What is an ETF?

Exchange-traded funds allow you to start investing easily and at low prices.

Derek Silva

Derek Silva

Published November 22, 2019

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KEY TAKEAWAYS

  • ETFs are traded on the stock market like stocks, but they’re collections of stocks and bonds, like mutual funds

  • An ETF usually has a lower management fee than a mutual fund and make it easier to diversify your investments compared to buying individual stocks

  • Investing apps, robo-advisors, and many retirement plans use ETFs to create your portfolio

  • Major brokers all offer ETFs and it’s usually free to buy or sell shares

In the last decade, ETFs, or exchange-traded funds, have become a popular way for people to invest. Virtually all brokerages and investment services, including both managed accounts and robo-advisors offer ETFs to create investment portfolios for you.

An ETF works like a bundle of individual stocks or bonds, but you only own a small percentage of a share for each stock or bond in the “bundle.” You trade these funds on a stock exchange, the same way you do with the stock of public companies, but ETFs offer multiple advantages over trading stocks. For example, you get more diversity than with a single stock and it’s cheaper to buy a fund with a dozen partial stocks than it is to buy whole shares of all dozen stocks individually.

All in all, ETFs are often a solid choice whether you’re a new or seasoned investor because they have a low cost to entry and may insulate you from risk. For more help with specific investment decisions, you should talk with an expert like a financial advisor.

What is an ETF?

An ETF, or exchange-traded fund, is an investment fund that gets traded on a stock exchange, such as the Nasdaq and the New York Stock Exchange (NYSE). ETFs may contain stocks, bonds, or both. They may also contain dozens, hundreds, or even thousands of individual securities.

The exact underlying assets of a fund (meaning what exactly is in it) depend on who made the ETF and why they made it. For example, an ETF that’s a 2050 target-date fund will have an appropriate mix of stocks and bonds for someone who plans to retire in 2050, and the mix will change over time.

Some of the biggest ETF issuers are BlackRock (iShares), Charles Schwab, Fidelity, Invesco (PowerShares), State Street Global Advisors (also called SSGA), and Vanguard. The funds that brokerage firms or robo-advisors offer are often from one of these six companies. It’s also common to have ETFs from multiple issuers.

ETF vs mutual fund

ETFs operate similarly to mutual funds because they offer investors a collection of multiple securities for one price. The major difference is that ETFs are traded on the stock market, like any other stock. Most ETFs are passively managed, while actively managed mutual funds are quite common. (More on that in the next section.) Many funds are available as both a mutual fund and an ETF. Mutual funds usually require a much higher minimum investment, and they may charge a higher annual management fee, but they could have higher returns.

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Types of ETFs

There are two broad types of investment funds based on how they are managed: passively managed and actively managed. (Most ETFs are passively managed.) Then there are multiple types of ETFs based on what’s in them or their investment goals.

Passive vs active funds

A passively managed ETF, usually as an index fund, is tied to a certain benchmark or stock market index and the contents change as the index does. Many passively managed ETFs are index funds that track the S&P 500 Index, which simply contains stocks from each of 500 largest companies listed on U.S. stock exchanges.

In an actively managed ETF, a company, group, or hedge fund is actively choosing which securities to include in the fund based on what they think will perform the best. Actively managed ETFs usually have higher management fees than passively managed funds (think a 1% fee vs a fee of 0.2% or less) because of the human cost of managing the fund.

Common types of ETFs

There are many ETFs, but here are some of the most common ETF types:

  • Stock ETFs include stock from multiple companies. They may also try to mirror the entire stock market. These generally have lower risk than buying individual stocks, but they still come with risk.
  • Bond ETFs include multiple individual bonds or try to mirror the entire bond market.
  • Sector ETFs focus on companies in a certain sector of the economy. There are multiple definitions for what an economic sector is, but common examples include the manufacturing sector, service sector, and financial sector.
  • An industry ETF contains stocks from companies in certain industries like agriculture, health care, real estate, or renewable energy.
  • Commodity ETFs allow you to trade raw goods like gold, precious metals, agricultural products, or crude oil. (Should you be investing in gold?)
  • International ETFs contain investments from other countries or parts of the world. A common example is an emerging markets ETF.
  • Currency ETFs allow you to invest in other currencies, based on their values (usually relative to the U.S. dollar).
  • Target-date funds have a mix of stocks and bonds, with the mix changing over time based on an expected retirement year. Target-date funds aren’t always ETFs, but a target-date ETF is a very common investment in 401(k) plans.
  • SRI funds, or socially responsible investing funds, contain the stocks of companies that support ethical, sustainable, or socially conscious practices. Examples include companies that support gender equality or green energy. These funds usually have higher management fees than standard ETFs.

Does the thought of choosing investments scare you? Read our article on how to start investing.

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Should you use ETFs?

If you are new to investing, ETFs are a great way to get started. They’re usually cheaper and easier to use than other investing options. All big brokers offer ETFs, and usually there are hundreds of funds to choose from. Some retirement accounts, like 401(k) and 403(b) plans, now offer only ETFs.

ETFs are a solid option for most people, but whether you should use them depends on your personal situation and investing goals. For more tailored investment advice, talk with a financial advisor.

Reasons to use an ETF

To help you choose your investing strategy, here are six advantages of ETFs:

Low investment minimums: You can usually invest in an ETF for as little as $1, while a mutual fund with the same underlying assets may require a minimum investment of $3,000 or more. It’s also cheaper to buy an ETF with 100 stocks than it is to buy shares of all 100 stocks individually.

Low management fees: Known as an expense ratio, this is an amount you need to pay annually for every fund you have in your portfolio. ETFs usually have lower expense ratios than mutual funds, though the exact fee depends on what fund you buy.

Instant diversification: Investing in multiple securities protects you from losing all your money if one company or one part of the economy doesn’t perform well. It’s harder and more expensive to create a diversified portfolio if you’re buying individual securities.

Thousands of ETF to choose from: There are many types of ETFs available, so you should be able to find something no matter your investing goals. If you don’t like the options available, some brokers even allow you to create your own ETFs.

Easy to invest through apps: Online brokerages, robo-advisors, and investing apps usually offer ETFs. No matter your level of investing knowledge or experience, you can find a digital service or app that creates an ETF portfolio for you.

Free trades: While this isn’t universal, many brokerages now allow investors to buy and sell ETF shares without paying trade commissions or fees.

Savvy, socially minded investors should take a look at what companies your ETF invests in, because it’s not always obvious and some may catch you by surprise.

About the author

Personal Finance Expert

Derek Silva

Personal Finance Expert

Derek is a tax expert at Policygenius in New York City. He has written about multiple personal finance topics in the past, and his work has been covered by Yahoo Finance, MSN, Business Insider and CNBC.

Policygenius’ editorial content is not written by an insurance agent. It’s intended for informational purposes and should not be considered legal or financial advice. Consult a professional to learn what financial products are right for you.

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