What Is an ETF? Definition and Guide

What is an ETF? An ETF, short for exchange-traded fund, is an investment fund that trades on stock exchanges. It represents a basket of securities that can include various investment classes such as stocks, bonds, and even commodities like real estate. Think of them as your all-in-one investment package.

When you invest in an ETF by buying shares, you are essentially buying a stake in the entire pool of securities held by the fund. This is different from investing in individual stocks or bonds of specific companies. Instead, you’re getting a piece of the whole pie. By owning shares of an ETF, you gain exposure to a diversified portfolio of multiple investments, which helps to add diversity to your overall investment portfolio. 

ETFs operate much like traditional mutual funds, but unlike mutual funds, you actually can buy or sell ETFs on a stock exchange, just like you would with regular stocks.

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In this article, we’ll cover:

• How ETFs work
• Advantages of ETFs
• Disadvantages of ETFs
• Types of ETFs
• Choosing an ETF
• Exchange-traded fund FAQs

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How do ETFs work?

ETFs can give you relatively easy investment access to a broad range of asset classes; instead of buying shares of multiple different securities, you get exposure to all the securities held by the fund.

Just like stocks, you can purchase shares in an ETF through a brokerage and trade them anytime during the stock market’s operating hours. The share price may change throughout the trading day as they are bought and sold on the market. Investors make money when assets within the ETF grow in value or generate profits in the form of dividends or interest.

ETF fees

All funds have management costs, and the fund’s strategy can affect how much you pay. As a general rule, passive funds are less expensive than active funds. Here’s the difference:

• Passive funds aim to match a market index, like the Dow Jones Industrial Average or the S&P 500, and most ETFs fall into this category. Fund managers make investments that mirror the index, which minimizes the need for frequent trading. Thus, fees tend to be lower.
• Active funds seek to outperform an index or achieve some other goal. For example, a fund might attempt to track a market sector, like technology or healthcare. That typically requires more oversight from management, including trading, and which can translate into higher fees.

In addition to management fees, ETFs may come with other costs, such as commissions or bid/ask spreads. 

“For anyone that feels overwhelmed at the thought of choosing an individual stock, consider buying a basket of many different stocks through an Exchange Traded Fund (ETF). ETFs are a low-cost way to own many different stocks at once, and are a great option if you don’t have the time, energy, or desire to keep tabs on individual companies.” Lauren Anastasio, Director of Financial Advice at Stash

Benefits of ETFs

If you’re new to investing, ETFs can be a great way to get started. ETFs allow you to invest in several assets at once without the pressure or risk of going all in on an individual commodity. Compared to mutual funds, ETF fees are generally lower, and most funds disclose their holdings on a daily basis, making it easier to track performance. These funds may be an efficient way to dip your toe into the world of investing, and they have long-term payoff potential as well.

• Built-in diversification: ETFs contain a basket of diverse investments, which could cushion your portfolio if a single commodity loses value.
• Many options: With over 1,700 ETFs traded on US markets, there’s an ETF available to match a wide range of investing goals interests, and you can gain investment exposure to an entire sector through a single ETF.
• Potential for lower fees: While the mutual fund might involve higher management fees due to its active management approach, the ETF’s fees tend to be lower. With ETFs, you can potentially keep more of your investment returns in your pocket, allowing your wealth to grow over time.
• Intraday trading allowed: ETFs can be traded throughout the day, just like individual stocks. This means you can seize those favorable moments, making adjustments to your portfolio when it matters most.
• Tax efficient: Often, ETFs distribute smaller and fewer capital gains, which can lower the amount of tax you have to pay.

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Downsides of ETFs

ETFs have many possible benefits, any type of investment presents risk, and ETFs are no exception. While investment advisors often praise the built-in portfolio diversification, it’s not necessarily a given. Additionally, some may come with higher fees or other costs.

• Diversity isn’t guaranteed: While ETFs contain multiple securities, they can be concentrated in one market segment or asset class, offering more limited diversification. 
• Fees can be higher: Passively managed ETFs are often celebrated for their lower fees compared to mutual funds. However, some ETFs are actively managed by professional managers who make investment decisions. These active ETFs may come with higher costs to cover the expenses associated with active management.
• ETFs can be risky: Although many see ETFs as lower risk than individual stocks, every fund has a different level of risk; inverse ETFs and leveraged ETFs are usually considered high-risk and unsuitable for inexperienced investors.

