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Exchange-traded funds (ETFs) are an increasingly popular class of funds that trade like stocks. They can be bought and sold throughout the market day and offer portfolio exposure to many of the world's leading indexes. In recent years, they have gained popularity among both buy-and-hold investors and active traders. In this section you'll find information and commentary to help you use ETFs in your portfolio.

The Basics of Exchange Traded Funds + Expand All

ETF Basics

As ETFs continue to grow in popularity, you may be wondering if there's a place for this type of investment in your own portfolio. Below are some common questions from investors who are new to ETFs.

What are ETFs?

When you invest in an ETF, you're investing in a basket of securities that provides exposure to a particular segment of the market, such as a broad market, sector or geographic area. Generally, ETFs track indexes. ETFs are popular among investors because they are an easy and low-cost way to quickly build a well-diversified portfolio.

How do ETFs compare to mutual funds or stocks?

Mutual funds are purchased or redeemed directly with the fund one time each market day, at the close of the market. While you can place an order to buy or sell earlier in the day, your order will be processed only at the end of the day. The price you pay for your mutual fund is based on the Net Asset Value of the fund, determined by the day's closing prices of all the securities within that fund (plus any applicable sales charges, or loads).

An ETF trades much more like a stock. It's traded on a stock exchange, and you can buy or sell shares at any time during the day. The price is determined by supply and demand for the ETF in the market. Just as with stocks, you typically pay a commission for each trade. An exception is Schwab ETFs™—which can be traded commission-free by Schwab clients online through their Schwab accounts.

The bottom line: ETFs offer diversification with the trading flexibility of a stock.

What are the benefits of ETFs?

Their costs are often low. ETF expense ratios are generally low (although there are exceptions).

They're more diversified than individual stocks. Because ETFs represent a basket of securities rather than a single stock, they provide more diversification, and investment risk is not concentrated on a single holding.

They represent almost every asset class. That's good news if you're looking to broadly diversify across asset classes or if you're looking to fill a niche in your portfolio. ETF asset classes include large-cap, mid-cap, and small-cap stocks; growth stocks and value stocks; domestic, international, and emerging market stocks; sectors; long-term, mid-term, and short-term bonds; real estate; currencies; commodities, and more.

They can be traded any time during the market day. ETFs allow you to take advantage of opportunities that occur during the day. Unlike traditional mutual funds, you don't have to wait until the markets close for your trade to be completed.

They offer potential tax benefits. Unlike mutual funds, ETFs don't sell their holdings to satisfy shareholder redemptions. This can keep capital gains low. And since most ETFs track indexes, their holdings tend to have less turnover, which further reduces distributions.

Their holdings are transparent. ETFs make their holdings publicly available on a daily basis. This can be help investors to understand exactly what they hold.

What are the risks and drawbacks of ETFs?

As you think about investing in ETFs, be aware that:

Market risk is always a consideration. Just like any other investment, you can lose money in ETFs if the market that they track experiences a downturn. Though you can't eliminate this risk, you can help mitigate it by investing in a mix of ETFs in different asset classes, such as domestic stocks, international stocks, and bonds.

Some ETFs are high risk. Leveraged ETFs and ETFs that are narrowly focused may be more volatile than traditional ETFs.

Investors generally pay a commission for every trade. Unlike no-load mutual funds, ETFs have a trade commission. If you are dollar-cost averaging, making small investments, or trading frequently, ETF commissions can take a big bite out of your investment. Schwab ETFs are an exception; Schwab clients can trade them commission–free online through their Schwab accounts.

Not all ETFs are low cost. Although many ETFs have low expense ratios, some do not. Be sure to check the expense ratio of any ETF you are considering as an investment.

Market price and net asset value are not always equal. The price you pay for an ETF will generally be close to the value of the underlying stocks or bonds in the fund; the net asset value (NAV). However, the market price can deviate from the NAV, meaning you might pay more (or less) than the underlying value per share. This is more common in ETFs that have low trading volume. It's generally a good idea to check both the NAV and the price when evaluating an ETF for purchase.

There is a spread between the bid price and the ask price. There is typically a difference, or spread, between the bid price (highest price a buyer is willing to pay for a share) and the ask price (lowest price a seller is willing to accept for a share). The amount of the spread varies from one ETF to another, and tends to be higher for ETFs with low trading volume. Since this spread is a part of the overall costs of investing in ETFs, it's something to take into consideration when evaluating funds for purchase.

What are the different types of ETFs?

ETFs are available in several different types:

ETFs commonly track broad-based market indexes. These are what most investors have in mind when they think of ETFs—they tend to be low cost, highly diversified, and highly liquid.

