Like stocks, ETFs give you the flexibility to buy and sell throughout the trading day as prices fluctuate, often with no commission or load fees.
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What is an exchange-traded fund (ETF)?
An exchange-traded fund (ETF) is a little like an individual stock and a little like a mutual fund, but there are key differences with both.
What is an ETF, and how does it work?
Exchange-traded funds (ETFs) are investment vehicles that let you purchase multiple assets is one easy step. Like mutual funds, ETFs typically invest in a collection of stocks, bonds, or other assets, but can often do it at a lower price. As a result, they are popular with investors who are looking for a way to diversify their portfolio with potentially lower fees. And because ETFs are traded on exchanges (as the name suggests) they offer features found in both individual stocks and mutual funds:
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Like mutual funds, ETF are “baskets” that hold a variety of stocks, bonds, or other assets which can diversify your portfolio and help reduce risk. |
ETFs offer diversification
If you choose to invest in individual stocks, your return is directly tied to how well that specific company does. With ETFs, your investment is divided among multiple companies or other asset classes. In fact, many ETFs attempt to track the holdings in specific indexes, such as the S&P 500, so you will automatically receive a significant amount of diversification.
Related: Learn more about different types of ETFs
Do ETFs pay dividends?
Many ETFs pay a dividend, but it depends on the fund and its holdings. If dividends are important to you, be sure to seek out funds that concentrate on dividend generating investments.
Are ETFs safe investments?
Like any investment, ETFs will fluctuate in value. While there is always a chance you could lose money, ETFs (and mutual funds) are generally considered less risky than individual stocks due to the diversification they offer.* For that reason, ETFs can be a valuable part of any investment portfolio.
Pros and cons of ETFs
While ETFs have many attractive qualities, they may not be right for every investor. Before you invest, it’s important to understand the benefits—and potential drawbacks—so that you can evaluate the impact ETFs may have on your portfolio. Here are some things to consider:
ETF pros:
Intraday Trading: Unlike mutual funds, you can buy and sell ETFs throughout the day and take advantage of price fluctuations.
Levels of diversification: With ETFs, you can cast a wide net—or narrow your focus and concentrate on specific industries or sectors.
Lower fees: While there are exceptions, ETF’s typically cost half as much as the average mutual fund.1
Tax efficiencies: Unlike mutual funds, ETFs do not generate capital gains taxes when they sell underlying assets. In general, these taxes are only triggered when you sell shares in the ETF or liquidate it completely.
ETF cons:
Fewer options: According to Statista, there are twice as many mutual funds available in the U.S. (8,582) as ETFs (3,304).2
Intraday trading may be unnecessary: While the extra liquidity is sometimes helpful, in most cases the price of an ETF will not change much during the day.
Potentially extra expense: Since ETFs require professional management, the cost—while low—will probably be higher than if you purchased a similar portfolio of individual stocks.
- Limited upside: You may be able to enjoy higher returns by buying a few potentially high-performing stocks.
How to invest in ETFs
Investing in ETFs can be quick and easy. To get started, all you need to do is open a brokerage account with a financial institution or online broker. From there, you simply have to select an ETF, indicate the number of shares you would like to purchase, and make sure you have enough in your account to cover the cost.
How do ETF fees work?
ETF fees cover the operational and management costs of the fund and are based on the total number of shares you own in the fund. Before you invest, you can see the impact ETF costs will have on your return by looking at the expense ratio in the prospectus. You do not have to worry about receiving a bill or paying upfront as fees will be deducted from your total return.
Exchange-Traded Fund (ETF) FAQs
Yes, since ETF are professionally managed, easy to purchase, and offer immediate diversification, they can be a solid choice for new investors.
The most popular ETFs in the U.S. is the SPDR S&P 500 ETF Trust (SPY) which invests in companies that are part of the S&P 500 index.3 Of course, there are thousands of other ETFs available so you may want to consult a financial professional to make sure you select a fund that’s right for you.
Like the market itself, the price of an ETF will fluctuate over time. Since these events can be difficult to predict, you may want to use a technique called dollar-cost averaging and purchase shares in the ETF on a regular basis.
ETFs may not be right for everyone, but they can be a good option for people who want a quick and easy way to pursue market growth and add diversification to their investment portfolio.
When you purchase a stock, you are investing in a single company and your returns will be based on how that company performs. ETFs, on the other hand, are a way to invest in multiple stocks (or other assets) at one time so that your returns will be based on the fund’s overall performance.
You can make money on an ETF in multiple ways. Depending on the underlying investments, the fund may earn interest, generate dividends, or simply increase in value so you can sell it for a profit.
While ETFs are generally more tax-efficient than mutual funds, they are not tax free. When you liquidate or sell shares in the fund, you will owe taxes on the profit (or realized gain) you generate.
When you buy an ETF, your money goes into a pool that is used to invest in a variety of stocks, bonds, or other assets (depending on the fund’s objectives). In return, you will receive shares in the fund—much like you would if you purchased a stock.
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*Diversification does not assure a profit or protect against market loss.
1 “4 top reasons why exchange-traded fund growth has ballooned,” CNBC, October 1, 2024.
2 “Mutual fund and ETF providers in the U.S. – statistics & facts,” Statista.com, July 2, 2024
3 “Most Popular ETFs of Last Week” Yahoo/Finance, December 17, 2024