An ETF, or exchange-traded fund, is a popular investment fund that allow investors to diversify their portfolios with the flexibility of trading throughout the day. While ETFs come in various forms, they all share the same basic characteristics. These funds can be a great addition to any portfolio, but it's essential to understand how they work before diving in.
Wise Takeaways
- ETFs bundle multiple assets into one investment, making it easy to diversify your portfolio.
- ETFs trade like stocks, so you can buy and sell throughout the day at market prices.
What is an ETF?
An ETF is an investment vehicle that bundles many securities into a single investment. ETFs are designed to track the price of their underlying assets, which can include stocks, bonds, commodities, and more.
Unlike mutual funds or index funds, ETFs are traded on stock exchanges throughout the day, just like individual stocks. That means investors can buy and sell them at market prices during trading hours. When you invest in an ETF, you don't directly own the underlying assets. Instead, you own shares in the fund itself, which represents a portion of its total holdings.
How do ETFs work?
A fund provider creates an ETF by purchasing a collection of assets, such as stocks, bonds, or commodities. Then, a fund is designed by tracking the performance of those assets. Investors can then buy shares of the ETF on the stock exchange.
ETFs combine the benefits of both mutual funds and stocks. How?
- First, like mutual funds, ETFs are an easy way to diversify your portfolio because they follow many underlying assets and combine them into a single basket.
- When you invest in an ETF, you are exposed to all of the investments within the basket. This diversification helps to mitigate the risks from any individual security.
- ETFs also have one of the key benefits of stock in that they can be traded throughout the day anytime the exchanges are open. If you decide you want to buy or sell shares of an ETF, you don’t have to wait until the end of the day. You can complete the transaction immediately.
What is the difference between ETF and a stock?
ETFs and stocks have one very important characteristic in common: both trade on major stock exchanges, so you can buy and sell whenever the exchange is open. Just like stocks, ETFs have their own ticket symbols so you can track their performance.
The major difference between the two is that when you purchase a stock, you’re buying ownership in a single company. When you buy shares in an ETF, you’re purchasing many underlying assets.
| Feature | ETF | Stock |
|---|---|---|
| Type of investor | All investors | Experienced investors |
| Number of assets | Many | One |
| Best uses | Long-term and diverse portfolios | Granular, strategic investment strategies |
| Management fees | Fees typically apply | No management fees |
| Trade times | Near-instant | Near-instant |
| Typical trade commission | Commission-free | Commission-free |
What is the difference between ETF and a mutual fund?
ETFs and mutual funds are both investment vehicles designed to hold many underlying investments. When you buy shares in these funds, you’re investing in each of its underlying assets. Both can specialize in different asset classes, sectors and styles, and both can be an effective way of diversifying your portfolio.
There are two critical differences between ETFs and mutual funds.
| Feature | ETF | Mutual Fund |
|---|---|---|
| Trading | Traded throughout the day on exchanges. | Traded once per day at the end of the trading day. |
| Price | Price fluctuates throughout the day based on market conditions. | Price set at the end of the day based on the closing price. |
| Management style | Generally passively managed, designed to track an index. | Usually actively managed, designed to beat the market. |
| Fees | Relatively low management fees. | Higher management fees due to active management. |
Are ETFs a good investment?
For the typical investor, ETFs are an excellent investment choice. The vast majority of my personal portfolio is in a variety of ETFs. When you’re investing for long-term goals like retirement or funding a college education, it’s tough to beat ETFs.
ETFs are arguably the best way to invest for the average person because of its low fees, instant access to diversified portfolios and ability to quickly buy and sell. With a target date fund ETF or a mix of diversified stock and bond ETFs, you could find all of your investment needs met with only a few ETFs.
Pros and cons of ETFs
Pros
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Diversification: ETFs make it easy to invest in many underlying securities across different asset classes, therefore reducing your exposure risk.
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Low management fees: Because most ETFs are passively managed, they have lower management fees than a typical mutual fund.
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Easy to trade: ETFs trade on major exchanges throughout the day, just like stocks. As a result, you get real-time pricing without waiting until the end of the day.
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Tax efficiency: Mutual fund investors may pay capital gains taxes while they still hold their shares, while ETF investors don’t pay taxes until they sell their investment.
Cons
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Possible trading fees: Depending on the brokerage firm you use, you might pay commissions or trading fees when buying or selling ETF shares.
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Illiquidity: Some ETFs can be relatively illiquid, meaning you may have a difficult time selling at the price you would hope.
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Management fees: Most ETFs are passively managed, resulting in low management fees. But if you’re not paying attention, you could inadvertently invest in an actively managed fund and pay a higher management fee than you expect.
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Eric Rosenberg is a finance, travel and technology writer in Ventura, California. He is a former bank manager and corporate finance and accounting professional who left his day job in 2016 to take his online side hustle full time.
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