What are the different types of exchange-traded funds (ETFs)

An exchange-traded fund (ETF)Exchange-traded fund (ETF) An investment fund that holds a collection of investments such as stocks and bonds, that trades on a stock exchange. It can be passively managed or actively managed.+ read full definition holds a collection of investments, such as stocks or bonds owned by a group of investors and managed by a professional money manager.

There are many different types of ETFs. Each one has pros and cons to consider if you’re adding to your investmentInvestment An item of value you buy to get income or to grow in value.+ read full definition portfolioPortfolio All the different investments that an individual or organization holds. May include stocks, bonds and mutual funds.+ read full definition. Read the fund’s prospectusProspectus A legal document that sets out the full, true and plain facts you need to know about a security. Contains information about the company or mutual fund selling the security, its management, products or services, plans and business risks.+ read full definition and ETF Facts carefully to better understand how the product works and its risks. Consider your risk tolerance and investment strategy before making a decision.

Watch our video: What is an ETF?

This article will explain:

• Index ETFs
• Actively managed ETFs
• Leveraged ETFs
• Volatility-linked ETFs
• Specialty ETFs
• Summary

Index ETFs

IndexIndex A benchmark or yardstick that lets you measure the performance of a stock market, part of a stock market or a single investment. Examples: S&P/TSX, S&P/TSX Canadian Bond Index.+ read full definition ETFs follow a benchmarkBenchmark A yardstick that you can use to measure the performance of an investment. Example: a stock market index may be a benchmark you can use to compare how well your own stocks are doing.+ read full definition, such as a stock market indexStock market index A listing that tracks a group of stocks and their value. Stocks in a given index will have something in common; they may trade on the same exchange, belong to the same industry or be about the same size. Indexes can help assess the results of mutual funds.+ read full definition (for example, the TSX/S&P 60). They are passive investments. They closely track an index. An Index ETF does not try to outperform the benchmark. The fund’s holdingsHoldings Shares or other interests in a business. Also refers to investments in a portfolio.+ read full definition are only adjusted if there is an adjustment in the components of the index.

Not all index ETFs follow stock marketStock market The collection of markets and exchanges where stocks, bonds and other securities are issued or traded.+ read full definition indices. Fixed-income ETFs, for example, follow indices that track bonds. Index ETFs can also track a specific commodityCommodity A raw material that trades in large amounts on a stock exchange. For example, grain, gold, and oil.+ read full definition like oil or gold, or single countries or regions

The specific index that an ETF tracks is important because it determines how investments are weighted in the fund. Two indices with the same investments in different proportions will provide different returns.

What are the risks with index ETFs?

Index ETFs have risks similar to the investments in the index they track. For example, an ETF that follows an equity indexEquity index A way to measure the performance of equity investments that trade on a certain stock market.+ read full definition has risks similar to stocks. An ETF that follows a fixed-income index has risks similar to bonds.

An index ETF may not achieve the same return as the index or sectorSector A part of the economy where businesses provide the same or related products or services. May also refer to a group.+ read full definition it tracks. That’s because the weighting of investments in the ETF may not be the same as those in the index, and fees and expenses lower the ETF return.

Like an index ETF, index mutual funds also track an index. But you buy and sell index mutual funds through a mutual fund dealerMutual fund dealer A company that buys and sells the shares or units of mutual funds for investors.+ read full definition — usually your bank or mutual fund companyMutual fund company An investment company that pools money from investors and invests it in a mix of investments, such as stocks, bonds, and money market investments. Most mutual fund companies offer a choice of more than one fund.+ read full definition. With Index ETFs, you have to open a trading accountAccount An agreement you make with a financial institution to handle your money. You can set up an account for depositing and withdrawing, earning interest, borrowing, investing, etc.+ read full definition because you buy and sell ETFs on an exchange like stocks.

Actively managed ETFs

Actively managed ETFs do not track an index. Instead, they try to meet a particular investment objective by investing in a portfolio of stocks, bonds or other assets. Active ETFs, like actively managed mutual funds, have more turnover than index ETFs because a portfolio managerPortfolio manager An investment professional who manages your investment portfolio. For example, they buy, sell and monitor investments that fit their clients’ goals and tolerance for risk.+ read full definition actively trades the investments in the portfolio.

