What Is an Exchange-Traded Fund (ETF)? Beginner’s Guide

Want the ease of stock trading, but diversification benefits of mutual funds? ETFs combine the best of both.
Alana Benson
Kevin Voigt
By Kevin Voigt and  Alana Benson 
Updated
Edited by Robert Beaupre Reviewed by Jody D’Agostini

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Nerdy takeaways
  • An exchange traded fund, or ETF, is a basket of investments such as stocks or bonds.

  • ETFs often have lower fees than other types of funds.

  • ETFs provide instant diversification by investing in many assets at once.

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Exchange-traded funds are a type of investment fund that offers the best attributes of two popular assets: They have the diversification benefits of mutual funds while mimicking the ease with which stocks are traded.

ETF meaning

An exchange-traded fund (ETF) is a basket of investments like stocks or bonds. Exchange-traded funds let you invest in many securities all at once, and ETFs often have lower fees than other types of funds. ETFs are traded more easily, too.

But as with all financial products, ETFs aren’t a one-size-fits-all solution. Evaluate them on their own merits, including management costs and commission fees (if any), how easily you can buy or sell them, how they fit into your existing portfolio and their investment quality.

How do ETFs work?

Exchange-traded funds work like this: The fund provider owns the underlying assets, designs a fund to track their performance and then sells shares in that fund to investors. Shareholders own a portion of an ETF, but they don’t own the underlying assets in the fund. Even so, investors in an ETF that tracks a stock index may get dividend payments for any dividend stocks in the index.

While ETFs are designed to track the value of an underlying asset or index — be it a commodity like gold or a basket of stocks such as the S&P 500 — they trade at market-determined prices that usually differ from that asset. What’s more, because of things like expenses, longer-term returns for an ETF will vary from those of its underlying asset.

Here is the abbreviated version of how ETFs work:

1. An ETF provider considers the universe of assets, including stocks, bonds, commodities or currencies, and creates a basket of them with a unique ticker.

2. Investors can buy a share of that basket using their brokerage account, just like buying shares of a company.

3. Buyers and sellers trade the ETF throughout the day on an exchange, much like a stock.

» Ready to learn more? How to invest in ETFs

Types of ETFs

Exchange-traded funds may trade like stocks, but under the hood, they more closely resemble mutual funds and index funds, which can vary greatly in terms of their underlying assets and investment goals. Below are a few common types of ETFs. These ETFs aren’t categorized by management type (passive or active) but rather by the types of investments held within the ETF.

» Check out our full list of the best ETFs

Stock ETFs

These comprise stocks and are usually meant for long-term growth. While typically less risky than individual stocks, they often carry slightly more risk than some of the others listed here, such as bond ETFs.

» Learn the differences: ETFs vs. stocks

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Commodity ETFs

Commodities are raw goods that can be bought or sold, such as gold, coffee and crude oil. Commodity ETFs let you bundle these securities into a single investment. With commodity ETFs, it’s especially important to know what’s inside them — do you have ownership in the fund’s physical stockpile of the commodity, or do you own equity in companies that produce, transport and store these goods? Does the ETF contain futures contracts? Is the commodity considered a “collectible” in the eyes of the IRS? These factors can come with serious tax implications and varying risk levels.

» Learn more: What are the best commodity ETFs?

Exchange-traded notes (ETNs)

Exchange-traded notes (ETNs) are technically not ETFs but are often confused with them due to their similar names and characteristics. Like ETFs, ETNs trade on exchanges throughout the trading day and track a basket of assets. ETNs often track commodities, bonds, derivatives such as futures, or more exotic assets such as carbon credits rather than stocks.

An ETN differs from an ETF in that it does not actually own the underlying assets — instead, it's a debt security that tracks the value of its underlying assets indirectly. What that means in practice is that an ETN's value relies on its issuer's creditworthiness — and the risk of an issuer default is worth considering when looking at ETNs.

The best-performing ETFs by category

Use the dropdown menu to see the best-performing ETFs in general, or the best-performing ETFs for specific assets like bonds, gold and dividend stocks.

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Bond ETFs

Unlike individual bonds, bond ETFs don’t have a maturity date, so the most common use for them is to generate regular cash payments to the investor. These payments come from the interest generated by the individual bonds within the fund. Bond ETFs can be an excellent, lower-risk complement to stock ETFs.

» More: See the best bond ETFs

International ETFs

Foreign stocks, along with U.S. stocks and bonds, are widely recommended for building a diverse portfolio. International ETFs, which may include investments in individual countries or specific country blocs, are an easy — and typically less risky — way to find these foreign investments.

» More: Learn about the best China ETFs

Bitcoin or crypto ETFs

In Jan. 2024, the Securities and Exchange Commission approved a handful of spot Bitcoin ETFs, which directly track the price of Bitcoin. This makes the cryptocurrency more accessible to the average investor, as Bitcoin ETFs can be bought and sold directly in brokerage accounts.

ETFs that offer exposure to other cryptocurrencies are still limited. Most crypto ETFs hold futures contracts or the stock of companies that either deal in or invest in the cryptocurrency markets.

» More: Check out the best Bitcoin ETFs

Sector ETFs

The U.S. stock market is divided into 11 sectors, and each is made up of companies that operate within that sector. Sector ETFs provide a way to invest in specific companies within those sectors, such as the health care, financial or industrial sectors. These can be especially useful to investors tracking business cycles, as some sectors tend to perform better during expansion periods and others better during contraction periods. Often, sector ETFs can carry higher risk than broad-market ETFs. Sector ETFs can give your portfolio exposure to an industry that intrigues you, such as gold ETFs or marijuana ETFs, with less risk than investing in a single company.

