What Are Exchange-Traded Funds (ETFs)?

Picking stocks can be overwhelming, especially if you’re new to investing and don’t know where to begin. Other than investing in popular companies like Tesla or Disney, how do you know which companies to add to your portfolio?

An exchange-traded fund (ETF) takes some of the guesswork out of picking stocks. They make it easier to start investing without worrying about picking the wrong stock and going bankrupt. Let’s consider what are ETFs, how they work, and why should you consider adding them to your investment portfolio. 

What is an ETF?

An ETF, or exchange-traded fund, is a security you can buy or sell on the stock exchange just like a stock or a bond. Instead of representing an individual security, like a share of a company, an ETF represents a basket of different securities. By bundling several assets into one security, an ETF makes investing more accessible, allowing you to invest in a fraction of something rather than owning it outright.

Many ETFs track indexes or specific sectors, like the S&P 500. The SPDR S&P 500 ETF – or SPY – does just that. It holds shares of companies like Apple, Amazon, Microsoft, and Tesla in the fund and resells shares of that to investors. This gives investors access to high-performing stocks without investing in them directly. 

ETFs are a good entry point for investors because they allow them to diversify risk across hundreds of companies rather than betting on just a handful to perform well. Holding an ETF incurs relatively low fees, and because investors can trade them in a brokerage account just like a stock, changing positions throughout the day is easy.

How do exchange-traded funds work? 

Exchange-traded funds are a type of security that represents a basket of assets rather than just a single one. The most well-known ETFs hold stocks, but others hold bonds, commodities, and even alternative assets like crypto. This allows investors to own fractions of shares of hundreds of companies within an economy rather than just betting on a handful to do well.

ETFs are created by broker-dealers. Each has its approach to selecting which companies will be included in an ETF and how they are allocated in the ETF’s portfolio. Many follow benchmark index funds or create ETFs for specific industries. Their goal is to create a basket of companies at the right price point to make their ETF appealing to investors.

Once an exchange-traded fund is created, shares of the EFT are sold to investors. This means investors don’t own the underlying asset. For example, an investor in SPY would own SPY, not the shares of Tesla or Amazon SPY is invested in. The good news is that ETF investors still benefit from assets that appreciate in value and if there is a dividend, they are still able to earn that too.

Exchange-traded funds generate revenue by charging a fee called the expense ratio, typically an annual percentage of the ETF's value. Well-known ETFs like the Vanguard S&P 500 ETF charge a small expense ratio of about 0.03%. While the expense ratio is typically cheaper than paying a financial advisor for active portfolio management, it's important to be mindful that ETF fees can accumulate over time.

Just like stocks, investors who buy ETFs can trade them on the stock market. ETF prices fluctuate with the market and investors can buy or sell during normal trading hours. The best way to purchase an ETF is through a brokerage account. We recommend Webull because it offers commission-free trading on a wide range of investment products, including ETFs, and it is very user-friendly. Other reputable brokerage accounts include Charles Schwab and Robinhood.

Related: How to start investing

Types of ETFs

When considering which types of exchange-traded funds to include in your investment strategy, you have several options to choose from. These are some you can consider to create a balanced portfolio:

• Index: Designed to follow a specific index, such as the S&P 500, these funds offer a useful way to measure the performance of a group of companies or a specific industry. For instance, the S&P 500 includes the 500 largest companies in the U.S. economy.
• Fixed income: Instead of bundling companies together, these ETFs track the performance of fixed-income assets like U.S. Treasuries and other types of bonds. Bond ETFs can help mitigate risk when the stock market is down.
• Industry-specific: Similar to index ETFs, these sector ETFs track specific companies, usually grouped within a sector. These include healthcare or aerospace and defense. 
• Commodities: Commodities, like gold and coffee, are bought and traded on exchanges just like stocks and bonds. Investors who are interested in diversifying their portfolio can add commodity ETFs to their mix to mitigate risks in other markets.
• Alternative investments: New assets like cryptocurrencies are becoming increasingly popular but can be challenging for the average investor to obtain. ETFs can help investors access alternative investments that are easy to trade and bundled together with other types of assets.
  

These are some of the most well-known ETF types but there are others you can choose from to diversify your portfolio even further. This includes exchange-traded funds to get exposure to foreign markets and ETFs designed to increase returns such as leveraged ETFs.

Related: What are index funds

ETFs vs. mutual funds

ETFs are similar to mutual funds in that they pool groups of securities together. Instead of purchasing an individual asset like a stock, you can buy shares of ETFs or mutual funds that bundle assets together.