What are the risks of actively managed ETFs?

The risk of actively managed ETFs include that it may be difficult to find an appropriate benchmark to monitor ETF performance. That’s because active ETFs can be flexible in terms of what they investInvest To use money for the purpose of making more money by making an investment. Often involves risk.+ read full definition in.

Actively managed ETFs also carry the additional risk of front running. Some ETFs disclose their holdings every day — that means everyone can see where an active ETF’s portfolio manager is putting the fund’s money and, if they want, they can try to replicate the fund’s holdings. This process can drive a stockStock An investment that gives you part ownership or shares in a company. Often provides voting rights in some business decisions.+ read full definition’s price up higher as many investors try to copy the strategy of a particular manager.

An actively managed ETF buys and sells investments based on the ETF’s investment objective and the portfolio manager’s strategy.

Leveraged ETFs

Leveraged ETFs are highly speculative short-termTerm The period of time that a contract covers. Also, the period of time that an investment pays a set rate of interest.+ read full definition investments. These ETFs use leverageLeverage A way to make a larger investment by using borrowed money to invest. The more you invest, the more money you can make. But if things don’t work out, you will have bigger losses.+ read full definition — they borrow to increase the amount that they can invest in the market. The objective of these funds is to double or triple the daily return of an index. This means the ETF must rebalance — or “re-leverage” — its position every day to keep the amounts borrowed in line with the actual stock owned.

What are the risks of leveraged ETFs?

Leveraged ETFs carry the same risks as other ETFs, but they also carry additional risks that make them highly speculative. As with any leveraged investment, your potential gains are multiplied — but so are your potential losses. If the ETF aims to double or triple the return of the index it’s tracking, and the market moves in the wrong direction, your losses will be doubled or tripled. For example, if the ETF’s objective is to triple the index, and the index drops by 10%, the shareShare A piece of ownership in a company. A share does not give you direct control over the company’s daily operations. But it does let you get a share of profits if the company pays dividends.+ read full definition value of the ETF will fall by 30%.

Leveraged ETFs are riskier over the long term due to the constant leveraging and rebalancing if the fund returns don’t meet the daily objectives. If returns vary widely from day to day, over time you’ll lose money even if the underlying index breaks even.

As with any leveraged investment, your potential gains are multiplied – but so are your losses if the index moves the other way. You can never lose more than the amount of your original investment, but you can lose all of it.

Leveraged ETFs are best suited to institutions and sophisticated investors who tradeTrade The process where one person or party buys an investment from another.+ read full definition daily and can afford to take on the added risks.

Leveraged ETFs are highly speculative short-term investments. They are not appropriate for investors who are planning to hold their investment for longer than a day – especially in volatile markets.

Volatility-linked ETFs

VolatilityVolatility The rate at which the price of a security increases or decreases for a given set of returns. A stock price that changes quickly and by a lot is more volatile. Volatility can be measured using standard deviation and beta.+ read full definition-linked ETFs are high-risk, complex investments. Volatility-linked ETFs are bets for or against volatility in the stock market. Some of these products do well when there are major swings in the market such as a stock market crash while others do well when the market is stable and there are no major changes.

These products are typically suited for financial professionals or investors who understand advanced investing strategies and are willing to take significant risk, including the possibility of losing their entire initial investment.

The Chicago Board OptionsOptions An investment that gives you the right to buy or sell it at a set price by a set date. The buy right is termed a “call” option, and the sell right is termed a “put” option. You buy options on a stock exchange.+ read full definition Exchange publishes the Volatility Index or VIX which measures expected stock market volatility by looking at current S&P 500 option prices. A higher VIX value means more volatility is expected. This is sometimes called the “fear index” but what it really represents is how much stock prices are expected to move (up or down) over the next 30 days.

Since the actual VIX cannot be bought (it’s simply an index), most volatility-linked ETFs are based on VIX future contracts, which is a bet on what the value will be on a future date.

What are the risks of volatility-linked ETFs?

You could risk major losses if you buy and sell volatility-linked ETFs without fully understanding how they work. Unlike most ETFs, volatility-linked ETFs are meant for short-term trading. This could mean owning the investment for mere hours. Some funds strongly advise against holding the product for more than one day.

Holding volatility-linked ETFs for the long term will likely expose you to even greater risks and further increase the likelihood of losing your money.

