Episode #34: Explaining 4 Types of ETFs

4 types of ETFs

July 21st, 2020

There are four main types of ETFs: passive, active, factor, and sector. In 2019—According to this article—there were 6,970 ETFs globally. With so many options to choose from, how do you determine which fits your investment mix? Or if you want to invest in an ETF at all? In this episode of Making Finance Fun, I explain the four different types of ETFs to give you the information you need to accomplish what you want with your investments.

Outline of This Episode

  • [1:28] The 4 main types of ETFS
  • [2:06] Passive ETFs
  • [5:38] Active ETFs
  • [9:24] Single and multifactor ETFs
  • [16:02] Sector ETFs

What is a passive ETF? 

According to Investopedia, a Passive ETF is a vehicle to track an entire index or sector with a single security. What does that mean for you? It simply tracks an index. Single security is just a fancy term for an investment. A passive ETF is simply trying to get the same performance as some sort of index. With one purchase you can get roughly the same performance.

For example, the Dow Jones is comprised of 30 large US-based companies. So rather than trying to buy equal amounts of all 30 you can buy an ETF that tracks the Dow Jones. As the types of ETFs go, these will generally be the cheapest ETFs you will find to own and you’ll likely see a market-like performance. 

The definition of an active ETF

So what are Actively Managed ETFs? These types of ETFs have a manager or team making decisions on the underlying portfolio allocation, otherwise not adhering to a passive investment strategy. Generally speaking, they may be trying to beat the S&P 500. An actively managed ETF will likely be more expensive than a passive ETF as far as investment fees and expense ratios go. Why?

Let me explain—let’s say the investment group is buying Coke and they’re selling Pepsi on a daily, weekly, monthly, quarterly, and yearly basis. The reason an active ETF is more expensive is because it consists of a team of people making investment decisions on an ongoing basis. You’ve essentially hired people to do something for you—not just copy an index. So they’re the exact opposite of a passive fund.

What’s the deal with single factor and multifactor ETFs?

A Factor ETF takes a factor from an index and makes an ETF out of it. For example, they might take the S&P 500 and create an ETF of only the companies that pay dividends (the dividend would be the factor). A factor ETF could choose to extract the companies with the highest dividend amount in terms of dollar amount or yield. So a single factor ETF chooses companies from an index based on ONE factor—whether it be by dividend, the largest companies, growth rate, etc. After they’re chosen, they’re more passively managed. 

A multifactor ETF is simply an ETF that’s created from two or more factors. For example, the ETF could be composed of the companies with the highest dividends AND the largest annual growth. Let’s use Vanguard as an example: Vanguard has a Mega Cap ETF that is a single factor ETF. Vanguard also has a multifactor ETF—the Mega Cap Value ETF. To hear more specific examples and explanations about these two types of ETFs, make sure you listen!

Sector ETFs explained

The fourth type of ETF is a Sector ETF (what I prefer to refer to as a specific ETF). According to Investopedia, these types of ETFs invest in the stocks and securities of a specific industry or sector, typically identified in the fund title. Examples might be Pepsi, Coke, Proctor & Gamble, Walmart, Costco, etc. They can be referred to as consumer staple companies. So the ETF consists of a company or companies that sell consumer staples. With these types of ETFs, you get a little bit better exposure and diversification versus simply purchasing the stock itself.

Ultimately, the types of ETFs you choose to buy—or don’t buy—depends on what you’re looking for. If you want something more affordable, you can choose a passively managed ETF. If you want to invest in very specific companies or industries, a factor ETF may be the way to go. Hopefully, I’ve explained each of the types of ETFs so you have a better understanding of what will work the best for you and your investment portfolio. Listen to the whole episode for ALL the details! 

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