What’s an Exchange-Traded Fund (ETF?) Here’s How To Invest
ETF stands for exchange-traded fund, and the thing that makes them so special is right there in the name. They’re funds that can be traded on public exchanges, just like stocks. You can’t do that with mutual funds, which you can buy only through brokerage firms, financial professionals, or fund companies themselves.
That gives ETF investors a huge advantage, but easy accessibility is far from the only benefit that ETFs bring to the table. They’re liquid, just like stocks. They’re easy to buy and sell, they’re cheap, and they give you exposure to a variety of securities that provide instant diversification with the purchase of a single share. If that sounds good, you are not alone.
In 2017, Bloomberg reported that ETFs replaced stocks as America’s investment of choice. Since they are so simple and easy, and since they don’t involve picking stocks, they’re also great for beginners. Here’s everything you need to know.
What Is an ETF and How Does it Work?
An ETF is a collection of securities packaged and sold in a single basket, or fund. Those funds aim to mirror the performance of — or track — indices like the S&P 500, sectors like manufacturing, industries like tech, themes like clean energy, or strategies like dividend investing.
What ETFs Include
ETFs can include stocks, bonds, or a blend of investment types, and they can be made up of just a few securities or thousands. Although most ETFs focus on stocks or bonds, they can also include other assets like commodities and real estate. They can’t include anything that the SEC doesn’t regulate, so there are no ETFs that include direct investments in cryptocurrency, for example.
Unlike stocks, ETFs aren’t tied to a single company or entity, and unlike mutual funds, they’re not sold directly to investors. Licensed brokers trade ETFs on public stock exchanges like the New York Stock Exchange or Nasdaq. ETF investors purchase slices of these funds in shares, same as company stock. Those shares are created and redeemed by financial institutions classified as “authorized participants.” Because ETFs are traded on an exchange, they also have their own ticker symbols. An ETF fund will align its market price with its underlying securities by continuously issuing and redeeming ETF shares.
Exchange-traded funds, or ETFs:
- Are collections of securities that follow a common theme, index, strategy, or segment of the economy
- Might contain stocks, bonds, real estate, commodities, or any variety of securities
- Are bought and sold in shares in real time on public exchanges, just like stocks
- Are cheaper and more accessible than traditional mutual funds, a concept that will be discussed in greater detail farther down the page
Understanding the Many Types of ETFs
Explore the wide world of ETFs to see which ones align with your investing style. Depending on your investment strategy and goals, you might discover a brand new addition to your portfolio. The following are just broad umbrella categories. ETFs can be subcategorized over and over. Here’s a breakdown of the different types of ETFs.
Index ETFs track the performance of an index, such as the S&P 500 or Dow Jones Industrial Average. The ETF contains slivers of the same securities weighted in the same proportions as the index. When the index rises or falls, so, too does the ETF.
Bond ETFs contain only bonds, but might include several variations, including floating-rate bonds, international treasury bonds, and many others.
Commodities ETFs offer diverse investments in physical raw materials like cotton, gold, and oil. Some funds own physical stores of the commodities themselves. Others invest indirectly in their production, transportation, storage, etc.
International ETFs expose you to securities from around the world. They may include securities from one foreign country or many, and they can focus on specialties like emerging markets.
Currency ETFs concentrate on currency futures contracts, which specify the purchase of an asset at a predetermined date using a specific currency.
Inverse ETFs are equivalent to shorting stock, except you’re shorting ETFs. Shorting is a more advanced strategy where investors borrow shares of a security they’re betting against, buy it when the price drops to repay the loan, and pocket the difference.
ETFs with leverage can double, triple, quadruple, quintuple (you get the idea) the gains on your investment. The caveat: These types of ETFs are reset daily, so that compounding return is meant to be achieved daily, and not for long-term investments.
Actively Managed ETFs
Index funds and other ETFs are passively managed — they simply strive to mirror their affiliated index. With actively managed ETFs, a fund manager chooses the securities and might periodically add new ones or replace old ones. That service comes with higher fees.
ETFs and ETNs both trade on the stock market, and both track an underlying asset, but an ETN is an unsecured debt security issued by a bank. ETFs, on the other hand, hold several assets within themselves. Barclays Bank initially developed ETNs to give investors easier access to complicated assets such as commodities and currencies.
How To Invest In ETFs
So now you know what an ETF is and what different kinds there are. The next step is learning how to turn the money you want to invest into ETF shares.
1. Open a brokerage account.
Just as with stocks, only licensed brokers can buy and sell ETFs. Open a free brokerage account. In this day and age, there should be zero fees. No minimum balance fees, commission fees, no trading fees, no maintenance fees. Every penny you put in should go toward the purchase of your ETF. InteractiveBrokers, M1 Finance, Firstrade, and E-Trade are among the best.