» One trendy sector: See our roundup of the best semiconductor ETFs

Leveraged ETFs

Leveraged ETFs are exchange-traded funds that track an existing index — but rather than match that index’s returns, they aim to increase them by two or three times. (It's important to note that they don't just amplify that index's gains by two or three times — they also amplify its losses.)

Imagine you had a traditional ETF that followed the S&P 500. If the S&P 500 went up by 2%, your ETF would likely also increase by about 2% because it holds most of the same companies the index tracks.

If you had a leveraged S&P 500 ETF, that 2% gain could be magnified and instead be a 4% gain. While that’s great if the market is going up, it’s not so great if the market is going down. This is what makes leveraged ETFs riskier than other types of ETFs.

» Dive deeper: Take a look at some of the best leveraged ETFs

How much do ETFs cost?

Exchange-traded funds can vary significantly when it comes to cost, with share prices ranging from the single digits to the triple digits. That range may feel intimidating, but it also means there is an ETF for every budget. It may help to outline how much you're willing to spend on an ETF before you dive in.

When researching ETFs, you'll also need to consider the fund's expense ratio, or the fee the fund charges to manage and maintain it. Because most ETFs are passively managed, ETF expense ratios are typically pretty low compared with other types of funds.

» Need more info? Learn about passive investing

ETF creation and redemption

Given that ETF shares correspond to shares of a basket of assets, the process of creating or retiring ETF shares is complex — and has to involve a purchase or sale of the underlying assets.

To create new ETF shares, an "authorized participant" — typically an institutional investor like a broker — gives the ETF a basket of assets that match the ETF's portfolio or a cash payment. In exchange, they receive a block of new ETF shares with the same value as this "creation basket." The authorized participant then sells those new shares to regular investors.

To retire or "redeem" ETF shares, this process happens backward. The authorized participant returns a block of ETF shares to the fund and, in exchange, receives a basket of cash, assets, or both that typically mirrors what a creation basket would be for that number of shares.

How to find the right ETFs for your portfolio

It's important to be aware that while costs generally are lower for ETFs, they also can vary widely from fund to fund, depending on the issuer as well as on complexity and demand. Even ETFs tracking the same index have different costs.

Most ETFs are passively managed investments; they simply track an index. Some investors prefer the hands-on approach of mutual funds, which are run by a professional manager who tries to outperform the market. There are actively managed ETFs that mimic mutual funds, but they come with higher fees. So consider your investing style before buying.

The explosion of this market also has seen some funds come to market that may not stack up on merit — borderline gimmicky funds that take a thin slice of the investing world and may not provide much diversification. Just because an ETF is cheap doesn’t necessarily mean it fits with your broader investment thesis.

» Ready to get started? See our guide to the best brokers for trading ETFs

Do ETFs pay dividends?

Yes, as long as the underlying stocks held within the ETF pay dividends. These companies’ dividends are collected by the ETF issuer and distributed to investors, typically quarterly, based on the number of shares the investor owns in the ETF. However, if none of the underlying companies in the ETF offer dividends, the ETF won’t pay dividends, either. Some ETFs are constructed specifically to maximize dividend income, known aptly as dividend ETFs.

Can you sell an ETF at any time?

Yes. Just like stocks, ETFs can be bought or sold at any time throughout the trading day (9:30 a.m. to 4 p.m. Eastern time), letting investors take advantage of intraday price fluctuations. This differs from mutual funds, which can only be purchased at the end of the trading day, for a price that is calculated after the market closes.

ETFs vs. mutual funds vs. stocks

When comparing exchange-traded funds with other investments, ETFs stand out in a number of ways. Lower investment costs, better diversification and an increasing number of options are just a few of the benefits of ETFs.

ETFs vs. mutual funds

Generally speaking, ETFs have lower fees than mutual funds — and this is a big part of their appeal.

ETFs also offer better tax-efficiency than mutual funds. There's generally more turnover within a mutual fund (especially those that are actively managed) relative to an ETF, and such buying and selling can result in capital gains. Similarly, when investors go to sell a mutual fund, the manager will need to raise cash by selling securities, which also can accrue capital gains. In either scenario, investors will be on the hook for those taxes.

The two products also have different management structures (typically active for mutual funds, passive for ETFs, though actively managed ETFs do exist).

ETFs vs. stocks

ETFs are made up of stocks, but there is no such thing as an "ETF stock." You can purchase a share of an ETF, but you cannot purchase stock in an ETF. ETFs are made up of individual stocks and other investments.

Like stocks, ETFs can be traded on exchanges and have unique ticker symbols that let you track their price activity. Unlike stocks, which represent just one company, ETFs represent a basket of stocks. Since ETFs include multiple assets, they may provide better diversification than a single stock. That diversification can help reduce your portfolio’s exposure to risk.

ETFs are sometimes focused around certain sectors or themes. For example, SPY is one of the ETFs that tracks the S&P 500, and there are fun ones like HACK for a cyber-security fund and FONE for an ETF focused on smartphones.

Here are a few of the key differences between ETFs, mutual funds and stocks.

Exchange-traded funds (ETFs)

Mutual funds

Individual stocks

Fees

Average equity ETF expense ratio: 0.15%.

Average equity fund expense ratio: 0.42%, plus any additional fees.

Commission fee: Often $0, but can be as high as $5.

How to buy

Traded during regular market hours and extended hours.

At the end of the trading day after markets close.

Traded during regular market hours and extended hours.

Source for fee information: The Investment Company Institute, Trends in the Expenses and Fees of Funds

Investment Company Institute. Trends in the Expenses and Fees of Funds, 2022. Accessed Feb 8, 2024.
.

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Neither the author nor editor held positions in the aforementioned investments at the time of publication.
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