What is an ETF?
Find out what an ETF is and how they can help you to build wealth.
One of the hardest parts of learning to invest is realizing that the terminology can be a lot to learn—but it's almost never as complicated as you think.
If you're learning about investing, you may have heard the term ETF. A lot of experts and social media influencers will tell you that certain ETFs are great investment opportunities, and maybe they are right—but what the heck is an ETF?
I'm going to break it down for you as simply as I can.
What is an ETF anyway?
ETF stands for exchange-traded fund. These funds have some characteristics of stocks and some of mutual funds. Like stocks, ETFs are traded throughout the day at market prices that can change. Like mutual funds, ETFs are groups of stocks or bonds that make it easier to diversify your portfolio and lower your risk.
There are several types of ETFs, and you’ll find ETFs with a particular focus like an industry (ex. tech), currency (ex. crypto), or commodity (ex. oil). Before investing in these ETFs be sure to research its niche.
Bottom line: an ETF allows you to buy shares of multiple stocks in one "container" in order to diversify and lower risk.
How do ETFs work?
Generally speaking, ETFs work much like any investment in the stock market for investors —you buy into one, and the value of the money you put in grows or decreases along with the investment’s performance.
ETFs can be actively or passively managed. Actively managed ETFs have a manager that watches the fund’s performance and can actively make changes by selling or buying the stocks or bonds in the fund. Since the funds are actively managed, they typically have a higher overhead costs.
Passively managed ETFs are created and are mostly left alone. Since there isn’t an active manager, there’s less overhead. These ETFs are worth considering for long-term investment strategies.
Why do investors buy ETFs?
Investors buy ETFs because of how they balance cost, risk, reward, and liquidity. ETFs usually have lower expense ratios than mutual funds and carry less risk than stocks. (Expense ratios show the relationship between what it costs to manage the fund and the fund’s value.)
ETFs also tend to be easier to sell, or more liquid, than mutual funds. However, this liquidity can vary depending on the type of ETF you have.
What are the pros and cons of ETFs?
As you decide whether or not to invest in ETFs, consider the pros and cons. We’ll focus on the general pros and cons here.
As you look at specific ETFs, you’ll want to create a list of pros and cons for those funds specifically before you invest.
- Management approach — ETFs can be either actively or passively managed. If you’re investing for long-term goals, passively managed ETFs can help you lower costs because they have a lower expense ratio.
- Specialization — ETFs often focus on a particular commodity, currency, or industry. These funds make it easier to diversify when investing in a particular category.
For example, rather than buying stocks in several different tech companies to diversify your portfolio yourself, you can invest in a tech-focused ETF that is already diversified.
- Risk — Because ETFs are already diversified, they can carry less risk than stocks. However, the risk associated with each ETF can vary. Be sure to do your research, especially if you’re considering a very niche, leveraged, or inverse ETF.
- Reward — The flip-side of risk is reward. While ETFs carry more risk than a mutual fund, they have the potential to yield higher returns than you’d expect from a mutual fund.
- Cost — ETFs are cost-effective. They have some of the lowest expense ratios. They also tend to be tax-efficient.
- Management approach — There isn’t really a negative side on this point. Just be sure to note how the ETF is managed and consider how that fits in with your investment goals.
- Specialization — While ETFs are diversified within their niche, it can be smart to have more diversity in your portfolio. You only have to look at how oil and gas markets have drastically changed over the past few years to understand that it’s wise to have a wider range of diversity in your investments.
- Risk — While ETFs have less risk than stocks, they do have more risk than mutual funds. So, here’s another reminder to research the ETF before you invest.
- Reward — Again, no firm concern here. The potential reward offered by an ETF varies.
- Cost — While ETFs are generally cost-effective, you do need to watch out for fees. Sometimes ETF managers will waive fees for a set period of time. These waivers can be renewed, but that’s not a guarantee.
What's the difference between an ETF and a mutual fund?
The key differences between ETFs and mutual funds are:
- trading times
- share pricing
- investment strategy
ETFs can be bought and sold during the day. These trading rules can make ETFs attractive to day traders. Long-term investors can also benefit from ETFs.
Mutual funds are only bought or sold at the end of a day. The price of a mutual fund can also vary, but prices are set once per day. Shares in funds sell at the end of the day, so the price prediction you see initially can change when your investment or sale are completed.
ETFs trade on market prices. These prices can fluctuate during the day.
Mutual funds trade on the NAV, or net asset value, which is set once a day after the market closes. Mutual funds are priced this way because they are made up of a variety of investments, and each investment’s price fluctuates throughout the day.
Mutual funds sometimes have a minimum number of shares required to be invested in the fund. These minimum requirements can keep some investors out of funds because they can be difficult to reach.
Mutual funds tend to include a large diversity of funds since their primary goal is to perform as well as market averages. While mutual funds can be large-cap or small-cap, when it comes to industries included in the fund, there isn’t necessarily a focus on a particular niche. (Large-cap and small-cap reference the size of the companies included in the fund, not their industry.)
ETFs, on the other hand, can be more focused, which means that they can perform better than mutual funds. However, it also means that they can perform worse. Some of this risk varies by the type of ETF you buy.
How do I start investing in ETFs?
First, you'll need to set-up an account with a broker. You can use an investing app like Robinhood or go with a more traditional broker like Charles Schwab. Once you have an account, you'll need to transfer money into it.
Once your account is funded, you can start investing. Before you invest in a fund, look at its historical and current performance. Be sure you understand what kind of ETF it is, how the fund is managed, and the industry or commodity it invests in.
You may be able to find these reports through your broker. You can also reference other online sources like Yahoo!Finance and the ETF Database's ETF Screener.
So, get your account set up, do your research, and start investing to reach your financial goals.
The opinions expressed in this article are for general information purposes only and are not intended to provide specific advice or recommendations about any investment product or security. This information is provided strictly as a means of education regarding the financial industry.