2. Understand expense ratios.
ETFs come with fees, but they should be minuscule compared to those you’d pay to buy into actively managed mutual funds. They’re called expense ratios, and by law, every ETF must list its expense ratio. Anything above .25 percent is pricey by ETF standards. The cheapest charge .05% or sometimes even less.
3. Choose how to make future contributions
You might set up your brokerage account to make regular, pre-scheduled automatic contributions or you might kick in what you can when you can on your own. You might save up until you have enough money for a whole share, or buy partial shares with whatever you have when you have it — just make sure your brokerage allows partial-share investing.
4. Research before you buy.
Thoroughly research the prospectus of any ETF you’re considering to make sure you understand its past performance, holdings, strategies, risk level and expense ratio.
The Advantages and Drawbacks of ETFs
ETFs offer investors some alluring perks over their investment relatives. Keep reading to see if any of these benefits stand out to you.
These are some of the main reasons that ETFs are so popular is that they offer. At the same time, it’s not all roses. Take a look at some of the pros and cons of investing in ETFs.
|Immediate exposure to many securities in one purchase||ETFs tend to have lower dividend yields, although some track dividend stocks specifically|
|Risk mitigation through diversification||In some cases, as with some foreign stocks, ETFs are limited only to large-cap stocks, which makes it harder to diversify with small- and mid-caps.|
|Low costs compared to traditional mutual funds||Even ETFs with dirt-cheap expense ratios charge at least a nominal fee. Individual stocks, on the other hand, do not.|
|Ease and accessibility — you buy and sell shares in real time just like with any old stock|
|Tax advantages over standard mutual funds and other common investments|
Meet Some of the Most Popular ETFs
If you’re new to the game, these are some of the best-known ETFs on the market. They might be a good place to start.
- The SPDR S&P 500 (SPY): The first and most famous of all the S&P 500 funds
- The SPDR Dow Jones Industrial Average (DIA): This one tracks the Dow, an index that’s almost as important and widely followed as the S&P 500
- ProShares UltraPro Short QQQ (SQQQ): This ETF tracks the tech-heavy Nasdaq-100
Good To Know
When people talk about the “stock market” as up or down, they’re usually referring to the S&P 500 index, which tracks the 500 largest U.S.-based corporations. Several funds, like Vanguard 500 Index Fund ETF (VOO) track the S&P. That means you can invest in the entire stock market with the purchase of a single share of a single fund — which happens to be among the cheapest ETFs on the market.
Are ETFs Good For Beginners?
Novice investors are often overwhelmed by their choices, and ETFs can remove a lot of guesswork and anxiety. The purchase of a single ETF can act as an entire portfolio, which in generations past might have taken years to build through the purchase of individual shares of stock.
For beginners who want to get their money in the market while they research, study, and learn more, it’s hard to imagine there’s a better place to park their cash than in an index ETF.
ETFs vs. Mutual Funds vs. Stocks: Understanding the Differences
When buying and selling securities, brokers usually point out the differences between three of the more commonly traded investments. Here’s an overview of the similarities and differences between ETFs, mutual funds and stocks.
- Description: A basket of securities, usually passively managed, that trades like stocks
- When you can trade: During trading hours and after-hours trading
- Maintenance costs: Yes; varies with the broker
- Commission fees: Yes
- 12b-1 fees: No
- Underlying assets: Yes, with index tracking
- Holdings: Disclosed on a daily basis
- Built-in diversification: Yes–stocks, bonds, commodities and other assets
- Risk of capital gains tax: Low–ETFs offset the capital gains risk because their structure results in fewer capital gains distributions, as ETFs use creation units to approximate securities.
- Description: A pool of money from different investors which is then used to purchase stocks, bonds and other assets to use in a portfolio.
- When you can trade: Once a day
- Maintenance costs: Yes; varies with broker but always includes a load fee
- Commission fees: Load Fee
- 12b-1 fees: Yes
- Underlying assets: Yes; can include indexed funds
- Holdings: Usually disclosed monthly but varies from company to company
- Built-in diversification: Yes; stocks, bonds, commodities and other assets
- Risk of capital gains tax: High–Because a mutual fund manager is constantly restructuring the fund by selling securities, this exposes shareholders to more capital gains taxes.
- Description: A market share of a company that you own
- When you can trade: During trading hours and after-hours trading
- Maintenance costs: No
- Commission fees: Yes
- 12b-1 fees: No
- Underlying assets: No
- Holdings: Individual security, but an investor can own multiple shares
- Built-in diversification: No–individual security
- Risk of capital gains tax: Low–High: A stock’s value, and its payout, depends entirely on the value of the company you’re investing in, so exposure to a capital gains situation could go either way.
Sean Dennison contributed to the reporting for this article.
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