What Are Exchange-Traded Funds (ETFs)?

Investing your money can help you build wealth, but there are many ways to do so. Investing often involves putting your money into single company stocks, but exchange-traded funds take this idea a little further. If you’re wondering, “What is an exchange-traded fund,” in the most basic sense, an ETF is a collection of similar investments in a single fund. This allows you to take advantage of industry- or market-level growth without the typical risk attached to individual company stocks. There are also ETFs that don’t use stocks, such as bond funds, which focus on bonds.

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What Is an Exchange-Traded Fund (ETF)?

Exchange-traded funds combine features of both stocks and index funds. They track market indices, but unlike a mutual fund, they can be traded like stocks. Exchange-traded funds track widely known indices like the S&P 500 or the Dow Jones Industrial Average. But they can also track smaller indices associated with a particular market segment, such as biotechnology.

How ETFs Compare to Other Investments

Exchange-traded funds offer a lot of advantages over individual stocks or actively managed funds, especially for beginner investors who haven’t quite mastered the ins and outs of the market. For one thing, having ETFs in your portfolio means you get more diversity than you would by purchasing individual stocks. While they’re still subject to market volatility (price changes), you might be able to minimize your losses by choosing an ETF that tracks a broader index.

Similar to stocks, ETFs can be bought and sold throughout the day, and their price fluctuates accordingly. With a mutual fund, the price is set once per day when the market closes. If you’re savvy about making trades, you may be able to leverage your investment in an exchange-traded fund to get a bigger return.

Why They’re a Good Pick for Beginners

Exchange-traded funds can be a good choice if you don’t have a lot of money to get started with, because they don’t require a large initial investment like some mutual fund offerings. (Many mutual fund companies require you to invest at least $3,000.) With an ETF, it’s up to you to decide how much or how little you want to invest.

Another upside is that unlike mutual funds, ETFs tend to carry fewer fees, meaning you’ll be able to keep more of your investment income. If you know nothing else about investment fees, you need to understand the expense ratio. This is the percentage of the fund’s assets that are used to cover expenses.

Some mutual funds can carry expense ratios as high as 2%. While this doesn’t seem like much, it can take a serious bite out of your earnings over the long term. Some ETFs, on the other hand, can have expense ratios as low as 0.09%.

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Pay Attention to Trading Fees

Because brokers sell ETFs, you might pay a commission fee every time you buy one, just as you would if you were purchasing stocks. These fees vary widely from one brokerage account to the next, so it’s important do your research.

To put things in perspective, if you’re investing $100 a month in an ETF and paying a $10 commission to the broker, you’d need to see a 10% return just to recover the cost. You also pay commission fees any time you sell an ETF. So if you’re making a lot of trades, that can eat into your returns even further.

Types of ETFs

ETFs offer a diverse range of options to suit a wide variety of financial goals and needs. Whether you’re looking to replicate the performance of a major index, gain exposure to specific sectors or explore alternative assets like cryptocurrencies, there’s likely an ETF that aligns with your investment strategy. The following are some of the various types of ETFs available on the market today:

Passive ETF: Passive ETFs are designed to mirror the performance of a broader index, such as the S&P 500, or a more niche sector or trend. These funds aim to provide investors with a diversified portfolio that reflects the index’s performance. This makes them a popular choice for those seeking a hands-off investment approach.
Actively Managed ETF: Unlike passive ETFs, actively managed ETFs do not track an index. Instead, portfolio managers actively select securities to include, aiming to outperform the market. While they offer potential benefits over passive ETFs, such as the ability to capitalize on market inefficiencies, they often come with higher costs.
Stock ETF: Stock ETFs consist of a collection of stocks within a specific industry or sector, such as technology or automotive. These funds offer diversified exposure to a particular market segment. They often come with lower fees than stock mutual funds, making them an attractive option.
Industry or Sector ETF: These ETFs concentrate on specific sectors or industries, such as energy or technology. For example, Blackrock’s iShares U.S. Technology ETF mirrors the performance of a technology-focused index, providing investors with targeted exposure to that sector’s growth potential.
Commodity ETF: Commodity ETFs invest in physical goods like crude oil or gold. They offer a cost-effective way to diversify a portfolio and hedge against market downturns. All without the complexities of owning the physical commodities themselves.
Bond ETF: Bond ETFs focus on providing regular income through investments in various bonds, including government, corporate and municipal bonds. Unlike individual bonds, bond ETFs do not have a maturity date, offering a more flexible investment option for those seeking steady income.
Currency ETF: Currency ETFs track the performance of currency pairs, allowing investors to speculate on currency movements or hedge against forex market volatility. These funds can be particularly useful for importers and exporters looking to manage currency risk.
Leveraged ETF: Leveraged ETFs seek to amplify the returns of their underlying investments, often using debt and derivatives. For instance, a 2× leveraged ETF aims to double the return of its benchmark index, offering higher potential gains (and losses) for risk-tolerant investors.
Inverse ETF: Inverse ETFs aim to profit from stock declines by shorting stocks through derivatives. These funds are technically exchange-traded notes (ETNs) and not true ETFs, offering a unique strategy for investors anticipating market downturns.

Bottom Line

An investor researches "What is an ETF?"

Exchange-traded funds have a lot of appeal for new investors based on their affordability and the potential for high earnings. Like with any investment, you’ll want to read over the fund prospectus carefully to make sure an ETF is a good fit for you and your financial needs and goals.

Tips for Managing Your Investments

A financial advisor can help you build a plan for your portfolio, as well as adjust and rebalance it over time. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area. And you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
SmartAsset’s investment calculator can help you determine what type of rates you need to earn to reach your savings goals.