What is an ETF?
An exchange-traded fund (ETF) is an investment fund that trades on an exchange, like a stock.
ETFs are similar to mutual funds except ETF shares can be bought and sold throughout the trading day. Mutual funds trade only at market close.
ETFs offer the best attributes of two popular assets: they have the diversification benefits of mutual funds while mimicking the ease with which stocks are traded.
Like any financial product, ETFs aren’t a one-size-fits-all solution. Evaluate them on their own merits, including management costs and commission fees (if any), how easily you can buy or sell them, and their investment quality.
ETF = Exchange-traded fund
An exchange-traded fund (ETF) is a fund that can be traded on an exchange like a stock. ETFs give you a way to buy and sell a basket of assets without having to buy all the components individually.
An ETF works like this:
- The fund provider owns the underlying assets, designs a fund to track their performance and then sells shares in that fund to investors.
- Shareholders own a portion of an ETF, but they don’t own the underlying assets in the fund. Even so, investors in an ETF that tracks a stock index get lump dividend payments, or reinvestments, for the stocks that make up the index.
While ETFs are designed to track the value of an underlying asset or index, they trade at market-determined prices that usually differ from that asset.
What’s more, because of things like expenses, longer-term returns for an ETF will vary from those of its underlying asset.
How ETFs work, in 3 steps
- An ETF provider considers the universe of assets, including stocks, bonds, commodities or currencies, and creates a basket of them, with a unique ticker.
- Investors can buy a share of that basket, just like buying shares of a company.
- Buyers and sellers trade the ETF throughout the day on an exchange, much like a stock.
5 Types of ETFs:
ETFs may trade like stocks, but under the hood they more resemble mutual funds and index funds, which can vary greatly in terms of their underlying assets and investment goals.
Below are a few common types of ETFs, just note that these categories aren’t mutually exclusive. For example, a stock ETF might also be index-based, and vice versa.
These ETFs aren’t categorized by management type (passive or active), but rather by the types of investments held within the ETF.
1. Stock ETFs
These comprise stocks and are usually meant for long-term growth. While typically less risky than individual stocks, they carry slightly more risk than some of the others listed here, such as bond ETFs.
2. Commodity ETFs
Commodities are raw goods that can be bought or sold, such as gold, coffee and crude oil. Commodity ETFs let you bundle these securities into a single investment.
With commodity ETFs, it’s especially important to know what’s inside them.
- Do you have ownership in the fund’s physical stockpile of the commodity, or own equity in companies that produce, transport and store these goods?
- Does the ETF contain futures contracts?
- Is the commodity considered a “collectible” in the eyes of the IRS?
These factors can come with serious tax implications and varying risk levels.
3. Bond ETFs
Unlike individual bonds, bond ETFs don’t have a maturity date, so the most common use for them is to generate regular cash payments to the investor. These payments come from the interest generated by the individual bonds within the fund. Bond ETFs can be an excellent, lower-risk complement to stock ETFs.
4. International ETFs
Foreign stocks are widely recommended for building a diverse portfolio, along with U.S. stocks and bonds. International ETFs are an easy, and typically less risky, way to find these foreign investments. These ETFs may include investments in individual countries or specific country blocs.
5. Sector ETFs
The U.S. stock market is divided into 11 sectors, and each is made up of companies that operate within that sector. Sector ETFs provide a way to invest in specific companies within those sectors, such as the health care, financial or industrial sectors.
These can be especially useful to investors tracking business cycles, as some sectors tend to perform better during expansion periods, others better during contraction periods. Often, these typically carry higher risk than broad-market ETFs.
How to invest in ETFs
There are a variety of ways to invest in ETFs, how you do so largely comes down to preference. these assets are a standard offering among the online brokers, though the number of offerings (and related fees) will vary by broker.
On the other end of the spectrum, robo-advisors construct their portfolios out of low-cost ETFs, giving hands-off investors access to these assets.
For all their simplicity, ETFs have nuances that are important to understand. Armed with the basics, you can decide whether an ETF makes sense for your portfolio, embark on the exciting journey of finding one — or several.
Before you invest
Before you start investing in ETFs, it's wise to make sure you have a solid monthly budget in place, have an emergency savings fund, and fully understand the risks involved.
Investing wisely in the stock market could generate financial gains in the long run. Uninformed investing, however, could cost you.
Take advantage of our free online financial education courses to help you better understand investing.