Exchange-traded funds have revolutionized the investing industry by making it easier than ever for investors to get exposure to the widest possible range of investments. With thousands of ETFs available, it can be very challenging for investors to figure out which types of ETFs are the best for their portfolios. The following types of ETFs are the most common, and you'll likely find the funds you're looking for within these categories:
- Broad-market ETFs;
- Sector ETFs;
- Dividend ETFs;
- Style-based ETFs;
- Commodity ETFs;
- Currency ETFs; and
- Bond ETFs.
Broad-market ETFs for full market exposure
The biggest and most popular ETFs are broad-market ETFs. They track indexes that cover all or a large part of the stock market. The best example is the SPDR S&P 500 (NYSEMKT:SPY), which is the largest ETF and tracks the S&P 500 index of U.S. stocks.
You can find broad-market ETFs that cover a variety of different indexes. Some broad-market ETFs offer exposure to the entire global stock market, while focusing on a particular size of company or geographic region. The cheapest broad-market ETFs are among the least expensive investments available, and they work well as a one-stop solution for asset allocation.
Sector ETFs for industry-specific investing
Sector ETFs let you invest in stocks within a particular sector of the market. The Sector SPDR group of ETFs breaks down the market into 10 different sectors, but there are other groups of ETFs that use different classifications that can include specific industries.
The advantage of sector ETFs is that they can give you pure-play exposure to a particularly attractive industry. Broad-market ETFs will have a small fraction allocated to each sector, but when the sector you choose does particularly well, then sector ETFs let you benefit fully without having returns watered down by poorer-performing stocks.
Dividend ETFs for solid income
Dividend ETFs focus on dividend-paying stocks, with the objective of paying substantial current income to investors. Yet there are different approaches that dividend ETFs can take toward that objective.
Some dividend ETFs look to maximize current yield, which results in maximum income distributions. Others choose stocks not just on yield but also on their histories of consistent dividend growth. ETFs that follow those two strategies can see their returns vary widely from each other, so it's important to know which type of dividend ETF you're looking at and which fits better with your investing style.
Style ETFs for growth or value investors
You can find style-based ETFs for all sorts of stocks, ranging from domestic large, mid-sized, or small companies to international stocks of all sizes and from all regions of the world. The two styles go in and out of favor, switching off in their relative performance, but both can be successful ways to invest.
Commodity ETFs for uncorrelated returns
Commodity ETFs offer exposure to commodity markets, which can provide returns that aren't necessarily linked to those of the stock market. That can be useful for investors looking for true diversification across asset classes. Most commodity ETFs use futures or other derivatives to get their exposure to their respective markets, while a few actually buy the physical commodity itself, with each share representing a corresponding amount of the commodity.
Because of their use of derivatives, many commodity ETFs can require being familiar with vagaries of the futures markets in order to avoid traps. Those that own physical commodities incur costs that slowly erode their value. Yet for many, those downsides are worth it to get a different type of asset exposure.
Currency ETFs for foreign exchange exposure
Similar to commodity ETFs, currency ETFs are designed to let you profit from moves in foreign currency values compared to the U.S. dollar. Many currency ETFs have conventions whereby a share of the ETF corresponds to the value of a particular amount of a certain foreign currency. Others track broad benchmarks of currency moves like the U.S. dollar index.
You can use currency ETFs either to hedge personal exposure on things like a vacation trip or to protect against adverse currency moves for key companies in your portfolio. By effectively mimicking a cash investment in the foreign currency, currency ETFs can act a lot like cash in an asset allocation strategy -- with a twist from the foreign exposure.
Bond ETFs for fixed income
Finally, bond ETFs give investors exposure to the bond market. You can find broad-market bond ETFs that cover the entire market, or bond sector ETFs that focus on particular types of bonds, such as Treasury bonds, corporate debt, or international sovereign obligations of foreign nations.
With bond ETFs, you need to know whether the fund focuses on a particular maturity or rolls over maturing bonds to buy new ones. The interest rate risks are different for each of those two types of funds, so matching up your ETF to your particular needs is paramount.
There's an ETF for you
With so many types of ETFs, there's at least one that will fit with your needs. Look more closely at the various ETFs described above and see which types deserve to be part of your portfolio.