An exchange-traded fund (ETF) is a fund that holds a basket of investments (stocks, bonds or other assets) and trades on a stock exchange like a single share. Buying one share of a broad market ETF gives you a small piece of every company in it.
How ETFs work
- Traded all day. Prices change during market hours, and you buy or sell through a brokerage account, like a stock.
- Mostly index-based. Most ETFs track an index, though actively managed ETFs are growing.
- Creation and redemption. Large institutions can swap baskets of the underlying securities for ETF shares and back. This mechanism keeps the ETF’s price close to the value of what it holds, and it is a main reason ETFs are tax-efficient.
ETF vs index mutual fund
They often hold exactly the same thing. The differences are practical:
- Trading: ETFs at any moment during the day; mutual funds once a day at the closing price.
- Minimums: ETFs cost one share, or a fraction with brokers that allow it; some mutual funds require $1,000 or more.
- Automatic investing: easier with mutual funds at many brokers, although more brokers now support recurring ETF purchases.
- Taxes: ETFs rarely distribute capital gains; index mutual funds are also efficient, active mutual funds less so.
- Costs: broad ETFs and index mutual funds both can have very low expense ratios.
Hidden costs
- Bid-ask spread: the gap between buying and selling prices. Tiny for big, popular ETFs, wider for small or exotic ones.
- Market orders in volatile moments can fill at a bad price; a limit order sets your price.
- Commissions: most large US brokers now charge none for online ETF trades.
ETFs a beginner should avoid
- Leveraged ETFs (2x, 3x) and inverse ETFs: designed for one-day moves, they can lose money over time even when the market goes your way. The SEC and FINRA have issued investor alerts about them.
- Very narrow theme ETFs: a hot theme can already be priced in, and the fees are often higher.
- ETNs: exchange-traded notes are debt of a bank, carrying the issuer’s credit risk.
How to pick one
Start from your asset allocation. For each slot (US stocks, international, bonds), choose a broad, liquid ETF with a low expense ratio, and keep the total number small. If you like automatic monthly investing, an index mutual fund may be just as good. The SEC’s Investor.gov bulletin comparing mutual funds and ETFs covers the rules for both.