If you want to invest in a volatility-linked ETF, make sure you understand that:

• These investments are high risk
• They may not match how the stock market performs, since VIX future contracts are based on future expectations, not current performance
• Their investment strategies may be more complex than other products, and it may be difficult to predict how the fund would react to a sudden market shock
• They are different from most other ETFs, as they are designed for short-term trading

Specialty ETFs

These ETFs focus on a specific assetAsset Something of value that a company or an individual owns or controls. Examples: buildings, equipment, property, a car, investments, or cash. Can also include patents, trademarks and other forms of intellectual property.+ read full definition or action. Six of the most common types of specialty ETFs are:

1. Commodity ETFs

These ETFs invest in physical commodities like precious metals, natural resources, and agriculture. They work either by holding and storing the commodity they invest in (for example, gold or grain), or by tracking a commodity index through physical holdings and derivatives.

Risk
Commodity ETFs tend to be higher risk because they are concentrated in one sector and the prices of commodities move frequently.

2. Inverse ETFs

An inverse ETFInverse ETF An inverse ETF allows investors to “short” an index. It’s called “inverse” because it profits when the index declines (and vice versa). Inverse ETFs can be risky for investors who hold them for too long – they are designed for day-to-day use and investors should monitor their performance daily.+ read full definition allows investors to short an index. It’s called inverse because it profitsProfits A financial gain for a person or company. Equals the money left over after you subtract your costs from the money you made.+ read full definition when the index declines. For example, if an index falls 10% the inverse ETF based on it would rise 10%.

Risk
Inverse ETFs can be risky for investors who hold them for too long. They are designed for day-to-day use and investors should monitor their performance daily.

3. Currency ETFs

Currency ETFs invest in a single currency (for example, the U.S. dollar) or basket of currencies (for example, emerging markets). The goal is to follow the movements of those currencies in the foreign exchange market.

Risk
Currency ETFs can be risky. If the underlying currency experiences big changes in price, you could lose money.

4. Covered call ETFs

These ETFs write covered calls (sell call options on the stocks that the ETF owns) to generate additional income (in the form of premiums). The call optionCall option An agreement that gives you the right to buy a stock, bond, or other investment at a set price by a set date (within a set time period). Also called a “call.” You buy a call hoping that the stock price will rise and you can buy it for less than its market price.+ read full definition buyer buys the option to buy the stock from the ETF at the predetermined price in the future.

Risk
They’re designed to provide income but covered call ETFs do have risks. For example, if the stock price increases dramatically, the ETF would lose the opportunity to profit from the price increase beyond the predetermined price of the corresponding call option.

5. Managed futures ETFs

Managed futuresFutures A derivative contract that commits you to buy or sell a commodity, currency or stock market index at a set price on a set date in the future. Unlike an option, you can’t change your mind later; you must do what your contract says you will do.+ read full definition ETFs use commodity futures (speculating on the future price of commodities such as natural gas or copper) to deliver positive returns in both up and down markets. They do so by taking both short and long positions to follow market trends.

Risk
If the markets don’t follow the predicted short and long positions, you could lose money.

6. Hedge fund ETFs

Hedge fundHedge fund A lightly regulated fund that pools people’s money to invest in different investments. Hedge funds can invest in almost anything. They often mix different approaches to investing as a way to ‘hedge’ or protect investors from poor results.+ read full definition ETFs aim to mirror the stock picks of major hedge funds. These ETFs use monthly published data on the holding of particular hedge funds.

Risk
Hedge funds often buy and sell their holdings quickly (day-to-day). By the time the holdings are published, the ETF might not be an accurate reflection of the underlying fund. And there might be greater volatility in difficult market conditions.

Stock market indices track the activity of a specific part of the market. Learn more about how the stock market works.

Summary

An ETF is an investment fund that holds a collection of investments, such as stocks or bonds owned by a group of investors. There are different types of ETFs with different types of assets.

• ETFs, like any other investment, do carry risk. Consider your risk tolerance and investment strategy before making a decision.
• Some ETFs are designed for short-term investing and are more speculative.
• Always understand the fees involved when adding ETFs to your investment portfolio.
• Read the fund’s prospectus and ETF Facts carefully to better understand how the product works and its risks.