What is an ETF: Exchange-traded funds explained
Updated: August 23, 2024
What is an ETF? An ETF, short for exchange-traded fund, is an investment offering you access to multiple stocks, bonds or other assets with a single transaction. ETFs are a cornerstone of many investors’ portfolios and may be enough to meet your investment needs alone. With more than 8,000 EFTs to choose from, understanding how ETFs work can help you make the best decisions for your financial goals.
What is an ETF?
ETF is an acronym for exchange-traded fund. An exchange-traded fund can be bought and sold similarly to stocks on many exchanges like the New York Stock Exchange or NASDAQ. But unlike stocks, an ETF is made up of many different investments. An ETF can give you access to hundreds or thousands of different stocks and other assets at once.
ETFs are run by professional fund managers. Each fund operates with a specific goal, which can be found in its prospectus document. ETFs commonly track major market indices, offer exposure to a certain business type or sector or follow other investment ideas.
A popular type of ETF, for example, is an S&P 500 index fund. These offer investors the ability to buy stock in the 500 companies included in the S&P 500 index with one transaction, and results mimic what you would get if you bought all stocks in the index.
ETFs typically charge management fees ranging from less than 0.10% to more than 10% per year. Paying close attention to costs and typical performance compared to the market as a whole can help guide your decision when you’re shopping for an ETF.
An ETF, or exchange-traded fund, gives investors access to a basket of assets with a single investment.
How do ETFs work?
With an ETF, investors pool their funds to allow for diverse portfolios that would be difficult to put together independently. Following the example of the S&P 500, it would be difficult, if not cost-prohibitive, for an individual investor to buy shares of 500 companies. But with an S&P 500 index fund, you can do so with a single purchase.
Every ETF follows an investment strategy, which may include tracking an index, giving investors access to a certain size or type of company, managing taxes or tapping into a certain market strategy. In my portfolio, for example, I have ETFs following indexes, trading different types of bonds, focusing on dividend growth stocks and managing for those (myself included) looking to retire around the year 2050, among others.
Major investment companies, such as Blackrock (iShares), State Street, Vanguard and Fidelity, offer ETFs. Every fund manager offers different fees and performance. You may find the best mix of ETFs comes from multiple investment companies and several ETF categories. Nearly all ETFs require an annual management fee, and it’s important to pay close attention to what you’ll pay to ensure the cost doesn’t take too much out of your investment gains.
3 common types of ETFs
You can find dozens of types of ETFs, but many of them may not be right for your portfolio. Here’s a look at some of the most common types of ETFs to help you get started.
Index funds
Index funds are a type of fund that follows the results of a specific market index. Some common indices include the S&P 500, Russel 2000, NASDAQ Composite, Dow Jones Industrial Average, Total Stock Market, Total Bond Market and many more.
In most cases, index funds closely mimic its underlying index results with less fees. Because they follow an index and the fund managers don’t have to make major investment decisions, fees are usually lower than actively managed funds.
Actively managed funds
Actively managed ETFs are funds in which a professional manager chooses the investments to maximize earnings while adhering to a specific market segment or investment thesis. While actively managed funds may sound like a good idea on the surface, they tend to perform worse than the market as a whole.
According to data from S&P Global, the vast majority of actively managed funds underperform compared to the market index they use as a benchmark.
Hint: Keep this in mind if you’re considering building a portfolio of single stocks.
Asset type and segment funds
Some funds focus on specific asset types, such as stocks or bonds, and there are many types within those areas of the markets. Stock funds, for example, can include large-cap funds, small-cap funds, growth funds, value funds and others. They may also be divided into market segments, such as finance, technology, medical, consumer staples and retail.
Bonds may include short-term, government, municipal and corporate bonds by risk level. In addition to stocks and bonds, you may also buy into funds focused on commodities, real estate, currencies, cryptocurrencies, leveraged investing and others.
What is cap in ETFs?
We’ve used the terms large-cap and small-cap so far in this article, but not all investors know what these mean. Cap refers to a company's market capitalization, which is the total value of all shares of stock.
According to FINRA¹, an investment industry organization, these are the typical cutoffs used for each category of market capitalization in the stock market:
- Mega-cap: $200 billion and above
- Large-cap: $10 billion to $200 billion
- Mid-cap: $2 billion to $10 billion
- Small-cap: $250 million to $2 billion
- Micro-cap: $250 million or less
To calculate the market cap, multiply the number of shares outstanding by the price per share. Large and mega-cap stocks tend to be older and more established, while small and micro-cap companies tend to be newer or riskier. Depending on your investment goals and financial situation, you may find a mix of these types of stocks purchased through ETFs to be a good fit for your portfolio.
