What is an ETF?

What It's About

An ETF is a collection of stocks or bonds in a single fund. Learn how they can help balance your investment portfolio.

An ETF is an exchange-traded fund. It’s a fund comprising dozens and sometimes hundreds of stocks. ETFs trade like a stock in the stock market, and investors can buy and sell them throughout the trading day. ETFs been around since 1993 and their popularity has grown massively, largely because they allow investors to invest in a “theme” quickly and easily.

For example, the first and most popular ETF was based on the Standard & Poor’s 500 index. It allowed investors to invest in the S&P 500 by buying just one index fund and gaining the diversification of the entire index immediately. From there, the only thing stopping ETFs was imagination, and fund companies have dreamed up all kinds of ETFs based on any possible theme.

Some of the most popular ETFs include the following:

  1. Market ETFs – funds based on the S&P 500 or Nasdaq Composite indexes, for example
  2. Country ETFs – funds based on specific countries or regions, such as Europe or China
  3. Industry ETFs – those based on financials, consumer goods, and materials, for example
  4. Bond ETFs – comprising all maturities, interest rates, and bond issuers
  5. Inverse ETFs – those allowing investors to bet on the fund’s stocks declining

ETFs are useful for investors, especially professional asset managers, who need to gain exposure to a particular investing theme. Have China stocks suddenly become hot? Just buy a China ETF and plug it into your (or your client’s) portfolio. Interest rates are rising and you want to own banks? Just buy a financial ETF.

ETFs are typically passive funds, meaning the fund manager does not actively trade the fund’s stocks.

ETFs are great for investors who are trading on a trend, because ETFs tend to have some diversification due to their variety of holdings. Diversification means investors don’t need to know as much about the individual holdings as they would if they bought individual stocks.

How ETFs work

ETFs trade like a stock, with traders paying a fee per trade. The investor finds the ticker symbol and inputs the order during normal trading hours. When the investor is ready to sell, he or she enters the order the same way. This process is different from the old way of trading mutual funds, which can be done only after the market closes. So ETFs offer this significant advantage.

There’s a key difference between ETFs and stocks, however. Unlike stocks, ETFs also charge an expense ratio to cover their cost and generate a profit for the fund’s manager. An expense ratio is the amount the fund charges the investor per year as a percent of total assets. For example, a low-expense ETF might charge 0.10% of assets per year. That means the investor pays $10 annually for every $10,000 that is invested. These costs are accrued daily, with the fee being factored into the fund’s value.

ETFs are created by huge fund managers such as Vanguard, and are typically passive funds, meaning the manager does not actively trade the fund’s stocks. Instead, the fund is based on a themed index, and so the fund only changes if the index composition or weighting changes.

Because ETFs are usually passive and so have fewer costs (trading commissions, the cost of active management, etc), they often have lower expense ratios than comparable mutual funds. ETFs can be a cheap way to get exposure to the sector that you want to invest in.

How do you buy an ETF?

If you want to invest in an ETF, you’ll need cash and a brokerage account. You can get started in about 15 minutes and fund your account quickly. From there you can begin buying and selling ETFs.

By Mackenzie O'Connor
Wealthbase Contributor

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