What are ETFs?

Exchange-traded funds, or ETFs, 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

  • Investing apps and robo-advisors almost all use ETFs to create customer portfolios

  • The major brokers all offer ETFs for those who want to manage their own investments

  • Increase your profits by using a broker or service with commision-free ETF trading

In the last decade, ETFs, or exchange-traded funds, have become a popular way for people to invest. In particular, robo-advisors and other investment services typically use ETFs to create investment portfolios for you.

An ETF works like a bundle of individual stocks or bonds. 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 individual stocks.

You can easily get more diversity with an ETF than from an individual stock simply because a fund has more than one stock. You don’t have to worry about picking stocks and analyzing a company’s financial statements. Trading an ETF is also cheaper than other types of funds if you work with a broker or investing app that has free ETF trades. Unlike mutual funds — the other common type of investment fund — ETFs have low management fees.

All in all, ETFs are often a solid choice whether you’re a new or seasoned investor. However, you should talk with an expert, like a financial advisor, for help with specific investment decisions.

In this article:

What is an ETF?

An exchange-traded fund (ETF) is a type of investment security that’s traded on stock exchanges, such as the Nasdaq and the New York Stock Exchange (NYSE). ETFs are composed of multiple individual securities (stocks or bonds).

Where to buy ETFs

You can find ETFs from all of the major investment brokers. If you’re managing your own investment portfolio, you can easily find ETFs. Some services offer more niche funds, but you should be able to find common ones wherever you have a brokerage account.

Digital investing services and robo-advisors also use ETFs, though they usually offer far fewer options than if you manage your own investments. In some cases, you can’t even choose your funds, you can only choose between a few pre-made portfolios based on your general investment objectives.

Most company retirement plans, like a 401(k), invest through ETFs. (Learn more about how 401(k) plans work.)

Who makes ETFs

Just because a brokerage firm or investment account offers ETFs, that doesn’t mean they created the funds. In many cases, they are just letting you trade funds from other companies. For example, your IRA or 401(k) may have ETFs from multiple issuers.

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

What’s in an ETF

An ETF may be composed of stocks, bonds, or both. The underlying securities of a fund (meaning what exactly is in the ETF) depends on who made it and why they made it.

Some funds are designed to help you save for retirement. For example, a 2050 target-date fund is built to have the proper asset mix for someone who plans to retire in or around the year 2050. Other ETFs may focus on specific industries, like manufacturing or specific parts of the world, such as funds for emerging markets. Funds may also center on social ideals, like promoting gender equality or renewable energy, or specific products, like agricultural commodities.

Read more about socially responsible investing.

The number of securities in an ETF also varies. Whether you have a stock ETF or bond ETF, it may contain dozens, hundreds, or even thousands of individual securities.

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Types of ETFs

Most exchange-traded funds are passively managed. A passively managed ETF is tied to a certain stock market index and the fund’s contents change as the index does. The most popular index funds are based off the S&P 500 Index. The index tracks the performance for the 500 large companies listed on U.S. stock exchanges, and all S&P 500 Index funds simply contain stocks from each of those top 500 companies.

The other main type of fund is actively managed. 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 funds usually have higher management fees than passively managed funds because it costs more to pay the team managing the fund.

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

ETFs vs mutual funds vs stocks

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, though, while actively managed mutual funds are quite common.

Stocks differ from a fund because shares of an individual stock represent just one company. A fund may include the shares from hundreds of companies, in addition to bonds.

How much ETFs cost

There are two major costs to consider with an ETF: the fund’s investment minimum and the fund’s expense ratio.

The minimum for a fund is the amount you need to invest in order to begin investing in the fund. ETFs usually have no minimum, which means you can invest for as low as $1.00. By contrast, mutual funds, which are the other most common type of fund that people invest in, can have a minimum of $3,000 minimum investment or more (although many are still affordable in terms of total costs).

An expense ratio is the management fee for a fund. You may also see it called a maintenance fee. Every fund has an expense ratio, but the exact fee varies because it is set by the fund manager. If a fund’s expense ratio is 1% and you own $100 of that fund, you will pay $1 for the fund management each fiscal year.

Actively managed funds may have expense ratios of more than 1%. Passively managed funds are cheaper, often 0.20% or less. Index fund fees are usually lower than other funds, and riskier funds may cost more.

Regardless of the type, a fund is usually cheaper as an ETF versus its mutual fund equivalent. Combined with the lower minimum, an ETF is often more affordable overall than a mutual fund.

The pros and cons of ETFs

The major advantages of ETFs are related to their low costs, but they’re also easier to use because online investing services and apps use them.

5 Pros of ETFs:

  • Low investment minimums
  • Low management fees (known as expense ratios)
  • ETFs make it easy to diversify your investments
  • Many fund options to choose from
  • Easy to invest in through apps and digital services

ETFs are a popular way to invest because they have low investment minimums and share prices are lower than what you would pay if you got all the individual securities in the fund.

The expense ratios (management fees) for ETFs are also lower than the ratios for mutual funds, though the exact fee depends on the individual fund. Many brokerages also allow you to buy and sell ETFs for free.

Because funds each contain multiple securities, they provide greater diversity than investing in a single company’s stock. Some ETFs are more diversified than others, but they make it easier in general to diversify your investments. That means your ETF value won’t dramatically decrease if a single company does poorly.

Most investing apps create portfolios by using ETFs. That means ETFs are accessible for people who want to manage their own investments but also for people who want help managing a portfolio.

Cons of ETFs

While ETFs are generally a good way to invest, there are a couple of possible disadvantages.

3 cons of ETFs:

  • The market determines ETF value
  • Trading commissions can eat at your investment returns
  • Growth is likely slower than individual stocks

As with other investments, ETF prices change according to the stock market and your investments could lose value if the market does poorly. However, market volatility is difficult to avoid with any form of investing.

Most major brokers have started offering commision-free ETF trades, but some brokerage services still charge a commission when you buy or sell shares of an ETF. These costs can quickly take away from your investing gains.

ETFs are a good option for long-term savings goals, but are very unlikely to offer fast, short-term growth. If your goal is to get rich quick, ETFs probably won’t help you.

Should you use ETFs?

If you are new to investing, ETFs are a great way to simplify investing. Picking a fund is generally easier and more affordable than picking individual stocks. They can offer instant diversification, in a way that individual stocks can’t, which protects you from volatility risks in the stock market.

ETFs are also cheaper than other investing options. Maintenance fees (in the form of expense ratios) are low, and you can save a lot of money if you use one of the brokers or services with commission-free ETF trades.

For investors managing their own portfolios, ETFs are also a good choice for the same reasons mentioned above. PLu, you don’t need to invest solely in ETFs. Your investment portfolio can include any combination of funds, individual stocks, and other assets.

You can also use ETFs for multiple savings goals. They can help with short-term goals, like the down payment of a house, or long-term loan goals, like meeting your retirement savings plan.

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.

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