Introduction
Exchange-traded funds, or ETFs, are investment funds that can be bought and sold on stock exchanges. Instead of purchasing many individual securities separately, an investor can use one ETF to gain exposure to a collection of stocks, bonds, or other assets.
This combination of diversification and exchange trading has made ETFs a common tool for both new and experienced investors. Some ETFs cover an entire stock market, while others focus on a particular sector, investment style, or strategy.
Understanding how ETFs work is important because the ETF structure alone does not determine an investment’s risk. What matters most is what the fund owns and how its strategy is designed.
What is an ETF?
An ETF is a pooled investment fund whose shares trade on an exchange. Investors buy shares of the ETF, and the fund holds a portfolio of underlying investments according to its stated objective.
For example, a broad U.S. stock market ETF may hold shares in hundreds or thousands of companies. Buying one share of that ETF gives an investor indirect exposure to that portfolio rather than ownership of only one company.
ETFs can hold stocks, bonds, commodities, or combinations of different securities. Some track indexes, while others are actively managed.
How ETFs work
ETF shares are listed on stock exchanges and can generally be traded throughout the trading day. Their market price changes as investors buy and sell shares.
Behind the scenes, ETFs also use a creation and redemption process involving large financial institutions known as authorized participants. These institutions can exchange baskets of securities for large blocks of ETF shares, or redeem ETF shares for the underlying basket.
This mechanism helps keep an ETF’s market price relatively close to the value of its underlying portfolio, although small premiums or discounts can still occur.
ETF market price vs net asset value
An ETF has both a market price and a net asset value, commonly called NAV. NAV represents the value of the fund’s assets minus its liabilities, typically expressed on a per-share basis.
The market price is the price at which ETF shares actually trade on an exchange. Because supply and demand affect trading, the market price can be slightly above or below NAV.
If an ETF trades above its NAV, it is trading at a premium. If it trades below NAV, it is trading at a discount.
Why investors use ETFs
Diversification
A single broad ETF can provide exposure to many companies or bonds, reducing reliance on the performance of one investment.
Convenience
Investors can access an entire market, asset class, sector, or strategy through one security rather than assembling the portfolio themselves.
Tradability
ETF shares generally trade throughout the market day, allowing investors to buy or sell them using a brokerage account.
Potentially low costs
Many passive index ETFs have low expense ratios, although investors should compare each fund because costs vary.
Costs of investing in ETFs
ETFs are often associated with low fees, but they are not free investments. The expense ratio is the annual operating cost charged by the fund and is deducted from fund assets rather than billed directly to the investor.
Investors may also face brokerage commissions depending on their broker, as well as trading costs created by the bid-ask spread. The spread is the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept.
Taxes can also affect returns and depend on the investor’s jurisdiction, account type, and the ETF’s investments and distributions.
Risks of ETFs
ETFs can make diversification easier, but they do not eliminate investment risk. If the securities held by an ETF decline in value, the ETF will generally decline as well.
Other risks depend on the fund. A sector ETF may be highly concentrated, a bond ETF can be sensitive to interest rates and credit conditions, and leveraged ETFs can behave very differently from conventional long-term index funds.
Liquidity also varies. Heavily traded ETFs may have narrow bid-ask spreads, while less liquid funds can be more expensive to trade.
Common types of ETFs
ETFs can be grouped by what they invest in or by the strategy they follow.
- Index ETFs: seek to track the performance of a particular index.
- Dividend ETFs: focus on companies selected using dividend-related criteria.
- Sector ETFs: invest in companies from a particular economic sector.
- Bond ETFs: hold portfolios of government, corporate, municipal, or other bonds.
- Actively managed ETFs: use managers who select investments according to a stated strategy.
- Leveraged ETFs: seek a multiple of the daily performance of a benchmark and involve additional complexity and risk.
ETF vs individual stocks
| Feature | ETF | Individual stock |
|---|---|---|
| What you buy | An interest in a fund holding a portfolio | Ownership in one company |
| Diversification | Can range from broad to highly concentrated | Limited to one company |
| Trading | Trades on an exchange | Trades on an exchange |
| Ongoing fund fee | Usually has an expense ratio | No fund expense ratio |
| Main risk | Depends on the fund’s holdings and strategy | Strongly dependent on one company’s performance |
What to check before buying an ETF
An ETF’s name provides only a starting point. Investors should understand the fund’s objective, underlying holdings, index or strategy, expense ratio, concentration, liquidity, distribution policy, and major risks.
For index funds, it is also useful to understand which index is being tracked. Two ETFs with similar names can follow different indexes and therefore hold different portfolios.
The central idea is simple: an ETF is a container. The investments and strategy inside that container determine how the fund is likely to behave.
Key takeaways
- An ETF is an investment fund whose shares trade on a stock exchange.
- ETFs can hold stocks, bonds, commodities, and other investments.
- ETF shares trade at market prices, which can differ slightly from the fund’s net asset value.
- Costs can include an expense ratio, bid-ask spread, brokerage fees, and taxes.
- ETFs can make diversification easier, but narrow or specialized funds may still be highly concentrated.
- Understanding the holdings and strategy is more important than relying on the ETF’s name alone.