Exchange-traded funds (ETFs) are what would happen if a mutual fund and stock had a baby. These pooled investment vehicles combine the best of what mutual funds and stocks each have to offer, and they're more accessible to investors than either.
Whatever type of investment you want can be accessed in 30 seconds or less with an ETF, depending on if you know the password to your brokerage account, says Matt Collins, head of ETFs at PGIM investments. But before you start searching for an ETF that lets you invest in mint chip ice cream because that's never going out of style, it's important to understand what an ETF is and how to pick a good one.
What are exchange-traded funds (ETFs)?
An ETF is a basket for holding a variety of investments the fund manager chooses. You can find an ETF with 25 of social media's favorite companies or one dedicated to companies supporting all the bad habits people love. But just because an ETF exists for a particular interest doesn't mean it makes a good investment.
The problem is that some of these themes are great marketing ideas, not great investing ideas. For example, the aforementioned social media ETF has underperformed the S&P 500 by almost 8% since its inception. And as a rule, no one should be using social media for investment advice.
When investing in ETFs, it's essential to know how the ETF works and how the managers implement its stated investment strategy. It's about more than just choosing the right investment theme; you have to choose the right approach to that theme.
How do ETFs work?
ETFs work like mutual funds that think they're individual stocks. Under the hood, an ETF looks like a mutual fund in that it holds various investments within the same wrapper. On the outside, ETFs can be traded throughout the day, just like a stock. "At 9:31 am or 2:30 pm, the price you pay for the ETF is the value of what that ETF owns," Collins says.
At least, that’s how it works in theory. In reality, ETFs can trade at a premium or discount to their net asset value (NAV), or the value of all the securities it holds. This price differential is usually self-correcting and short-lived, as investors try to profit from it, but it is still something to look into before investing in an ETF.
ETFs vs. stocks
Although ETFs trade like stocks and can even be made up of a collection of stocks, they are not the same.
A stock is a share in a specific company, such as Coca-Cola or Nike. When you buy stock in a company, you own a piece — albeit a small piece — of that company. You may also get certain privileges, such as the right to vote on key issues affecting the company. This is not the case with an ETF.
When you buy a share of an ETF, you own a piece of the ETF, not the securities within the ETF. For example, if you have a share of an ETF that holds Coca-Cola stock, you own a piece of the ETF, but you do not own a piece of Coca-Cola. You can't vote on issues the company presents to stockholders, but the ETF manager may be able to.
You still profit from Coca-Cola's success through your ETF, though. For example, if Coca-Cola pays dividends, the ETF fund manager will pass that along to you and the other ETF investors. Since ETFs trade like stocks, you may encounter trading commissions with ETFs. These are small fees you pay each time you place a trade. However, many large brokerage firms now offer commission-free ETFs, so watch for those.
You'll also encounter a bid-ask spread with ETFs. This is the difference between the highest price a buyer is willing to pay (the "bid") and the lowest price sellers are willing to accept (the "ask"). The spread acts like a commission in that it is a cost you incur on each trade. A larger spread or more trades means a higher cost.
ETFs vs. mutual funds
ETFs and mutual funds are both pooled investment vehicles that can hold a variety of different securities. The key difference between ETFs and mutual funds is in how they trade and what they cost.
Mutual funds trade once per day at market close. So if you place a trade for a mutual fund at noon, you won't know the price you're going to pay per share until after market close when the fund manager calculates the value of the fund's holdings. To compensate for this, you can buy mutual funds in specific dollar amounts, such as $50 of fund X.
As with stocks, you typically buy ETFs on a per-share basis, although some brokerage firms have introduced dollar-based investing for ETFs, too.
Like mutual funds, ETFs have management costs. The company packaging that ice cream ETF for you has to make money somehow. This is the expense ratio and it is expressed as a percentage of the money you invest in the ETF. For example, a 0.5% expense ratio means 0.5% of your money will go toward covering the fund's operating costs.
Mutual funds may add other charges, such as sales loads, distribution and marketing fees or redemption fees.
At a glance: ETFs vs. mutual funds vs. stocks
The easiest way to understand the difference between ETFs, mutual funds, and stocks is with a side-by-side comparison. This table illustrates the key differences between each type of investment.
| ETFs | Mutual funds | Stocks | |
| How they trade | Throughout the trading day | Once per day after market closed | Throughout the trading day |
| Average ownership costs | Expense ratio, commissions, bid-ask spread | Expense ratio, sales charges, distribution fees, redemption fees | Trading commission |
| How you own the underlying assets | You own shares of the ETF, not the underlying assets | You own shares of the mutual fund, not the underlying assets | Directly |
Do ETFs pay dividends?
