What is an ETF (Exchange-Traded Fund)?

An ETF (exchange-traded fund) is an investment fund that trades on a stock exchange. Investing in an ETF can add diversification, tax efficiency, and trading flexibility to an investor's portfolio. 

ETFs can hold stocks or bonds, or a mix of both. They share some characteristics with various other investments, such as mutual funds and stocks, but they also have their own unique qualities. Take time to learn more about ETFs and why they might be a good fit for your investment portfolio. 

What is an ETF? 

When you invest in an ETF, you gain ownership in a collection of underlying assets such as stocks, bonds, and commodities. Because an ETF can contain different types of assets across asset classes, industries, or geographies, it can be a good way to diversify your portfolio. 

ETFs are usually managed by experienced fund managers. Most ETFs are index funds, meaning they track an index such as the S&P 500. With index funds, the fund manager doesn't make a lot of decisions about which assets to buy and sell, but they make sure the fund doesn't stray far from its target index. Because ETFs often don't require active management, they are typically less expensive than other types of funds.

How do ETFs work? 

Investors, also known as shareholders, own a portion of the ETF, but they don't directly own the underlying assets in the fund. However, if you invest in an ETF that tracks a stock index, you may get dividend payments or dividend reinvestments for the stocks that make up the index. 

Because they trade on an exchange, ETFs can be bought and sold throughout the trading day, just like stocks. That means the market price of ETF shares may fluctuate throughout the day. 

4 Benefits of ETFs

Investing in ETFs can yield several important benefits for investors, such as: 

Diversification

One of the most important principles of sound investing is building a diversified portfolio with a wide variety of securities and assets. By not investing in a narrow range of securities or only one asset class, you can mitigate risk and better protect your portfolio. When some assets may be underperforming, others should be doing well. ETFs offer an easy option for diversifying your investments because you can add exposure to a variety of asset classes, industries, or geographies. 

Trading flexibility

Mutual funds can only be traded once per day, after the markets close, which means pricing changes often occur after trading orders have been made. ETFs, however, are traded on an exchange and can be bought and sold throughout the day while markets are open. Share prices vary throughout the day, and investors can make buying and selling decisions based on practical, real-time pricing information.  

Lower costs

All funds charge fees, but ETF fees are typically lower than those of mutual funds and other types of funds. Because investors own shares of the ETF rather than the actual assets in the ETF. This can typically keep costs lower.

Tax benefits

ETFs are typically more tax efficient because they typically have lower capital gains than mutual funds. That means investors pay less in capital gains taxes. With mutual funds, the investor incurs capital gains (and resulting taxes) throughout the life of the investment. But with ETFs, investors primarily incur capital gains when they sell their shares. However, ETFs may also incur capital gains through distributions. 

5 Types of ETFs

There are a number of different types of ETFs available, such as: 

Passive ETFs

Passive ETFs are set up to track the performance of an index, such as the S&P 500, or a specific sector, such as gold mining stocks. These ETFs are aimed at matching the performance of the index, prior to any fees, not beating it.

Active ETFs

Actively managed ETFs have fund managers making decisions about which assets to include in the portfolio, rather than simply targeting an index of securities. 

Bond ETFs

As the name implies, bond ETFs hold bonds, which might include government bonds, corporate bonds, and municipal bonds. These ETFs are typically used to provide investors with regular income.

Stock ETFs

These funds include a collection of stocks and are usually set up to focus on a specific industry or sector. A stock ETF may offer diversified exposure to a single industry. For example, a tech stock ETF might include holdings in huge tech companies as well as newcomers with growth potential. They usually include lower fees than stock mutual funds because investors don't actually own the underlying securities. 

Commodity ETFs

Commodity ETFs invest in commodities such as beef, soybeans, crude oil, and gold. They help investors diversify their portfolios without owning the actual commodities.  

ETF vs mutual fund

ETFs and mutual funds both allow investors to purchase a collection of assets. But they also have some important differences. 

ETFs generally have lower fees than mutual funds, and that's one of the main reasons they are appealing to so many investors. 

In addition to lower fees, ETFs are also more tax-efficient than mutual funds. With mutual funds, there's usually more buying and selling of the underlying securities — and all that trading typically results in capital gains. If the fund manager sells securities that have been held in the fund less than one year, investors are liable for short-term capital gains taxes, which are taxed at your ordinary income tax rate. 

ETFs and mutual funds also typically differ in their management structure. Mutual funds are usually actively managed and ETFs are usually passively managed, although there are some actively managed ETFs. 

ETF vs index fund

An ETF may be constructed to track the performance of an index or a commodity, particular market segment or industry, a trend, or even another index. An index fund refers to a type of mutual fund that only tracks a benchmark index. 

ETF vs stocks

ETFs and stocks are similar in that they both trade on exchanges. Each ETF and each stock has its own ticker symbol that allows investors to track their price activity. 

However, while stocks represent just one company, ETFs represent an entire collection of stocks or other types of investments. Because ETFs include a variety of assets, they can provide more diversification than purchasing a single stock. 

ETF management fees

ETF providers deduct investment management fees from the value of the fund. Because these funds are handled in-house, investors don’t see these fees on their account statements. The deduction of fees simply adjusts the value of the asset. Investors should review the ETF's prospectus or other offering documents for full breakdown of fees.

ETF management fees cover expenses such as manager salaries, custodial services, and marketing costs. The return that an ETF investor receives is based on the total return the fund actually earned, minus expenses. You can determine what the expenses will be for an ETF by looking at the ETF's stated annual expense ratio. If the ETF's stated annual expense ratio is 1%, you can expect to pay $1 in fees per year for every $100 investment.  

3 steps to start investing in ETFs 

Investing in ETFs isn't difficult. You can get started with three easy steps. 

Step 1: Open an investment or brokerage account. 

You'll need an investment or brokerage account to invest in ETFs. You can open an account online from a number of different companies — many of which have no account minimums or transaction fees. If you want help, consider opening an account with a robo advisor, which will build a portfolio based on your specific needs. For example, Acorns Invest offers curated ETF portfolios that are built and managed for you. 

Step 2: Research and select ETFs. 

If you plan to choose your own ETF investments, you'll need to conduct research to find the ones that best fit your needs. Keep an eye on each ETF's holdings, performance, expenses, commissions, and trading prices to help you make decisions. 

Step 3: Stick with it. 

Keep in mind that an ETF is intended to be a low-maintenance investment. Resist the temptation to compulsively check how your investment is performing. Just let the ETF do its work, and make sure your investments continue to match your long-term financial plan.