What Is an ETF?
An exchange-traded fund, or ETF, is similar to a traditional mutual fund in that it holds a basket of securities. That makes it easier for investors like you and me to build a diversified portfolio.
Quick take: With one share of an ETF, you can gain access to the entire stock or bond market, or a specific sector, such as tech stocks or high-yield bonds. Unlike traditional mutual funds, ETFs trade on an exchange, just like stocks do, which means you can buy and sell ETF shares over the course of the day. And ETFs don’t have a minimum investment requirement like some mutual funds do. Sweet! Plus, ETFs can have tax advantages over traditional mutual funds.
Tell me more! ETFs and traditional mutual funds both offer an easy way for investors to build a diversified portfolio. Instead of having to buy individual stocks or bonds, you can get access to hundreds or thousands of companies through one share of an ETF or mutual fund. But ETFs stand out from traditional mutual funds in three main ways:
- You can trade ETFs throughout the day. This offers more flexibility than traditional mutual funds, which trade only once per day. This also means that the share price of ETFs can fluctuate throughout the day.
- ETFs can be more tax-efficient than mutual funds, because they generally don’t distribute capital gains while you’re still holding the investment, the way some mutual funds do. (This point is moot in tax-advantaged retirement accounts.) Keep in mind that selling your ETF shares, or any investment, often leads to capital-gains taxes.
- ETFs don’t have minimum investment requirements. With a traditional mutual fund, you often need to come up with a dollar amount, say $1,000 to $3,000, as an initial investment to get into that fund. With an ETF, you can simply buy a share of the ETF, for whatever its current price.
Here are two more things you really need to know about ETFs:
1. ETF costs
There are two common ETF costs to be aware of:
- Expense ratios. Almost all ETFs charge an expense ratio, which is charged as a percentage of your invested assets. For example, the Vanguard Total Stock Market Index ETF has an expense ratio of 0.03%. If you invest $10,000 in that ETF, your annual cost will be $3. Not bad, not bad at all. Compare that to a 1% expense ratio: If you invest $10,000, you’ll be paying $100 a year. Be sure to compare expense ratios when investing in ETFs and mutual funds.
- Bid/ask spreads. With ETFs, you’re buying shares on an exchange, thus competing with other buyers and sellers. The bid/ask spread is the difference between the highest price a buyer will pay for a particular investment and the lowest price a seller will sell it for. That spread is a type of trading cost to you when you buy or sell an ETF. Read more about bid/ask spreads in this Vanguard commentary.
2. Index funds vs. actively managed funds. Most ETFs are index funds. They track a specific index, such as the S&P 500, rather than being actively managed by a manager who buys and sells investments for the fund with the aim of beating market returns. Index ETFs — just like index mutual funds — make it easy to build a highly diversified portfolio at a low cost.
In contrast, actively managed funds, whether ETFs or traditional mutual funds, inevitably charge higher expenses than index funds. If you consider yourself an active investor eager to access various types of esoteric investing strategies, or you think there are some managers who truly can beat the market, then there’s a possibility that an actively managed ETF or mutual fund is right for you.
For the rest of us, aka passive investors whose mantra is to match market returns while keeping costs at a minimum, index ETFs and index mutual funds are akin to the holy grail.
One more thing: If you’re investing for retirement, then choosing between an index ETF and an index mutual fund really comes down to cost (assuming they match the same index). That is, you should compare expense ratios. But the access to intraday trading that ETFs offer shouldn’t really matter to you — hopefully, you’re not going to want to trade in and out of investments throughout the day. And the tax efficiency of ETFs generally gets lost if you’re investing in a tax-advantaged retirement account. Read more about how to invest for retirement.
Bottom line: An ETF can be a low-cost, easy way to build a diversified portfolio, because one ETF gives you access, potentially, to many different investments in one share. All you have to do is open a brokerage account (check out our list of top brokers on our sister site, StockBrokers.com) and start shopping! By which we mean, researching ETFs.
No joke... fees really do matter
Here’s a look at how investment fees really can mess you up. Let’s say you have $100,000 invested, earning 4% annually.
- After 20 years with a 0.25% expense ratio, you’d have $208,815
- After 20 years with a 0.5% expense ratio, you’d have $198,979
- After 20 years with a 1% expense ratio, you’d have $180,611
Get more personal finance tips and strategies
- What credit is and why it matters
- How to fix your credit score
- How many credit cards should I have?
- How to start investing
- How to save for retirement
- Best high-yield savings accounts
- Best cashback credit cards
Check out investor.com’s personal finance education hub.