ETFs are a bit more cost-effective than mutual funds. They have lower fees and there isn’t a minimum requirement to get started. The Vanguard 500 Index Fund Admiral Shares is the mutual fund equivalent to the Vanguard S&P 500 ETF. Both the ETF and the mutual fund track the S&P 500. The big difference is that the mutual fund has a $3,000 investment minimum and charges a slightly higher expense ratio of 0.04%.

ETFs are also easier to trade than mutual funds. Mutual funds aren’t listed on exchanges like the New York Stock Exchange. They are only traded once a day, usually at the end of the trading day. That means you can’t do quick mutual fund trades throughout the day as the market changes.

Depending on your investment strategy, mutual funds might be more appealing. You can automatically invest in mutual funds but you can’t do that with ETFs. If you’re looking for a hands-off approach to investing, mutual funds provide a solution without much work on your part.

Mutual funds also come with more support than an ETF. The burden of providing a high-quality product falls on the fund manager’s shoulders. If you have questions, they are usually a phone call away and are more than willing to assist you if it means earning your business.

ETFs vs. stocks

ETFs can easily get confused with stocks. Both are listed on the stock exchange and both can be traded throughout the day. The biggest comes down to what each represents.

A stock is a share of a company. When you buy Tesla stock, you are purchasing a share of ownership in the company. Being a shareholder comes with privileges like being able to vote at the annual company meeting. Warren Buffet’s annual shareholder meeting for his company, Berkshire Hathaway, is a major event. Many people own shares of Berkshire Hathaway just to go to the annual shareholder meeting.

An ETF is a security just like a stock, but instead of representing a share of a single company, it represents a bundle of different companies. That means when you buy a share of an ETF you’re owning a fraction of a company’s share, rather than the entire thing outright.

While exchange-traded funds are great for diversification, there are trade-offs. Owning an ETF with Berkshire Hathaway in it isn’t the same as owning a share of Berkshire Hathaway directly. You won’t be considered a shareholder because the ETF fund provider owns the underlying asset, not you. That means even though ETF investors receive some of the financial benefits, they won't have a say in how the company is governed.

Another key difference is the fees. While some brokerage firms may charge a fee for trades, most have eliminated that. Holding stocks in a brokerage account is typically fee-free, except when managed by an advisor.

ETFs charge an annual fee represented as the expense ratio. Even though ETFs are passively managed, fund managers still charge a fee for operating them. ETFs mitigate some of the risks involved in gambling on picking stocks but it doesn’t eliminate the risk completely. 

Pros of exchange-traded funds

There are many reasons why you might want to consider adding ETFs to your investment portfolio. Here are a few of the big draws of ETFs:

• Access to a variety of companies spanning different sectors and sizes
• Ability to manage risk and ride market volatility by diversifying your investments
• Lower fees than other types of funds or actively managed portfolios
• Knowing the ETF’s composition so you can make better decisions on where you want your money invested 
• Ability to trade ETFs like stocks throughout the day

Cons of exchange-traded funds

While there are some major benefits to investing in ETFs, there are also trade-offs. You’ll want to consider these if you want to add ETFs to your portfolio:

• Not all ETFs are passive and actively managed ETFs can come with higher fees that can eat away at your overall return
• ETFs focused on a single sector like healthcare can give you diversity with a variety of companies in that sector but they can also amplify risks within that industry
• When you buy an ETF you don’t own the underlying asset within the fund
• There can be a lag time in trading which might make it difficult for you to reinvest your funds to capitalize on market fluctuations

FAQs

Can you sell an ETF at any time? 

You can sell an ETF anytime during the trading day. The stock market is open Monday through Friday from 9:30 a.m. to 4:00 p.m. Eastern time.

Are exchange-traded funds a good investment? 

Exchange-traded funds can be a good investment depending on your investment strategy. It’s a good place for investors to start because it gives them broad exposure to a variety of companies while also diversifying risk. 

Even though individual stocks in popular companies can be great to invest in, they also limit your portfolio to the returns generated by that company. If that company’s stock sees a sharp decline your portfolio will be affected by it. Although one can say the same about ETFs, owning a bundle of different companies distributes the risks—and rewards—across all the companies in an ETF.

How do exchange-traded funds make money?

There are three ways exchange-traded funds make money. First, the ETF owns the underlying assets in the fund — not you. ETF prices fluctuate on the market independent of the companies held by the ETF. An ETF fund manager can capitalize on the appreciation of certain stocks by selling some of their positions in that stock and reinvesting the difference.

ETFs also make money by charging an expense ratio. This is a percentage of the fund that is charged annually by the fund manager who manages the ETF. 

Last, ETFs earn revenue through dividends. Some ETF managers pass dividend earnings onto investors. Others reinvest the earnings back into the fund to allow it to grow.

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