What do ETFs cost?
ETF managers charge an annual management fee for their work operating the fund. A few funds charge no annual management fee, while a few others charge exorbitantly high fees over 10%. You’ll likely find most low-cost funds charge less than 0.10% per year while the majority of the higher-priced funds charge around 1% to 2% per year.
The fee for ETFs is called an expense ratio. For a $100 investment, a fund with a 1% expense ratio would charge $1 per year.
Here’s a look at common costs you may encounter:
- Expense ratio: As explained above, the expense ratio is an ongoing annual fee paid to ETF managers
- Operating expenses: Operating expenses, such as trading costs incurred by the fund, may reduce ETF returns
- Brokerage commissions: While the best brokerage accounts don’t charge any commissions for stock or ETF trades, some brokerages maintain fees for each trade, plus more for phone or broker-assisted trades
Are ETFs a good investment?
For the typical investor, ETFs are an excellent investment choice. The vast majority of my personal portfolio is in a variety of ETFs. When you’re investing for long-term goals like retirement or funding a college education, it’s tough to beat ETFs.
ETFs are arguably the best way to invest for the average person because of its low fees, instant access to diversified portfolios and ability to quickly buy and sell. With a target date fund ETF or a mix of diversified stock and bond ETFs, you could find all of your investment needs met with only a few ETFs.
Pros and cons of ETFs
ETFs are an excellent way to invest, but they’re not perfect for every investor and situation. Here’s a breakdown of some of the most important pros and cons of ETFs to know when you’re building your portfolio.
Pros
-
Instant portfolio diversification
-
Less investment knowledge required
-
Typically low fees
Cons
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Less fine-tuned control over your portfolio
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Not always the best choice for taxes
ETF vs. Stock
Many ETFs are made up of stocks or a combination of stocks and other assets. But they’re not the same as buying single stocks. When deciding between stocks and ETFs, consider these major differences:
| Features | ETF | Stock |
|---|---|---|
| Ideal investors | All investors | Experienced investors |
| Number of assets | Many | One |
| Best uses | Long-term and diverse portfolios | Granular, strategic investment strategies |
| Management fees | Fees typically apply | No management fees |
| Trade times | Near-instant | Near-instant |
| Typical trade commission | Commission-free | Commission-free |
How to invest in ETFs
While the physical process of entering an order and buying an ETF can be done in just a few moments, it’s important to take the time to research the best ETFs for your unique financial goals. Follow these steps to invest in an ETF.
Step 1: Open a brokerage account
To start investing in ETFs, you'll need to open a brokerage account. Choose a brokerage that offers low fees and user-friendly investment tools. You'll typically need to provide personal information, like your Social Security Number and income details.
If you’re an active investor or options trader looking for a way to save money on trades, you may want to check out discount broker tastytrade. This online service has some of the lowest prices on the market.
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Interactive Brokers offers low trading fees and robust trading tools — major assets to day traders and other DIY investors. Lower-volume traders will also appreciate that they can access commission-free trading through the IBKR Lite plan.
Step 2: Understand your investment goals
Before investing, clearly define your financial goals. Are you saving for retirement, looking for a steady income, or seeking growth? Understanding your goals will help you choose the right ETFs, whether it’s focused on specific sectors, dividend yields, or broad market indices.
Step 3: Research the best ETFs for your goals
Once you know your objectives, research ETFs that align with them. Look at factors like expense ratios, performance history and the underlying assets of each ETF. Many online tools and resources can help you compare different ETFs and find the ones that best suit your strategy.
Step 4: Enter a trade order
After selecting your ETFs, enter a trade order through your brokerage account. You'll need to specify the number of shares you want to buy and the type of order (e.g. market or limit). Review your order carefully before submitting it.
Step 5: Monitor your portfolio
Once you've made your investment, regularly monitor your portfolio's performance. Reassess your goals and make adjustments as needed, such as rebalancing your holdings or adding new ETFs to align with changing market conditions.
Learn more in our full guide on how to invest in ETFs.
Can you sell ETFs any time?
You can sell ETFs at any time during market hours, which are typically weekdays from 9:30 a.m. to 4:00 p.m. EST. With an account at a major brokerage such as Fidelity, trades should execute almost instantly after it’s entered online.
Keep in mind that taxes may apply, and taxes can change based on how long you’ve held the ETF. If you’re unsure how a sale may impact your taxes, consider consulting with a tax professional or IRS resources explaining capital gain.
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Eric Rosenberg is a finance, travel and technology writer in Ventura, California. He is a former bank manager and corporate finance and accounting professional who left his day job in 2016 to take his online side hustle full time.
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