What Is 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, which gives them the best of both worlds — the diversification benefits of mutual funds with the liquidity and ease of stock trading.

In 2017, Bloomberg reported that ETFs replaced stocks as America’s investment of choice — and it’s not hard to understand why. 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.

Since they are so simple and easy, and since they don’t involve picking stocks, beginners can build a complete portfolio with just one ETF, meaning that exchange-traded funds are truly a one-size-fits-all investment strategy. Here’s everything you need to know.

What Is an ETF?

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.

ETFs can include stocks, bonds or a blend of investment types, and they can be made up of just a few securities or many. Although most ETFs focus on stocks or bonds, they can also include other assets, like commodities and real estate. They can’t include anything the SEC doesn’t regulate, so there are no ETFs that include direct investments in cryptocurrency, for example.

How Do ETFs Work?

Unlike stocks, ETFs aren’t tied to a single company, 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. Same as with company stock, you need a brokerage account to buy shares of ETFs. If your brokerage allows, you can buy them in partial, or fractional, shares, which lets you get started on the smallest of budgets.

Advantages and Drawbacks of ETFs

ETFs offer investors some alluring perks over their investment relatives. At the same time, it’s not all roses. Take a look at some of the pros and cons of investing in ETFs.

Pros

• Immediate exposure to many securities in one purchase.
• Risk mitigation through diversification.
• Low costs compared to traditional mutual funds.
• Ease and accessibility — you buy and sell shares in real time, just like stocks.
• Tax advantages over standard mutual funds and other common investments.

Cons

• ETFs tend to have lower dividend yields, although some track dividend stocks specifically.
• 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.
• Even ETFs with dirt-cheap expense ratios charge at least a nominal fee. Individual stocks, on the other hand, do not.

What Is the Difference Between an ETF and a Stock?

Stocks are equity securities that represent an ownership stake in a single publicly traded company. ETFs are bought and sold in shares on the open market just like stocks, but they’re funds that contain dozens, hundreds or even thousands of stocks or other securities.

Which Is Better, Stocks or ETFs?

For investors who value diversification, ETFs reign supreme, but since an ETF is bound to contain both winners and losers during any given trading session, individual stocks can achieve fast gains that most ETFs can’t match — but losses won’t be as dramatic with ETFs, either.

Understanding the Many Types of ETFs

The following are the most common types of ETFs, but each category is broad and can include many subcategories.

• Index ETFs: track a specific index of the market, like the S&P 500
• Bond ETFs: invest solely in bonds
• Commodity ETFs: invest in commodities, like gold
• International ETFs: invest in foreign markets
• Currency ETFs: track specific currencies
• Inverse ETFs: performs opposite the index it tracks — increasing in value when the index decreases and vice versa
• Leveraged ETFs: rebalanced daily to reach a leverage goal
• Actively managed ETFs: a fund manager makes decisions on the fund’s portfolio
• Exchange-traded notes: debt securities issued by financial institutions

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 top 500 companies with the purchase of a single share of a single fund — which happens to be among the cheapest ETFs on the market. 

What Is an Example of an ETF?

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.

Meet the Best Performing ETFs of 2022

The following is a roundup of the ETFs that beat the bear market of 2022 and delivered impressive gains for their investors.

Is an ETF a Good Investment?

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.

Novice investors are often overwhelmed by their choices, and ETFs can remove a lot of guesswork and anxiety. 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.

Sean Dennison contributed to the reporting for this article.