ETFs are becoming increasingly popular because they offer investors a cost-effective way to diversify their portfolios. Whether you want to invest in a specific geographic market, different-sized companies, or sectors, you can find an ETF to suit your needs. ARK even offers a Space Exploration & Innovation ETF.
With the wide variety of ETFs available, it's important to understand the different types and how they can help you achieve your investment goals. While there are many ways to categorize ETFs, here are the seven common types:
1. Equity ETFs
Equity ETFs track related stocks, such as those from large or small businesses or a specific country. The most popular ones are broad-market ETFs, which mirror entire stock market indexes. For example, the SPDR® S&P 500® ETF Trust tracks the S&P 500 index of U.S. stocks. Keep in mind that the goal of an equity ETF is to mirror the underlying index, not outperform it. You can find broad-market ETFs that cover various indexes, some focusing on the global stock market while others target specific company sizes or geographic regions.
2. Fixed Income/ Bond ETFs
Bond ETFs provide exposure to the bond market. You can choose from broad-market bond ETFs that cover the entire market, such as the iShares Core U.S. Aggregate Bond ETF, or bond sector ETFs that focus on specific types of bonds, including Treasury bonds, corporate debt, or international sovereign obligations. Financial professionals often recommend allocating a portion of your portfolio to bond ETFs because they reduce volatility and generate additional income.
3. Sector/ Industry ETFs
Sector/industry ETFs allow you to invest in stocks within a particular market sector or industry, such as consumer staples or technology. By investing in these ETFs, you can diversify your holdings within a specific sector and reduce the risk associated with holding individual stocks. For example, instead of investing in multiple tech companies, you can invest in The Technology Select Sector SPDR® Fund, which represents the technology sector of the S&P 500 Index.
4. Commodity ETFs
Commodity ETFs provide exposure to commodity markets like gold, oil, or agriculture, offering returns that may not be correlated with the stock market. These ETFs are attractive to investors looking to diversify across asset classes. Most commodity ETFs use futures or derivatives to gain exposure, while a few purchase the physical commodity itself. It's important to note that derivatives carry additional risks, such as counterparty risk, compared to ETFs that own the underlying asset directly.
5. Foreign Currency ETFs
Foreign currency ETFs help investors gain exposure to foreign currencies without engaging in complex transactions. They can track a single currency or a basket of currencies, similar to how a market ETF tracks its underlying index. These ETFs either invest in the currency directly, use derivatives, or a combination of both. Investing in foreign currency ETFs can hedge against adverse currency moves in your investment portfolio. Examples of common foreign currency ETFs include the WisdomTree Chinese Yuan Strategy ETF and the Invesco CurrencyShares® Canadian Dollar ETF.
6. Leveraged ETFs
Leveraged ETFs aim to provide higher rates of return by using financial derivatives and/or debt to track an underlying index. Unlike typical ETFs that closely track their index, leveraged ETFs strive to offer 2-3 times the returns. However, they are riskier investments. For example, the ProShares UltraPro® QQQ seeks three times the daily performance of the Nasdaq-100 Index®:
A common misconception about leveraged ETFs is that they produce magnified annual returns. However, their goal is to offer leveraged daily returns on underlying indexes, and even this has no guarantee. For example, if the QQQ increases by 10% over the coming year, it is not reasonable to expect TQQQ to increase by 30% during the same period. As you can see from the above investment objective for TQQQ, the keyword is ‘daily’:
Therefore, leverage ETFs may not be suitable for long-term investments.
7. Inverse ETFs
Inverse ETFs allow investors to profit when the market or underlying index declines, without having to sell anything short. When the market drops, investors often hedge by shorting their positions. However, this may not be possible for all investors due to trading limitations or short-selling restrictions. Inverse ETFs offer the same investment position as shorting an ETF or index. Some inverse ETFs are also leveraged, such as the ProShares UltraPro Short QQQ, which provides three times leveraged daily inverse exposure to the Nasdaq 100 Index®.
Bottom line
By understanding these different types of ETFs, you can better align them with your investment objectives and make informed decisions. Remember to carefully assess the risks and suitability of each type before including them in your portfolio.
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