What Is an ETF?

Learn about ETFs versus mutual funds.

An ETF is an exchange-traded fund. If you deconstruct those words, it makes it easier to understand the basic structure and definition of ETFs: They are simply funds that trade on an exchange, such as the New York Stock Exchange. To find the best ETF, you need to understand the characteristics of good investments, how the stock market relates to ETF investing, and what advantages and disadvantages ETFs have, especially when you compare ETFs to mutual funds.

How ETFs Work

Exchange-traded funds are available for purchase or sale any time the stock market is open. Each ETF has its own ticker symbol, just like a stock. When you buy an ETF, however, you are investing money in a mutual fund that might hold hundreds of different securities. Thanks in part to a complicated mechanism in which shares are bought and sold by “authorized participants” — usually institutional investors — the market price of an ETF is kept in line with the value of the underlying securities.

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Investing in ETFs

Anyone with a brokerage account can buy or sell an ETF on the open market. Unlike mutual funds, which often have a minimum dollar amount for investment, the minimum purchase for an ETF is the current price of one share. To buy an ETF, you can either inform your broker of the ETF you want to buy or order on your brokerage firm’s website. The amount you will pay is the current market price of the ETF times the number of shares you want to buy, plus any additional fees like commissions.

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Advantages of ETFs

Exchange-traded funds have many inherent benefits. Some of these include:

  • All-day trading: This flexibility is extremely valuable if the market is rising or falling rapidly.
  • Low costs: Some ETFs cost as little as 0.03 percent per year.
  • Diverse investment opportunities: You can buy an ETF in almost any asset class, currency or commodity in the world.
  • Tax advantages: You typically won’t have a taxable capital gain on an ETF until you sell it, unlike mutual funds, which pass taxable gains through to shareholders.

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Disadvantages of ETFs

Although ETFs come with many attractive characteristics, there are some drawbacks. Here are some of the most problematic:

  • Trading commissions: Although ETFs might have low annual fees, you might have to pay a commission to buy, which could make ETFs more expensive than buying no-load mutual funds.
  • Tracking error: There is no guarantee that ETFs will accurately track their underlying portfolios.
  • Underperformance: Even with low annual fees, an ETF tracking an index, such as the Standard & Poor’s 500 Index, will tend to underperform that index.
  • Overtrading: The flexible trading properties of an ETF might actually enable investors to overtrade, hurting their performance.

In many cases, the advantages of ETFs will outweigh the disadvantages, particularly compared with mutual funds, but each individual investor will have to determine the best investments.

How to Make Money With ETFs

With ETFs covering nearly every type of available investment, there are many ways you can make money with ETFs. If your investment objective is capital appreciation, the way to make money is to “buy low and sell high” — just like you would with stocks. For example, if you buy an ETF that tracks the Standard & Poor’s 500 index, you can hold it until it reaches your target price, then sell it at a profit. As with a stock, you will face capital gains taxes if you do take profits — short-term capital gains if you held the ETF for less than one year, or long-term if you held it for one year or longer.

If you are an income investor, you might never need to sell your ETF to make money. Exchange-traded funds that focus on income payments typically purchase bonds or other interest-bearing investments, then pass those payments on to ETF shareholders.

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