Types of ETFs you can invest in

When it comes to investing in ETFs, there are several types to choose from. These funds usually have a particular focus or objective, like matching the performance of an index, investing in specific sectors, or implementing a particular investing strategy. You can select an ETF that best supports your investment goals, risk tolerance, and personal interests.

• Market ETFs
• Passive ETFs
• Active ETFs
• Sector ETFs
• Thematic ETFs
• Bond ETFs
• Commodity ETFs
• Foreign market ETFs
• Currency ETFs
• Inverse ETFs
• Leveraged ETFs

Market ETFs

Market ETFs, also known as equity funds, are designed to track specific market indexes, such as the S&P 500 or Dow Jones Industrial Average. These indexes represent a basket of securities from various companies that collectively represent the overall market. When you invest in a market ETF, your goal is to closely replicate the performance of the underlying index. This means that as the index goes up, your ETF should follow suit. And when the index experiences a dip, your ETF’s value may fluctuate accordingly.

A market ETF’s success depends on how closely the ETF tracks the underlying index. Factors such as the ETF’s management strategy, transaction costs, and tracking error can impact how well the ETF mirrors the index’s performance. Make sure to do your research and find an ETF that has a track record of closely aligning with the index you want to follow.

Passive ETFs

Passive ETFs generally follow a buy-and-hold indexing strategy designed to mirror the performance of a specific benchmark or index. These benchmarks can range from widely recognized market indices like the S&P 500 or the Dow Jones Industrial Average to sector-specific or asset-class-focused indices. By tracking a benchmark, passive ETFs aim to provide investors with broad market exposure. Passive ETFs are also considered budget-friendly. These funds tend to have lower costs because they don’t play the trading game as actively managed funds do.

When exploring passive ETFs, take a peek at the benchmark’s characteristics. How was the team chosen? What is their methodology? What is their track record? These factors can help you align your goals, tolerance for risk, and desire for diversification

Active ETFs

In contrast to passive ETFs that follow a set benchmark, active ETFs have a manager or team of experts who make strategic decisions about portfolio allocation. They bring their experience and knowledge to the table, allowing them to deviate from the index when they see opportunities. Because the active management approach requires far more effort, an actively managed ETF generally has higher management fees compared to a passive ETF.

The fund manager’s goal is to generate attractive returns by actively selecting investments they believe will outperform the broader market or achieve a specific investment objective. But while active ETFs offer potential rewards, it’s important to be aware of the risks. Market volatility can impact the performance of active ETFs, as their success relies on the ability of the managers to make accurate investment decisions. The market can be unpredictable, and even the most seasoned managers face challenges in timing the market effectively.

When considering active ETFs, it’s crucial to assess the track record and investment strategy of the fund’s manager or team. Look for a proven history of successful portfolio management, a consistent investment approach, and alignment with your investment goals. 

Sector ETFs

Similar to a market ETF, these funds aim to match the overall performance of an index, but focus on a specific sector or industry, such as technology. These funds may offer diversification within a given sector, but if the entire sector’s performance falls, the value of the fund’s shares may also drop.

Thematic ETFs

Even more narrowly focused than sector ETFs, these funds target a subset of a sector; for instance, the fund may invest in stocks related to esports or video games rather than technology overall. The narrow focus of these funds may tend to offer less diversification.

Bond ETFs

Also called fixed-income ETFs, these funds invest exclusively in bonds. Because bonds tend to be less volatile than stocks, they’re often considered lower risk. Bond ETFs can be an excellent addition to your investment portfolio, offering stability and balance in comparison to the potentially higher volatility of stocks.

It’s important to remember that while bond ETFs offer lower risk, they are not without risks. Factors such as interest rate changes, the credit quality of the underlying bonds, and macroeconomic conditions can impact bond prices and returns.

