An exchange-traded fund is a basket of securities — stocks, bonds, commodities or some combination of these — that you can buy and sell through a broker. ETFs offer the best attributes of two popular assets: They have the diversification benefits of mutual funds while mimicking the ease with which stocks are traded.
Like any financial product, 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, and their investment quality.
ETF = Exchange-traded fund
An exchange-traded fund — better known by the acronym “ETF” — is a fund that can be traded on an exchange like a stock (hence the name). ETFs give you a way to buy and sell a basket of assets without having to buy all the components individually.
An ETF works 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 get lump dividend payments, or reinvestments, for the stocks that make up the index. (Related: Learn how to invest in index funds, or compare index funds and ETFs.)
While ETFs are designed to track the value of an underlying asset — 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.
How ETFs work, in 3 steps
- An ETF provider considers the universe of assets, including stocks, bonds, commodities or currencies, and creates a basket of them, with a unique ticker.
- Investors can buy a share of that basket, just like buying shares of a company.
- Buyers and sellers trade the ETF throughout the day on an exchange, much like a stock.
» Ready to get started? See our guide to the best brokers for trading ETFs
ETFs vs. mutual funds vs. stocks
Generally speaking, ETFs have lower fees than mutual funds — and this is a big part of their appeal. Whereas the average U.S. equity mutual fund charges 1.42% in annual administrative expenses — what’s called an expense ratio — the fees on the average equity ETF are 0.53%, according to data from ETF.com, a subsidiary of the Chicago Board Options Exchange that’s dedicated to these investments.
ETFs also offer tax-efficiency advantages to investors. 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.
ETFs are increasingly popular, but the number of available mutual funds still is higher. The two products also have different management structures (typically active for mutual funds, passive for ETFs, though actively managed ETFs do exist).
Like stocks, ETFs can be traded on exchanges and have unique ticker symbols that let you track their price activity. There’s SPY for one of the ETFs that track the S&P 500, and fun ones like HACK for a cyber-security fund and FONE for an ETF focused on smartphones. That’s where the similarities end, however, because ETFs represent a basket of assets, whereas a stock represents just one company.
5 Types of ETFs: Stock ETFs dominate market
ETFs may trade like stocks, but under the hood they more 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 — just note that these categories aren’t mutually exclusive. For example, a stock ETF might also be index-based, and vice versa. These ETFs aren’t categorized by management type (passive or active), but rather by the types of investments held within the ETF.
- Stock ETFs: These comprise stocks and are usually meant for long-term growth. While typically less risky than individual stocks, they carry slightly more risk than some of the others listed here, such as bond ETFs.
- 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 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.
- 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.
- International ETFs: Foreign stocks are widely recommended for building a diverse portfolio, along with U.S. stocks and bonds. International ETFs are an easy — and typically less risky — way to find these foreign investments. These ETFs may include investments in individual countries or specific country blocs.
- 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, others better during contraction periods. Often, these typically carry higher risk than broad-market ETFs.
Pros and cons of ETFs
U.S. investors had $3.4 trillion invested in ETFs in 2018 — more than double the cash invested in ETFs in 2013, according to the Investment Company Institute. Investors have flocked to ETFs because of their simplicity, relative cheapness and access to a diversified product.
Investors have flocked to ETFs because of their simplicity, relative cheapness and access to a diversified product.
Pros of ETF investment
- Diversification: While it’s easy to think of diversification in the sense of the broad market verticals — stocks, bonds or a particular commodity, for example — ETFs also let investors diversify across horizontals, like industries. It would take a lot of money and effort to buy all the components of a particular basket, but with the click of a button, an ETF delivers those benefits to your portfolio.
- Transparency: Anyone with internet access can search the price activity for a particular ETF on an exchange. In addition, a fund’s holdings are disclosed each day to the public, whereas that happens monthly or quarterly with mutual funds.
- Tax benefits: Investors typically are taxed only upon selling the investment, whereas mutual funds incur such burdens over the course of the investment.
Cons of ETF investment
- Trading costs: ETF costs may not end with the expense ratio. Because ETFs are exchange-traded, they may be subject to commission fees from online brokers. Many brokers have decided to drop their ETF commissions to zero, but not all have.
- Any buyers for the ETF? As with any security, you’ll be at the whim of the current market prices when it comes time to sell, but ETFs that aren’t traded as frequently can be harder to unload.
- Risk the ETF will close: The primary reason this happens is that a fund hasn’t brought in enough assets to cover administrative costs. The biggest inconvenience of a shuttered ETF is that investors must sell sooner than they may have intended — and possibly at a loss. There’s also the annoyance of having to reinvest that money and the potential for an unexpected tax burden.
Shopping for ETFs
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 — the biggest being iShares, SPDR and Vanguard — as well as on complexity and demand. Even ETFs tracking the same index have different costs.
One trend that’s been good for ETF shoppers — in October 2019 many major brokerages dropped their commissions on stock, ETF and options trades to $0.
Here are some of our top picks for the best brokers for ETF investors:
» Check out our full list of the best brokers for ETF investors.
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.
How to invest in ETFs
There are a variety of ways to invest in ETFs, how you do so largely comes down to preference. For hands-on investors, the world of ETF investing is but a few clicks away. These assets are a standard offering among the online brokers, though the number of offerings (and related fees) will vary by broker. On the other end of the spectrum, robo-advisors construct their portfolios out of low-cost ETFs, giving hands-off investors access to these assets.
For all their simplicity, ETFs have nuances that are important to understand. Armed with the basics, you can decide whether an ETF makes sense for your portfolio, embark on the exciting journey of finding one — or several.