broadest of these funds include equities from all of the largest 30 economies in the world. Others distinguish between developed and developing economies or including certain regions.
The largest international ETF is the Vanguard FTSE Developed Markets ETF (VEA) which includes almost 4,000 different stocks from developed countries.
The newest segment of the stock ETF universe is actively managed ETFs. These funds are managed like most mutual funds, by a fund manager and a team of analysts. Their goal is to create a portfolio that will outperform a benchmark index by actively picking stocks to invest in.
Pros and cons of stock ETFs
Advantages of ETFs:
- Stock ETFs are an efficient way to own a diversified or focused portfolio of equites.
- ETF management fees are much lower than they are for other investment products,
- Stock ETFs can be used to build a portfolio with very specific objectives.
Disadvantages of ETFs:
- ETFs aim to track the performances of an index, which by definition means they will never outperform the index.
- While management fees are low, you do have to pay commission when you buy and sell ETFs.
- ETFs that invest in very narrow market niches are often illiquid and have high expense ratios.
Recommended ETF Broker
For many investors, stocks are the most important asset class. Fortunately, there are a large number of stock ETFs that can be used to build an equity portfolio or as the core of a broader portfolio of investments.
Richard Bowman is a writer, analyst and investor based in Cape Town, South Africa. He has over 18 years’ experience in asset management, stockbroking, financial media and systematic trading. Richard combines fundamental, quantitative and technical analysis with a dash of common sense.
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