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What are ETFs and how do they work?

Man checking financial trading data on mobile phone while relaxing on terrace
(Image credit: Kathrin Ziegler/Getty)

In the first half of 2022, U.S. investors bought $297.3 billion in ETFs.

Similar to mutual funds, ETFs are popular among investors for their low risk and seemingly endless options for diversification. But ETFs can be less costly than mutual funds, and they're a great choice for new investors or someone who plans to buy and hold.

What is an Exchange-Traded Fund (ETF)?

Exchange-traded funds, or ETFs, haven't been around very long. First available in 1993, these investment products, which are now widely available, allow you to pool your money into diverse investment portfolios.

ETFs typically include dozens or thousands of stocks, bonds and other assets. There are also funds with specific themes, including industry-based themes, asset classes and strategies. Technology themes, which include everything from robotics to AI, are some of the most popular choices for investors.

When compared to other products, these are some of the main benefits of ETF investing:

  • Low or no minimum buy-in
  • Low fees 
  • Tax efficiency 
  • Diversification made easy

How is an ETF different from a mutual fund?

Mutual funds and ETFs have a lot in common. Like ETFs, mutual funds can be extremely diverse—made up of various stocks and bonds—making them less risky than investing in individual companies. Both products can also be actively or passively managed.

But when compared to ETFs, mutual funds have some disadvantages:

  • Higher taxes. Mutual fund investors typically pay more capital gains taxes, since taxes can be assessed before shares are sold. 
  • Higher minimum investment. ETF minimums may start as low as $0-$50, but mutual fund requirements are usually higher. The minimum for most Vanguard mutual funds is $3,000.
  • Less flexible trading. ETFs can be traded in real-time as prices fluctuate throughout the day, but mutual fund shares can only be traded once a day, after markets close and a net asset value (NAV) is calculated.

On the other hand, ETF transaction fees can add up quickly. For that reason, mutual funds can be a better choice for someone who wants to make frequent deposits to their investment account, or for investors who plan to use dollar cost averaging—a strategy that involves investing a fixed dollar amount at regular, recurring intervals.

What are the different types of ETFs?

There are many different classifications for ETFs, but investors should consider these two types before making a purchase:

  • Actively managed: Portfolio managers sell and trade based on the ETF's stated investment strategy, and investors pay fees for the active management.
  • Index-based: Portfolios are built based on indexes, like the S&P 500 stock index, and trades are made based on pre-set benchmarks.

Similar to other assets like mutual funds, index-based funds have historically outperformed actively-managed funds. However, active EFTs performed exceptionally well in the first half of 2022.

How do you buy ETFs? 

ETFs can be bought and sold on stock exchanges. You may already be familiar with some of the largest ETF providers, which include Vanguard, Charles Schwab and JP Morgan, but many other companies offer ETFs, and there are more than 8,500 funds to choose from.

Before buying, you'll want to compare these common costs across several funds:

  • Expense Ratios: An annual fee range from 0.03% to 10.00% of your fund assets.
  • Commission fees: The fee charged for every purchase and sale.
  • Bid/ask spreads: The allowable difference between a seller's price and a buyer's bid. Lower spreads mean saving money when you buy and sell shares.

While low-cost funds are the most popular option for investors, fees aren't the only thing to consider. The Securities and Exchange Commission (SEC) recommends doing more research in advance. Here's what their Investor Bulletin (opens in new tab) advises:

Before investing in an ETF, you should read both its summary prospectus and its full prospectus, which provide detailed information on the ETF's investment objective, principal investment strategies, risks, costs, and historical performance (if any).

If you're considering a specific ETF, you can also use the Financial Industry Regulatory Authority's (FINRA's) Fund Analyzer (opens in new tab) to get a better look at account fees, discounts, and projections.

Should I invest in ETFs?

There are a handful of good reasons to consider investing in ETFs. These are at the top of the list:

Diversification made easy

First, ETFs make it easy to build a diverse portfolio. Rather than hand-picking an array of stocks and paying a fee for each purchase, you can choose a fund that does the work for you.

Why does it matter? Holding a diverse array of assets is a fundamental investment strategy, since it limits your risk of total loss in the event that a certain company, industry, commodity or even currency you're invested in (think Bitcoin) takes a hard hit.

Low-cost investing

Second, ETFs are exceptionally low cost. Investment companies compete to offer the lowest fees, and plenty of funds charge next to nothing for buying and selling. According to Kiplinger, the average mutual fund (opens in new tab) costs more than 20 times the typical ETF.

Something for everyone

ETF categories are practically endless. They can give investors instant access to foreign markets, new technology and more.

For an investor who wants to further probe their options or diversify their ETF holdings, here are a few categories to consider: 

  • Growth ETFs invest in companies that are expected to grow rapidly.
  • Dividend ETFs invest in dividend-paying stocks, and investors receive dividend payments at set intervals.
  • Sustainable ETFs built their portfolios around environmental, social and governance (ESG) investing.

ETF Frequently Asked Questions (FAQ)

Here are a few more items to consider before investing in ETFs.

Is ETF a Stock?

ETFs are not stocks, but ETF portfolios often contain stocks. Both are similar in that they're sold on exchanges, and they can be traded at prices that fluctuate throughout the day. However, the return for an individual stock is based on the performance of just one company.

Are there ETFs for crypto?

Yes, there are ETFs that invest in crypto companies, and some track specific currencies such as Bitcoin or Ethereum, and even blockchain companies. Crypto-based ETFs can be a good option for someone who wants to invest in cryptocurrencies without worrying about storage and other security issues.

How risky are ETFs?

ETFs can be low-risk investments since they're generally made up of diverse assets. However, some are higher risk depending on their features, including industry-specific ETFs and cryptocurrency funds.

Sarah Brady
Personal finance writer

Sarah Brady is a personal finance writer and educator who's been helping individuals and entrepreneurs improve their financial wellness since 2013. Sarah's other publications include Forbes, TIME's Next Advisor, Investopedia and Experian, and her work has been syndicated by Yahoo! News and MSN. She is a former educator for the City of San Francisco’s affordable home buying programs, as well as a former Certified Credit Counselor (NFCC) and Housing Counselor (HUD).