Exchange-traded funds (ETFs) trade like stocks and can help you easily create a diversified portfolio to match your investing goals. Learn more about ETFs, how they work, and how you can invest in ETFs.
What is an ETF?
An ETF is a tradeable fund, containing many investments, generally organized around a strategy, theme, or exposure. That approach could be tracking a sector of the stock market, like technology or energy; investing in a specific type of bond, like high-yield or municipal; or tracking a market index, like the S&P 500®1 or Nasdaq composite index.2 Unlike mutual funds, ETFs trade on exchanges just like stocks, and their price changes throughout the day, providing liquidity and flexibility.
How do ETFs work?
ETFs have become popular with investors in large part because they can provide a way to buy a potentially diversified investment. In a single trade, an ETF can give you exposure to hundreds or even thousands of different bonds, stocks, or other types of investments. That means the performance of your ETF is determined by the price change of all those assets. If you were to buy a stock, your investment's performance would be tied to that single company, which could increase your risk.
You can invest in ETFs through a broker, such as a broker dealer or financial institution. At most places, you can trade ETFs in brokerage accounts and in retirement accounts, like Roth IRAs and traditional IRAs. Some providers allow you to invest in ETFs in your HSA.
Types of ETFs
There are more than 3,000 ETFs listed on US exchanges alone, following dozens of different investing objectives. Here are some different types of ETFs:
- Index ETFs track a market index, such as the S&P 500® or Nasdaq composite.
- Actively managed ETFs are funds managed by a team of professionals to potentially outperform passively managed funds, like an index ETF.
- Fixed-income ETFs provide exposure to different types of bonds like US Treasury, corporate, municipal, international, and high-yield bonds.
- Style ETFs focus on a specific investing style (like growth or value) or market capitalization (like large or small), or a combination of investing style and market capitalization, such as large-cap value or small-cap growth.
- Sector and industry ETFs invest in stocks in a specific sector of the stock market, like energy, health care, or utilities, or in a specific industry within those sectors, like oil, pharmaceuticals, or water.
- Commodity ETFs track the price of a commodity, such as timber, oil, or gold.
- Foreign market ETFs give exposure to non-US markets and international companies, such as Japan's Nikkei index or Hong Kong's Hang Seng index.
- Inverse ETFs profit from a decline in the underlying market or index. Keep in mind, these types of ETFs are risky and more complex and are generally used by experienced investors for short-term trading objectives.
- Leveraged ETFs are considered higher-risk investments and track the price movement of a market, segment of the market, or index by magnitudes, like 2 or 3 times the price change, whether up or down. Like inverse ETFs, these types of ETFs are also risky and complex, and you should carefully evaluate your goals and objectives prior to investing.
ETFs vs. mutual funds
Mutual funds and ETFs are similar and often have mirrored investing objectives. But knowing their key differences can help investors decide which might be best for them.
- ETFs can be bought and sold throughout the day, and you can track prices changes anytime the market is open. You can typically only buy and sell and see prices for mutual funds once a day after the markets close.
- Although only some ETFs are actively managed, pricing is generally lower than mutual fund pricing because of the structure of the security. For example, in most cases, active ETFs are less expensive than a comparable mutual fund.
- Holdings transparency is another difference. ETFs share their ingredients somewhat frequently, whereas mutual funds make their big reveal on a quarterly basis, with a 30-day delay.
ETFs vs. stocks
The main difference between ETFs and stocks is that ETFs, depending on the fund, can potentially provide a diversified investment.
- Stocks represent a piece of ownership, or a share, in a public company. Investing in a single stock means the performance of that investment is determined entirely by the performance of that company. An ETF that invests in stocks, on the other hand, invests in many different companies across a sector or market. Diversifying your investments doesn't guarantee you won't lose money, but it can help protect your portfolio from the ups and downs of the market.
- ETFs also may invest in other types of investments than equity in companies. ETFs could invest in bonds, currencies, or commodities.
Advantages of ETFs
Lower fees
Both ETFs and mutual funds have an "expense ratio," which is essentially the cost of being invested. For example, if you have an ETF with a 0.18% expense ratio on a $1,000 investment, you're paying $1.80 in fees a year. Because of an ETF's structure, their administrative costs tend to be less than those of like mutual funds.3
Easily tradeable
ETFs are listed on public exchanges, and you can buy and sell them throughout market hours just like stocks. You can also see their prices change throughout the trading day in real time.
Tax efficiency
When mutual funds change their holdings, any profits from selling investments are considered "capital gains" and are taxed. Who's responsible for those taxes? The shareholders, aka the people who own shares in the mutual fund. ETFs are structured in a unique way that helps shareholders reduce the annual taxes on their holdings. You typically only realize a gain (or a loss) when you sell shares of an ETF. To learn the nuts and bolts of how that's done, check out the article Inside ETFs.
Disadvantages of ETFs
Trading costs
There could be commissions or fees associated with buying or selling ETFs from certain financial institutions. There's another cost to consider too: the bid-ask spread. Like mutual funds, some ETFs are traded thousands of times throughout the day, but other more specialized ETFs have low trading volume. Because there aren't many buyers and sellers, there can be a price gap between what someone is willing to pay to buy (the bid) and what someone is willing to receive to sell (the ask). The lower the trading volume, often the larger the spread between the bid and ask. A large spread could mean you'd have to take a discount on your sale or pay a premium on your buy. Your other option: waiting for the spread to narrow before you trade.
Lack of customization
Because ETFs are premade funds, you don't get a say in what they invest in. In other words, ETFs can't be personalized. So if you choose to invest in a given fund, make sure you're comfortable and committed to gaining exposure to all those securities.
Possible tracking errors
Certain index of passive ETFs aim to track market indexes and indicators, giving investors a way to mimic the performance of that benchmark. However, an ETF's performance can miss the exact price changes of that index or indicator, leading to what's called "tracking error." Before investing in any ETF tracking an index or indicator, make sure to investigate its track(ing) record to see how closely it's mirrors the benchmark.
How to invest in ETFs
Here are the steps for how to invest in ETFs.
1. Open and fund an account that can trade ETFs
Most brokerage accounts allow you to trade ETFs, and some retirement accounts, like IRAs, do too. Before opening an account, look into the trading capabilities of the brokerage or financial institution, and see if the financial institution charges any trading commissions or fees. Once you have an account, you'll have to deposit money in it to start investing in ETFs.
2. Research ETFs that align with your financial goals
Before placing any trades, do your homework. It's a smart idea to thoroughly read a fund's objective and strategy, investigate what a fund invests in, and research the fund's expense ratio. Many brokerages have internal tools to help you research ETFs (like the Fidelity ETF Screener), and there are also third-party research firms, like Morningstar, that could give you helpful insight. Keep in mind how this investment may fit into your investing plan and asset allocation strategy, and make sure it aligns with your investment goals, risk tolerance, and time horizon.
3. Buy the ETF using the ticker
A "ticker" is the short letter code associated with a given ETF—a ticker would look like "ABCD," for example. These tickers are how trade orders are communicated to exchanges. To buy an ETF, keep its ticker handy and input it into your brokerage's trading function when you're ready to execute.
4. Decide when you want to sell
It might seem strange to pick a time to sell an ETF you only just bought, but having a clear plan from the start could help you maximize your potential profit or at least minimize your potential loss. For instance, you might want to pick an upper and lower price your ETF could hit as your get-out signals. Here's more about creating an exit strategy for any investment.