Exchange Traded Funds (ETFs) allow creative portfolio managers to deliver innovative product solutions to investors. Those solutions might mean developing customized, forward-thinking portfolios across various investment approaches. This article discusses the potential investment opportunities created by different ETF categories. Investors will find them similar to the categories offered by mutual funds.
The Building Blocks of ETFs
Most ETFs use traditional investment building blocks (stocks, bonds, cash, commodities) to pursue common investment objectives (capital appreciation, income).
This is why the array of ETF categories is broad. A sampling of ETF categories includes:
- Asset class
- Investing Style
- Specialty solutions
There are two distinct approaches to managing an ETF portfolio: passive and active. These define the first categories of ETFs.
Passive ETFs are intended to keep pace with a specific index (e.g., S&P 500, Nasdaq 100), before fees and expenses. Active ETFs seek to outperform a given index.
Exchange Traded Funds that track an index own the components of that index in an effort to mimic the index’s performance. Individual securities will typically be purchased or sold only when the index adds or removes them.
An active ETF has much more flexibility. Active ETF managers make deliberate decisions about what securities to own or avoid. They decide when to buy and when to sell based on their professional judgment and investment processes
Asset class ETFs represent a straightforward approach to investing. They typically invest in a single asset type, which is typically noted in the fund’s name. Recognizable examples are:
- Stock ETFs
- Bond ETFs
This category of ETFs may help investors satisfy specific investment objectives since different asset classes generally don’t behave the same way and have historically delivered distinct investment outcomes. For example, stocks have typically provided growth over time and have the potential to help build wealth. Bonds seek to generate current income.
Sectors are broad segments of an economy, like healthcare, technology or consumer. They also define another ETF category.
There is an index for every sector in the U.S. economy. And sector index ETFs are a very common way for investors to own them.
Sector ETFs may help investors gain specific types of exposures or be used to make investment choices based on macroeconomic indicators.
Geography refers to different markets in different regions of the world. They are easily defined as:
International refers to regions outside the United States. Global includes the U.S. and international regions. These represent additional categories of ETFs.
Management style defines two philosophies investment return. They are growth and value. And together they represent two more categories of ETFs.
Growth ETFs may invest in companies that are expected to achieve future earnings increases. Value ETFs may invest in companies that portfolio managers view as bargains or that sell at a discount relative to their peers.
In the context of ETFs, size refers to a company’s total value or market capitalization (price per share multiplied by total shares held by investors). Size represents another easy-to-define ETF category.
There are many ETFs that specialize in different market capitalizations, but in general there are just a few. For example:
- Small cap companies
- Mid cap companies
- Large cap companies
Market capitalization is an ETF category that applies to both stocks and bonds. For example, there can be both stock and bond funds that invest in the securities of small-, mid- or large-cap companies.
And this leads to the final category of ETFs. Those that don’t fit so easily into any others.
Exchange Traded Funds that follow unique or innovative investment methodologies or that take a hybrid approach using a combination of methodologies might properly be considered specialty solutions.
Some examples include:
- Custom index funds
- Asset allocation funds
- Multi-manager funds
- Rules-based funds
- Factor-based funds
Importantly, any of these approaches may be available in either an active or passive ETF.
Given the large number of ETF categories, it may be possible for some investors to accomplish their specific goals by including ETFs as part of a well-diversified portfolio.
Working with experienced financial professionals can help you stay the course. They can provide guidance and encouragement to help focus your attention on your long-term goals.