What is an ETF? Learn about exchange-traded funds
Flexible like stocks, but diversified like mutual funds
Investing in the market can feel overwhelming, especially when trying to learn the lingo behind the countless investment opportunities. The term "ETF” is one of the acronyms you’ll likely come across — short for exchange-traded funds — and there’s a reason these are so popular among investors.
In everyday language, ETFs are a bundle of investments, from stocks and bonds to commodities and currencies. ETFs represent nearly $10 trillion worth of managed assets across the globe but are easily accessible for both new and seasoned investors.
- You can only purchase an ETF through market transactions at market price.
- Index based-ETFs are the most common type.
- Investors often incorporate ETFs into their portfolio because of the lower risk and tax efficiencies they may offer.
How ETFs work
ETFs are a way for investors to pool their money into one investment fund. The fund includes stocks, bonds or other types of investments with the goal of earning interest from this bundle.
ETFs trade on the stock exchange, in the same way you see a single stock tracked and exchanged in the market. The ability to buy and sell an ETF throughout the trading day means the price fluctuates daily.
An ETF typically follows an index (like the S&P 500), commodity, bonds, industry sector or even a theme, such as value-priced stocks, giving investors a variety of ETF options to choose from.
“The best way to describe an ETF is like a bundle of investments that you can buy on the stock market. Instead of picking individual stocks or bonds, an ETF gives you a piece of many different investments all at once,” explained Seth Diener, a private wealth manager at Diener Money Management with over 20 years of investing experience.
Why invest in ETFs?
If you’re a beginner investor, ETFs may be worth considering. They’re often less expensive than other types of investments and often have no or low fees. Brokers often allow clients the option to purchase ETFs commission-free, and some platforms allow free trading.
But beginners aren’t the only investors who may benefit. ETFs offer diversification since one fund gives you access to a variety of companies and securities. Whenever an investor diversifies, it can help lower risk while tapping into the return potential of the market.
“When those investments go up or down, the value of your ETF goes up or down too. It's an easy way to own a little bit of lots of different things and potentially make money as they grow,” Diener explained.
» MORE: What is a good investment?
Pros and cons of ETFs
Whether you’re new to investing or have several trades in your portfolio, understanding the pros and cons of ETFs — or any investment – is essential before you make your choice. While ETFs offer numerous advantages, there are drawbacks worth considering, too.
- Diversification: An ETF spreads out your investments, which could help lower risk.
- Tax benefits: ETFs are generally tax-efficient and managed by fund managers with tax strategies in mind.
- Liquidity and ease of trading: You buy ETFs at market price throughout the trading day, which means you can buy and sell as needed.
- Less expensive than other investments: ETFs typically have lower expense ratios, which are the costs investors must pay to cover administrative and overhead fees.
- Volatility: Since the price of ETFs fluctuates throughout the trading day – especially if there are volatile stocks within the securities — it exposes you to volatility.
- Lower dividend yields: You don’t receive a dividend from the ETF itself, but may if the commodities that make up the ETF pay them out.
- Can’t target a specific investment: Because ETFs are a pool of securities, you can’t target one specific security, such as a single stock.
Types of ETFs
ETFs are available in a variety of asset combinations, which allows you to choose an ETF specific to your investing needs. You can find ETF categories based on industry, themes, valuations or U.S. holdings versus international holdings.
Some of the most common types of ETFs include:
- Index-based ETFs: The most common and based on stock market indexes, such as the S&P 500 or Nasdaq-100
- Stock ETFs: A combination of stocks based on an industry, sector or theme (such as value stocks)
- Bond ETFs: Includes government, corporate and municipal bonds
- Commodity ETFs: Includes investments in commodities, such as oil, natural gas or gold
- Sector/industry ETFs: Focuses on one particular sector or industry, such as energy or technology
- Foreign market ETFs: Only invests in securities in foreign markets
- Currency ETFs: Focuses on the prices of currencies, both foreign and domestic
ETFs vs. mutual funds vs. stocks
While there is some overlap and similarities among ETFs, mutual funds and stocks, they are all different investment products with key differences you need to know as an investor.
- Mutual funds
- ETFs and mutual funds are similar because in both cases investors pool their money into a group of diversified investments. However, mutual funds are not traded on the stock market. Instead, as an investor, you specify the dollar amount you want to spend with a mutual fund.
Another difference is how you buy mutual funds. You can only purchase mutual funds at the end of the trading day, which means you don’t know how much you’re spending until the transaction goes through, unlike with an ETF, where you know the exact price.
- Stocks are also bought throughout the day, but unlike ETFs, stocks represent a fraction of ownership in one publicly traded company. And because a stock represents one company, it’s subject to a greater amount of volatility, versus something like an ETF that has multiple holdings and spreads out some of the risk.
How to choose an ETF
When you evaluate the various ETFs, there are a few key points you should consider:
- How much you want to invest: ETFs range in cost from $10 per share to several hundred dollars per share. It’s important to have a spending target in mind.
- Assets: Take a look at the volume of assets in the fund and compare the dollar amount to other ETFs. If you find a higher dollar volume of assets, it means more interest from other investors.
- Expense ratios: The expense ratio is how much the ETF costs the investor. It’s represented as a percentage of your investment, and these costs cover the managerial and administrative fees for the ETF. The lower the percentage, the lower the cost for the investor.
Cost is an important aspect, but “it is not always best to go with the cheapest or the most expensive,” said Diener. “Investors should be aware of the fees and be mindful of them when picking ETFs to buy.”
How do you buy an ETF?
Most online investing platforms or retirement planning sites offer commission-free trading for purchasing ETFs. You can also talk to a financial advisor about investing in ETFs and adding to your portfolio. Once you open a brokerage account, you need to choose an investment strategy and research your ETF options before finalizing your selections.
How much do ETFs cost?
Each ETF has costs, such as administrative and overhead, and investors cover these expenses. You can find out the cost of an ETF by looking at its expense ratio. The lower the percentage is, the lower the cost of the fund. There are a wide range of expense ratios among ETFs, depending on which fund you’re reviewing.
What is an S&P 500 ETF?
An S&P 500 ETF is a fund that tracks the entire S&P 500 Index. There are dozens of ETFs with “S&P 500” in the name, but not all track the entire index as a whole, with some ETFs only tracking a smaller part of it.
Do you pay taxes on ETFs?
If your ETF performs well, it may trigger a long-term capital gains tax. Although ETFs are generally regarded as a tax-efficient investment, you may be responsible for taxes on ETFs at the end of the year. The amount of taxes owed depends on the structure, assets, how long you’ve had the fund and the taxation rate of the particular ETF.
- ConsumerAffairs writers primarily rely on government data, industry experts and original research from other reputable publications to inform their work. Specific sources for this article include:
- Nasdaq, “Global ETF Market Facts: Three Things to Know From Q1 2023.” Accessed June 4, 2023.
- Statista, “ETFs - statistics & facts.” Accessed June 4, 2023.
- Investor.gov, “Exchange-Traded Funds (ETFs).” Accessed June 4, 2023.
- Securities and Exchange Commission, “How Fees and Expenses Affect Your Investment Portfolio.” Accessed June 4, 2023.
- Nasdaq, “When Do You Have to Pay ETF Taxes?” Accessed June 4, 2023.
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