What Is an Equity ETF and How Does It Work?

Exchange Traded Funds (ETFs) are pooled investment vehicles that trade on stock exchanges, much like individual stocks. Investors can buy and sell shares throughout the trading day. Equity ETFs are a specific category, primarily investing in stocks or other equity-related securities. They offer exposure to a collection of companies rather than a single stock.

Understanding Equity ETFs

An equity ETF holds a diversified basket of stocks, providing exposure to a broad market segment, industry, or specific investment theme. Unlike traditional mutual funds, priced once daily after market close, equity ETFs trade continuously on an exchange. This allows for real-time pricing and trading flexibility.

Equity ETFs offer inherent diversification, which can reduce the risk associated with investing in a single company. While an individual stock’s performance depends solely on one company, an ETF’s return is the weighted average of its many holdings, leading to lower volatility.

Authorized participants (APs), typically large financial institutions, maintain an ETF’s market price close to its Net Asset Value (NAV). APs create new ETF shares by delivering underlying securities to the issuer, and redeem shares by returning them in exchange for securities. This “in-kind” creation and redemption process helps ensure the ETF’s market price aligns with its underlying assets, contributing to its liquidity and price stability.

Categorizing Equity ETFs

Equity ETFs are classified in various ways. One common classification is by market capitalization, including large-cap, mid-cap, and small-cap ETFs. These invest in established, medium-sized, and smaller companies, respectively. This categorization helps investors align their portfolio with specific company sizes.

Another categorization is by investment style, such as growth, value, or blend. Growth ETFs focus on companies expected to grow earnings at an above-average rate. Value ETFs invest in companies perceived as undervalued, while blend ETFs combine both styles.

Geographic classification includes domestic U.S., international (developed or emerging markets), and global equity ETFs. These provide exposure to different national or regional economies. Sector or industry-specific equity ETFs concentrate investments within a particular economic sector, such as technology, healthcare, energy, or financials. This allows investors to target specific areas of the economy they believe will perform well.

Equity ETFs are also distinguished by their investment strategy. Most are index-tracking, aiming to replicate a specific market index by holding its constituent securities. A smaller number are actively managed, where a fund manager selects securities to outperform a benchmark.

Key Characteristics for Investors

Expense ratios represent the annual cost of owning an ETF, expressed as a percentage of assets. These fees cover management and operational costs, deducted from the ETF’s assets. For index equity ETFs, average expense ratios are around 0.15% to 0.16%, while actively managed equity ETFs may average approximately 0.43%.

Liquidity refers to how easily an ETF’s shares can be bought or sold without significantly impacting its market price. It is influenced by the ETF’s trading volume and the liquidity of its underlying securities. A narrower bid-ask spread (the difference between buy and sell prices) often indicates higher liquidity.

Tracking error measures the difference between an ETF’s performance and its underlying benchmark index. Factors contributing to tracking error include expense ratios, transaction costs, and cash holdings.

Equity ETFs are bought and sold through brokerage accounts, like individual stocks. Investors can place orders to buy or sell shares at any time during market hours, with prices fluctuating based on supply and demand.