Types & Taxation of Exchange Traded Fund (ETF)

Types & Taxation of Exchange Traded Fund (ETF)

What Is an ETF?

An exchange-traded fund (ETF) is a type of security that tracks an index, sector, commodity, or another asset, but which can be purchased or sold on a stock exchange the same way a regular stock can. An ETF can be structured to track anything from the price of an individual commodity to a large and diverse collection of securities. ETFs can even be structured to track specific investment strategies.


A well-known example is the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index. ETFs can contain many types of investments, including stocks, commodities, bonds, or a mixture of investment types. An exchange-traded fund is marketable security, meaning it has an associated price that allows it to be easily bought and sold.

An ETF is called an exchange-traded fund because it's traded on an exchange just like stocks are. The price of an ETF’s shares will change throughout the trading day as the shares are bought and sold on the market. This is unlike mutual funds, which are not traded on an exchange, and trade only once per day after the markets close. Additionally, ETFs tend to be more cost-effective and more liquid when compared to mutual funds.

KEY TAKEAWAYS

  • An exchange-traded fund (ETF) is a basket of securities that trade on an exchange just like a stock does.
  • ETF share prices fluctuate all day as the ETF is bought and sold; this is different from mutual funds that only trade once a day after the market closes.
  • ETFs can contain all types of investments including stocks, commodities, or bonds; some offer U.S.-only holdings, while others are international.
  • ETFs offer low expense ratios and fewer broker commissions than buying the stocks individually does.

Cash Invested in ETFs

An ETF is a type of fund that holds multiple underlying assets, rather than only one like a stock does. Because there are multiple assets within an ETF, they can be a popular choice for diversification.

An ETF can own hundreds or thousands of stocks across various industries, or it could be isolated to one particular industry or sector. Some funds focus on only U.S. offerings, while others have a global outlook. For example, banking-focused ETFs would contain stocks of various banks across the industry.

Types of ETFs


There are various types of ETFs available to investors that can be used for income generation, speculation, price increases, and to hedge or partly offset risk in an investor's portfolio. Here is a brief description of some of the ETFs available on the market today.

Bond ETFs

Bond ETFs are used to provide regular income to investors. Their income distribution depends on the performance of underlying bonds. They might include government bonds, corporate bonds, and state and local bonds—called municipal bonds. Unlike their underlying instruments, bond ETFs do not have a maturity date. They generally trade at a premium or discount from the actual bond price. 

Stock ETFs

Stock ETFs comprise a basket of stocks to track a single industry or sector. For example, a stock ETF might track automotive or foreign stocks. The aim is to provide diversified exposure to a single industry, one that includes high performers and new entrants with potential for growth. Unlike stock mutual funds, stock ETFs have lower fees and do not involve actual ownership of securities. 

Industry ETFs

Industry or sector ETFs are funds that focus on a specific sector or industry. For example, an energy sector ETF will include companies operating in that sector. The idea behind industry ETFs is to gain exposure to the upside of that industry by tracking the performance of companies operating in that sector. One example is the technology sector, which has witnessed an influx of funds in recent years. At the same time, the downside of volatile stock performance is also curtailed in an ETF because they do not involve direct ownership of securities. Industry ETFs are also used to rotate in and out of sectors during economic cycles.

Commodity ETFs

As their name indicates, commodity ETFs invest in commodities, including crude oil or gold. Commodity ETFs provide several benefits. First, they diversify a portfolio, making it easier to hedge downturns. For example, commodity ETFs can provide a cushion during a slump in the stock market. Second, holding shares in a commodity ETF is cheaper than physical possession of the commodity. This is because the former does not involve insurance and storage costs.

Currency ETFs

Currency ETFs are pooled investment vehicles that track the performance of currency pairs, consisting of domestic and foreign currencies. Currency ETFs serve multiple purposes. They can be used to speculate on the prices of currencies based on political and economic developments for a country. They are also used to diversify a portfolio or as a hedge against volatility in forex markets by importers and exporters. Some of them are also used to hedge against the threat of inflation.

Inverse ETFs

Inverse ETFs attempt to earn gains from stock declines by shorting stocks. Shorting is selling a stock, expecting a decline in value, and repurchasing it at a lower price. An inverse ETF uses derivatives to short a stock. Essentially, they are bets that the market will decline. When the market declines, an inverse ETF increases by a proportionate amount. Investors should be aware that many inverse ETFs are exchange-traded notes (ETNs) and not true ETFs. An ETN is a bond but trades like a stock and is backed by an issuer like a bank. Be sure to check with your broker to determine if an ETN is a good fit for your portfolio.

In the U.S., most ETFs are set up as open-ended funds and are subject to the Investment Company Act of 1940 except where subsequent rules have modified their regulatory requirements. Open-end funds do not limit the number of investors involved in the product.

Advantages and Disadvantages of ETFs

ETFs provide lower average costs because it would be expensive for an investor to buy all the stocks held in an ETF portfolio individually. Investors only need to execute one transaction to buy and one transaction to sell, which leads to fewer broker commissions because there are only a few trades being done by investors. Brokers typically charge a commission for each trade. Some brokers even offer no-commission trading on certain low-cost ETFs reducing costs for investors even further.

An ETF's expense ratio is the cost to operate and manage the fund. ETFs typically have low expenses because they track an index. For example, if an ETF tracks the S&P 500 Index, it might contain all 500 stocks from the S&P, making it a passively managed fund that is less time-intensive. However, not all ETFs track an index in a passive manner.



ETFs vs. Mutual Funds vs. Stocks

 Exchange Traded FundsMutual FundsStocks
ETFs are a type of index funds that track a basket of securities.Mutual funds are pooled investments into bonds, securities, and other instruments that provide returns.Stocks are securities that provide returns based on performance.
ETF prices can trade at a premium or at a loss to the net asset value of the fund.Mutual fund prices trade at the net asset value of the overall fund.Stock returns are based on their actual performance in the markets.
ETFs are traded in the markets during regular hours just like stocks are.Mutual funds can be redeemed only at the end of a trading day.Stocks are traded during regular market hours.
Some ETFs can be purchased commission-free and are cheaper than mutual funds because they do not charge marketing fees.Some mutual funds do not charge load fees, but most are more expensive than ETFs because they charge administration and marketing fees.Stocks can be purchased commission-free on some platforms and generally do not have charges associated with them after purchase.
ETFs do not involve actual ownership of securities.Mutual funds own the securities in their basket.Stocks involve physical ownership of the security.
ETFs diversify risk by tracking different companies in a sector or industry in a single fund.Mutual funds diversify risk by creating a portfolio that spans multiple asset classes and security instruments.Risk is concentrated in a stock's performance.
ETF trading occurs in-kind, meaning they cannot be redeemed for cash.Mutual fund shares can be redeemed for money at the fund's net asset value for that day.Stocks are bought and sold using cash.
Because ETF share exchanges are treated as in-kind distributions, ETFs are the most tax-efficient amongst all three types of financial instruments.Mutual funds offer tax benefits when they return capital or include certain types of tax-exempt bonds in their portfolio.Stocks are taxed at ordinary income tax rates or at capital gains rates.

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