ETFs do pay dividends. These can be paid on a monthly, quarterly or any other schedule the ETF manager chooses.
Some ETF dividends are "qualified," meaning you only pay the lower capital gains tax rate on the income. Otherwise, you'll pay taxes at your ordinary income rate.
Types of ETFs
One of the benefits of ETFs is there are many to choose from. If you can dream it up, an ETF is probably trying to turn it into an investment strategy.
Passive ETFs
Passive ETFs track a market index, like the S&P 500. They are considered to be passively managed because the manager doesn't make any active decisions about what to buy or sell, she simply follows the index. If the S&P 500 adds Tesla, the manager of your S&P 500 index fund should also add Tesla.
"The only thing I don't love is [that] when people hear ETFs, they hear passive," Collins says. There are so many more types of ETFs available than your standard index strategy.
Active ETFs
Active ETFs are run by a manager who actively decides what to buy and sell and when. These funds aim to outperform a benchmark, so while the fund may state its benchmark is the S&P 500, the manager is trying to do things to ensure your ETF does better than the S&P 500 based on the fund's stated objective.
For example, an active S&P 500 ETF could provide higher returns in bull markets, minimize losses in bear markets or provide higher dividends in all markets.
Active ETFs are growing faster than passive ETFs, with a 14% growth rate in the first half of 2023 for active compared to only 3% for passive, according to Morningstar. You can find actively managed ETFs in any of the following types of ETFs.
Stock ETFs
Stock ETFs hold a portfolio of stocks. That S&P 500 ETF is a stock ETF. Stock ETFs can hold thousands of stocks or just a handful, so while an ETF is less risky than holding just one stock, not all ETFs are diversified.
These can specialize in a particular segment of the equity market, such as geography (e.g. U.S. stocks or international stocks), company size (e.g. large cap stocks or small cap stocks), sector (e.g. industrial stocks or finance stocks), or valuation type (e.g. growth stocks or value stocks).
Bond ETFs
Bond ETFs invest in bonds. Like stock ETFs, they can target a particular segment of the bond market, such as U.S. government bonds or corporate bonds, short-term or long-term bonds, or domestic or international bonds. Some bond ETFs aim to cover the entire global bond market.
Unlike when you invest in individual bonds, there is no maturity date on a bond ETF. You can leave your money in the fund for as long as you like and the fund manager will take care of reinvesting the fund assets as the bonds in the portfolio mature.
Commodity ETFs
Commodity ETFs aim to track the price of a specific commodity.
Commodities are raw goods that are identical from one unit to the next. Think of wares such as gold, corn, or cocoa. While there are different types of corn and coffee, all white corn and all criollo cocoa beans are essentially identical.
Commodity ETFs can track these goods by:
- Owning the physical commodity
- Investing in companies that produce, store, or transport the commodity
- Owning derivatives contracts, such as futures contracts, which are agreements to trade a specified quantity of a commodity at a predetermined price and time.
It's crucial to know how a commodity ETF invests because each of these strategies holds varying levels of risk.
Sector ETFs
Sector ETFs target a specific sector of the stock market. There are 11 sectors ranging from energy to finance to healthcare.
Sector ETFs can be passively managed and simply track a sector index, or they can take an active approach by trying to choose only the best of the best within a given sector. In either case, sector ETFs are less diversified than more broad-based ETFs since their holdings are concentrated within a single sector. If banks start collapsing, your financial sector ETF will tumble more than an ETF with energy and healthcare stocks.
Leveraged ETFs
These are for the risk-takers in the investment world. Leveraged ETFs aim to amplify the returns of an underlying index. For example, if the S&P 500 returns 5%, your 2x leveraged ETF would gain 10%.
While this sounds great in rising markets, it can be devastating in declining markets because your losses are also amplified. As such, you should take great care when investing in leveraged ETFs. Often the pain is not worth the gain.
ETF pros and cons
ETFs have a lot to offer, from accessibility to tax efficiency, but they also have their drawbacks. They may not be the best investment for everyone or every situation.
Pros
- Accessibility: ETFs are available to anyone with a brokerage account and can be purchased for only a few dollars.
- Easy to trade: You can purchase ETFs throughout the trading day, either in share or dollar amounts.
- Transparency: Most ETFs publish their holdings daily, so investors always know what they're investing in.
- Tax efficiency: ETFs are more tax-efficient than mutual funds because ETFs tend to have lower capital gains distributions, which are taxable to the investor.
