Types of exchange-traded funds (ETFs): A guide

Exchange-traded funds (ETFs) have become a popular investment option because they require little effort to manage and often come with relatively low fees. Whether you’re looking to invest in stocks, bonds, real estate or even commodities, you’ll likely find an ETF that works for you.

Each type of ETF comes with its own benefits and risks, however, and some are better suited for different kinds of investors. Understanding how different ETFs work can help you build a balanced portfolio that aligns with your unique financial goals.

First things first: What are ETFs?

An ETF, or exchange-traded fund, is a type of investment product that consists of a collection of assets, which could include stocks, bonds, commodities and currencies, and can be bought and sold on a stock exchange throughout the trading day.

ETFs can be structured as index funds – for instance, an ETF index fund tracking the S&P 500 – but this is not always the case.

Some non-index ETFs may concentrate on particular sectors like financials or consumer discretionary spending, or themes such as artificial intelligence or clean energy. They might also employ complex trading strategies, including options and leverage, to construct and manage a portfolio of assets.

What are some of the types of ETFs?

There are many different types of ETFs. It may be worth familiarizing yourself with some of the options as you decide on investments that might be right for your portfolio.

Equity ETFs

Equity ETFs invest in a “basket” of stocks, such as a specific index or market segment. These funds allow you to gain exposure to a wide range of companies with a single investment.

Equity ETFs come in many forms: For example, large-cap ETFs focus on established companies, while small-cap ETFs target smaller firms. Other equity funds invest in certain sectors or industries. ETF index funds – tracking indexes like the S&P 500 and the Nasdaq Composite – are also considered equity ETFs.

Equity funds may offer built-in diversification, though they do carry investment risk. While equity ETFs may be a choice for investors of all skill levels to consider since there are so many options, they may be especially sensible for anyone looking for a passive investment strategy who doesn’t want to manage holding a portfolio of individual stocks.

International and global ETFs

International and global ETFs invest in companies outside the U.S. and may focus on specific regions or markets. These type of equity funds can provide access to fast-growing economies and reduce some investors’ dependency on U.S. markets. Currency fluctuations or political instability can affect their performance, among other factors.

Sector and industry ETFs

Sector and industry ETFs focus on a particular market sector, allowing investors to target industries they believe will outperform the broader market or manage sector-specific exposure in a larger portfolio.

With these types of equity funds, investors can capitalize on long-term growth trends within a specific sector and improve their overall diversification.

Thematic ETFs

Thematic ETFs focus on investment “themes,” such as health care or sustainability. These equity ETFs may select companies expected to benefit from a particular development or societal shift.

Thematic ETFs can offer targeted exposure to emerging trends, along with the opportunity to support companies that align with investors’ values. Returns, depending on the ETF’s focus, may be unpredictable, so it may be beneficial to only have these funds represent a small part of a broader, well-diversified portfolio.

Real estate ETFs

Real estate ETFs primarily invest in a basket of real estate investment trusts (REITs). These equity funds allow investors to access the real estate market without directly buying property. Investing in a real estate ETF may provide broader exposure to the real estate market than investing in a single REIT.

According to the Financial Industry Regulatory Authority (FINRA), there is a possibility of fraud with REITs because investors may be oversold on potential returns while underinformed of inherent risks. Before pursuing a real estate ETF, you may want to seek advice from a licensed financial professional and assess the prospectus of the ETF you’re considering to understand the investments the ETF is making.

Bond ETFs

Bond ETFs invest in bonds and other debt securities and provide investors easy access to the bond market without requiring them to buy individual bonds.

Focuses of individual bond ETFs include government bonds, corporate bonds and municipal bonds, and each comes with different levels of risk and potential returns.

While bonds have historically been considered less volatile than stocks, there are still plenty of risks to consider. Investors should know that the value of bonds tends to decrease when interest rates rise. There’s also a credit risk if the issuer of the bonds defaults, but this risk is relatively low for funds that invest in government bonds.

Bond ETFs can be a good fit for conservative investors or anyone looking to stabilize their portfolio. They tend to be a popular choice for individuals nearing retirement, too. This is because as one ages, it’s generally advisable to reduce portfolio risk by shifting from riskier assets like stocks to more stable ones like bonds, which tend to help preserve savings and generate income during retirement.

Commodity ETFs

Commodity ETFs invest in physical assets, like gold, silver or agricultural products. These ETFs track the price of a single commodity or a bundle of related commodities, using either futures contracts or direct investment in the physical asset.

While commodity ETFs allow investors to gain exposure to an asset without requiring them to own or store physical goods, these funds also come with the risk of price volatility. In addition, some commodity ETFs aren’t registered as investment funds and consequently don’t offer the same protections that ETFs typically offer.

Despite the risks, commodity ETFs can be an option worth considering for investors looking to protect themselves from inflation and to diversify their portfolios beyond stocks and bonds. Given their unpredictable returns, though, commodity ETFs should typically be a small component of a broader investment strategy.

Leveraged and inverse ETFs

Leveraged and inverse ETFs aim to either multiply an index’s daily return or move in the opposite direction. For example, a “2x Leveraged ETF” may try to double the daily return of an index, while an inverse ETF is designed to rise when the index falls. These funds reset daily and often use complex tools like futures and options.

Leveraged and inverse ETFs can provide short-term opportunities to boost gains or protect against losses, but they can also be risky. Their value can change quickly, and holding them for too long can lead to unexpected results. Because of their complexity, these ETFs may be better suited for experienced investors and active traders. Learn more about the risks of complex registered funds here (PDF).

The bottom line

There’s no one-size-fits-all approach when it comes to ETFs. With so many types available, you can build a portfolio of ETFs customized to your risk tolerance, timeline and investing interests.

Before choosing an ETF, consider the fund’s investments, the level of risk you can handle and how the fund might advance your long-term goals.

If you’re unsure which ETFs are right for your portfolio – or you’re considering more complex ETFs like leveraged or inverse ETFs – a licensed financial professional may be a good resource to help you evaluate your options.

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