Exchange-Traded Funds (ETFs) can offer a great mix of diversification, flexibility, and cost efficiency. Used by both institutional and individual investors, they have become a staple in portfolios, blending the best aspects of stocks and mutual funds to create a powerful investment vehicle.

But what exactly are ETFs, and how do they work?

1. ETFs Are Investment Funds That Trade Like Stocks

Think of an ETF like a well-balanced sports team. Instead of relying on a single superstar player (an individual stock), a strong team has a mix of players that help keep the team competitive, even if one underperforms.

Similarly, an investor considering technology stocks could:

• Buy shares of individual companies, which carries higher risk.
• Invest in a technology-focused ETF, which holds multiple major tech companies, reducing risk through diversification.

In contrast to Mutual Funds, ETFs generally have lower expense ratios and can be traded at real-time pricing throughout the day.

2. How ETFs Are Created and Managed

ETFs operate through a creation and redemption process that ensures their price closely follows the value of their underlying assets.

Large financial institutions, called Authorized Participants (APs), create new ETF shares by exchanging a basket of securities for ETF shares, and vice versa. This prevents significant price deviations between the ETF and its holdings.

Put simply, if demand for an ETF rises, APs create more shares to meet supply, preventing extreme price fluctuations.

3. The Different Types of ETFs and Their Uses

ETFs come in various forms, each serving different investment goals:

• Broad Market ETFs – Track major indexes (S&P 500, Nasdaq, MSCI World).
• Sector ETFs – Focus on specific industries (e.g., tech, healthcare, energy).
• Bond ETFs – Provide exposure to government, corporate, or municipal bonds.
• Commodity ETFs – Invest in physical assets like gold, oil, or agriculture.
• Dividend ETFs – Hold income-generating stocks for passive income.
• Inverse & Leveraged ETFs – Designed for short-term trading, not long-term investing.

Because ETFs are versatile, investors can customize their portfolios to align with their risk tolerance and financial goals.

For example, a retired investor may prefer bond ETFs and dividend ETFs for steady income, while a younger investor might opt for growth ETFs for long-term capital appreciation.

4. Potential Risks of ETFs

While ETFs offer many advantages, they are not risk-free. Here are a few key risks investors should understand:

• Market Risk – ETFs can lose value as market conditions change.
• Tracking Error – Some ETFs may not perfectly match the performance of the index they track.
• Liquidity Concerns – Niche ETFs with lower trading volume can be harder to buy and sell, leading to higher transaction costs or difficulty selling shares during downturns.

ETFs offer a blend of diversification, efficiency, and flexibility, making them an attractive choice for both passive and active investors. While they do carry some risks, as all investments do, ETFs can be a cost-effective way to access markets, manage risk, and enhance portfolio diversification. Speak with your financial advisor to determine which ETFs best fit your investment goals and risk tolerance.

The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of the author and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. This information was developed by Oechsli, an independent third party, for financial advisor use. Raymond James is not affiliated with and does not endorse, authorize or sponsor the opinions or services of Oechsli. Raymond James and its advisors do not offer tax or legal advice. You should discuss any tax or legal matters with the appropriate professional.

Every type of investment, including mutual funds and ETFs involves risk. Risk refers to the possibility that you will lose money (both principal and any earnings) or fail to make money on an investment. ETF shareholders should be aware that the general level of stock or bond prices may decline, thus affecting the value of an exchange-traded fund. Although exchange-traded funds are designed to provide investment results that generally correspond to the price and yield performance of their respective underlying indexes, the funds may not be able to exactly replicate the performance of the indexes because of fund expenses and other factors. This material is being provided for information purposes only and does not constitute a recommendation.