Cons
- Commissions: You may incur trading commissions when buying or selling ETFs.
- Bid-ask spread: The difference between what buyers are willing to pay and sellers are willing to accept on an ETF creates an additional cost to ownership.
- Illiquidity: Your ability to sell an ETF depends on how many other investors are willing to buy your shares. ETFs with low trading volume put investors at risk of being unable to sell — or unable to sell at a fair price — when they want to liquidate.
- Closure risk: There is the possibility that an ETF you buy could close, such as if it's unable to bring in enough assets to cover its operating costs.
How to invest in ETFs
The beauty of ETFs is how easy they are to access. To invest in ETFs, you only need to open a brokerage account, choose your fund, and place a trade.
1. Open a brokerage account
To invest in ETFs, you need a brokerage account where you can buy and sell them. You can open this account at any online brokerage firm in only a few minutes. When choosing a brokerage firm, things to watch out for include account minimums and fees, trading costs, and what sort of investment options are available.
2. Research ETFs
There are nearly 3,000 ETFs in the U.S. alone. To say you have a lot of ETFs to choose from is an understatement. When researching ETFs, here's what you need to look for:
- Cost: Obviously lower is better but sometimes it's worth paying a bit extra for a better manager. That said, make sure you know what you're paying for and are getting compensated for any extra costs.
- Provider expertise: You want an ETF provider that has experience in the space you're investing in, Collins says. Don't just read about your ETF from third party websites. He says to go to the provider's website and read about the company as well as the specific ETF you're considering.
- Performance history: It's best to choose an ETF that has been tested through a variety of market conditions. Robert Minter, director of investment strategy for ETFs at Abrdn, suggests looking at the underlying index for a gauge of how it'll fare in challenging markets if the ETF is too new to have much performance history.
- Portfolio: Make sure you know what's inside the ETFs you own. An increasing number of ETFs have been coming out with only a handful of holdings, Minter says, which can be risky for unwitting investors.
- Investment strategy: ETFs can take different approaches to the same investment theme. For example, to invest in the clean energy movement, one ETF may own electric vehicle (EV) manufacturers while another may invest in the particular metal used to create EV batteries.
- Trading volume: To ensure you'll be able to sell an ETF when you want to, look for one that has a high trading volume with millions of shares trading hands per day.
- Size: It takes $25 million to $50 million for an ETF to break even, Minter says. "An ETF with $5 million in it is probably going to close at some point unless they get more assets into it." The larger the ETF, the less likely it is to close.
There is an exception to that last point about size. While Minter recommends finding ETFs with at least $25 million in assets under management (AUM), Collins prefers a more forward-looking approach by seeing if the ETF is growing.
All ETFs start small, so rather than ruling out an ETF simply because it hasn't reached $25 million yet, you can look at if it's gaining traction. You can see if an ETF is growing by watching the AUM over time or the number of shares outstanding instead. Since ETFs issue new shares as more buyers make purchases, a growing ETF will have an increasing number of shares outstanding.
3. Purchase your ETFs
After you've chosen an ETF, you can hop back to your brokerage account and place the trade. The most common types of ETF trades are:
- Market orders are placed immediately to get the next available price
- Limit orders let you set a maximum price you're willing to pay (or accept if you're selling). The trade won't execute until and unless that price is met.
If you're new to ETF investing, market orders are your best bet as you're guaranteed execution. With a limit order, it's possible that the ETF never reaches your price point and therefore you never get invested.
4. Track your portfolio
Your work isn't done after you buy an ETF. You now need to keep tabs on it. The ability to trade ETFs like stocks can make investors trigger happy. Just because you can buy and sell an ETF whenever you want doesn't mean you should, Collins says. ETFs are best utilized as long-term investments.
Ideally, you have decided what portion of your portfolio you want to dedicate to each investment you own, but these proportions can change over time. If one ETF has a great year, it may grow to account for 30% rather than 20% of your portfolio. In this case, you should rebalance by selling enough of the ETF to bring it back to 20% of your portfolio and investing the proceeds into your remaining investments.
The takeaway
ETFs are great investments for new and experienced investors alike. They're widely available, easy to trade, low cost and transparent. With thousands available worldwide, there's plenty of options to satisfy every investor's tastes. But the sheer volume of available ETFs can also be a drawback. With so many to choose from, how do you pick the right ETFs for you?
"People work extremely hard for their income and they probably work even harder to have something leftover after expenses," Robert Minter says. What you do with your hard-earned savings is a big decision. Talking to a financial advisor who can help you plan your portfolio and make the most of each dollar you save may be the wisest financial choice you can make.