Commodity ETFs

Commodities are raw materials such as oil, gold, and agricultural goods. Some commodity ETFs actually purchase the commodities, though this is limited to precious metals. Other funds invest in companies that produce or handle commodities; this can give investors exposure to commodities without the costs associated with the physical possession of goods. 

Foreign market ETFs

Like market EFTs, these funds attempt to mirror an index. The difference is that these target a non-U.S. index, like the Nikkei Index, an index of the Tokyo Stock Exchange. Foreign market ETFs could bring more geographic diversity to your portfolio.

Currency ETFs

Currency ETFs, also called foreign currency ETFs, track the relative value of one or more currencies. These funds can give investors exposure to trading currencies without the complexity and burden of trading on the foreign exchange market.

Inverse ETFs

Unlike most other funds, these ETFs are designed to increase in price when a given market index declines in price. Inverse ETFs require active management, which may increase fees, and they tend to represent a significant risk.

Leveraged ETFs

Leveraging, an investing strategy that uses borrowed funds to buy options and futures to increase the impact of price movements, can lead to significant gain and equally significant loss. Since leveraged ETFs follow this strategy, using financial derivatives and debt to boost the returns of an underlying index, they can be just as risky.

> Explore ETFs to learn more about the different types offered.

How to pick an ETF

With so many types of ETFs, it may feel overwhelming to choose the right fund to invest in. Let’s dive in with an approach that keeps it real, while focusing on the bigger picture.

1. Know your investment objective

Start by asking yourself what you hope to achieve with your investment. Are you looking for long-term growth, stable income, or specific sector exposure? Understanding your objective will help you narrow down the options and focus on the ETFs that can help you reach your goals.

2. Assess costs and operating expense ratios

Expense ratios are like the price tags on ETFs, representing the annual costs you’ll incur as an investor. These ratios cover the fund’s management fees, administrative expenses, and other operational costs. It’s important to pay attention to expense ratios because they directly impact your investment returns. 

Lower expense ratios generally mean more money in your pocket for growth. They can have a significant long-term impact on your investment growth, especially when compounded over time.

3. Understand the impact of expense ratios on returns

It’s important to see the bigger picture when it comes to expense ratios. These seemingly small numbers can have a significant long-term impact on your investment growth.

4. Evaluate the ETF’s index and tracking record

Another critical factor in choosing an ETF is the index it tracks. Does the index align with your investment objectives? Is it broad-based or specific to a sector or asset class? Understanding the index composition will give you insights into the underlying assets and the potential risks and rewards associated with the ETF.

Additionally, take a look at the ETF’s tracking record. Has it closely followed its underlying index over time? Consistent tracking performance is an indicator of a well-managed ETF and can increase your confidence in its ability to deliver the desired investment exposure.

5. Consider market position and competition

The ETF market is constantly evolving, and competition among fund providers is fierce. It’s worth considering a fund’s market position and the presence of similar offerings. The first ETF issuer for a particular sector often has an advantage, as they have the opportunity to gather assets before competitors enter the market.

Protect your portfolio with a diverse and defensive strategy

Whichever assets you choose, it’s usually wise to protect your portfolio with a diverse and defensive investment strategy. A single investment in an ETF can provide diversification and the flexibility you need to stay defensive as your portfolio grows. Stash can help you start investing in ETFs; with over 90 options, you can find the fund that matches your investing goals. 

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ETF FAQ

1. Are ETFs good investments for beginners?

They can be. ETFs offer some diversification in a single purchase, they are often less expensive than mutual funds, and there’s one for virtually any investment strategy. 

That said, not all ETFs are created equal. Some are quite risky, and not all add meaningful diversity to a portfolio. As with any investment, it’s important to fully understand an ETF before buying shares.

2. Are ETFs safer to invest in than stocks?

It depends. For example, a market or index ETF is likely less risky than any given individual stock, because it relies on the performance of many companies, rather than just one. If one company’s value falls, others may rise, shielding you from the struggling company’s price dip. On the other hand, a leveraged ETF is probably riskier than buying shares of a long-established company with many decades of stable performance. 

As a general rule, a basket of stocks tends to be less risky than an individual stock, but it’s important to research any investment before buying.