Niche ETFs track narrower sectors of the economy such as stock sectors, bond sectors, and single countries. Niche ETFs offer less diversification, and may have higher costs, but they can be a good way to fill a specific gap in your portfolio.

Exotic ETFs track unusual strategies such as commodities and currencies. They're often more expensive and generally used by experienced investors because of their higher risk.

Leveraged ETFs are managed to move up and down faster than the index they track—some may move up three times as quickly as their index over the course of the trading day. They are often volatile and investors should seek to understand them carefully prior to investing. For more information, read Leveraged and Inverse ETFs: Not Right for Everyone.

Inverse ETFs are managed to move in the opposite direction than the indexes they track; when the index goes up, they go down. They can be used to hedge market exposure or profit from market declines, and are generally only used by experienced investors due to their risky nature. For more information, read Leveraged and Inverse ETFs: Not Right for Everyone.

Research and Commentary

Understanding the Nuances of ETFs
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Tactical Portfolio Strategies With ETFs
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CSIM Quarterly Newsletter
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Schwab ETFs™: Interactive Presentation

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Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can view and download a prospectus by clicking on Prospectuses & Reports. Please read the prospectus carefully before investing.

*Restrictions Apply: Online trades of Schwab ETFs are commission-free at Charles Schwab & Co., Inc. (Member SIPC), while trades of third-party ETFs may be subject to commissions. Broker-Assisted and Automated Phone trades are subject to service charges. Waivers may apply. See the Charles Schwab Pricing Guide for details. All ETFs are subject to management fees and expenses.  An exchange processing fee applies to sell transactions.

Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth less than their original cost. Unlike mutual funds, shares of ETFs are not individually redeemable directly with the ETF.

Shares are bought and sold at market price which may be higher or lower than the net asset value (NAV). 

Diversification does not eliminate the risk of market loss.

International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Investments in smaller companies typically exhibit higher volatility.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates.

An investment in the fund(s) is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Government backing applies only to the government-issued bonds that make up the fund, not the fund itself. TIPS generally have lower yields than conventional fixed rate bonds and will likely decline in price during periods of deflation, which could result in losses.

Investing in REITs may pose additional risks such as real estate industry risk, interest rate risk and liquidity risk. The Schwab U.S. REIT ETF is non-diversified and may invest in securities of relatively few issuers. As a result, the fund may experience increased volatility.

Transactions in shares of the Funds will generate tax consequences and transaction expenses; other account fees may apply. All registered investment companies are obliged to distribute portfolio gains to shareholders at year's end regardless of performance. The information provided is not intended to be investment or tax advice. Tax consequences vary by individual taxpayer.

The information presented represents the author's opinion and should not be considered investment advice. It is not known if the information is accurate or complete.

Schwab ETFs are distributed by SEI Investments Distribution Co. (SIDCO). SIDCO is not affiliated with The Charles Schwab Corporation or any of its affiliates.

"Standard & Poor’s®” and “S&P®” are registered trademarks of Standard & Poor’s Financial Services LLC (S&P) and Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (Dow Jones). The Dow Jones Total Stock Market, Dow Jones Real Estate and the Dow Jones Dividend Indices are products of S&P Dow Jones Indices or its affiliates, and have been licensed for use by Charles Schwab Investment Management, Inc. (CSIM). “FTSE®” is a trade mark owned by the London Stock Exchange plc and is used by FTSE International Limited (“FTSE”) under licence. The FTSE Global Equity Index Series is calculated by FTSE. Russell Investments (“Russell”) and Research Affiliates LLC (“RA”) have entered into a strategic alliance with respect to the Russell Fundamental Index® Series. The Russell Fundamental Index® Series are joint trademarks of Russell and RA and are used by the funds under license. “Research Affiliates” and “Fundamental Index” are trademarks of RA. Subject to RA’s intellectual property rights in certain content, Russell is the owner of all copyrights related to the Russell Fundamental Index® Series. Russell is the owner of the trademarks and copyrights related to the Russell Indexes. Barclays and the names identifying the Barclays’ indices are trademarks or names of Barclays Bank PLC and its affiliates (“Barclays”) and have been licensed for use by CSIM in connection with the issuance, marketing and promotion of the Schwab ETFs. The Schwab ETFs are not sponsored, endorsed, sold or promoted by S&P Dow Jones Indices, FTSE, Russell, RA, Barclays or their respective affiliates (together, the “Index Sponsors”) and the Index Sponsors do not make any representation regarding the advisability of trading in the Schwab ETFs. The Index Sponsors do not accept any obligations or liability in relation to the issuance, marketing, operation or trading of the Schwab ETFs. Charles Schwab & Co., Inc. is not affiliated with Russell or RA.

Neither SIDCO nor CSIM, nor any of their affiliates, are affiliated with the companies listed above.

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