An ETF, or exchange-traded fund, is a basket of investments that trades on a stock exchange like an individual stock. One ETF share can give you exposure to multiple stocks, bonds, commodities or other assets through one purchase.
An ETF designed to track the S&P 500, for example, seeks to follow the performance of the companies in that index. Other ETFs focus on government bonds, technology companies, international markets, gold or a specific investment strategy.
ETF Meaning at a Glance
| Feature | How ETFs work |
|---|---|
| Full name | Exchange-traded fund |
| What you buy | A share of a fund that owns or tracks a portfolio of assets |
| Where it trades | A stock exchange |
| Trading price | Changes throughout the day |
| Main benefit | Diversification through one investment |
| Common costs | Expense ratio, bid-ask spread and possible trading fees |
| Main risk | The ETF can lose value when its underlying investments decline |
How Does an ETF Work?
An ETF pools money from many investors and uses it to hold a portfolio of assets. Each ETF share represents a proportional interest in that portfolio and the income it produces.
Most ETFs follow an index, such as:
- The S&P 500
- The total U.S. stock market
- A bond index
- A sector such as healthcare or energy
- International stocks
- A commodity such as gold
Some ETFs are actively managed. In these funds, an investment adviser selects securities according to the fund's stated strategy instead of following an index.
Individual investors usually buy and sell ETF shares on an exchange. Large financial institutions called authorized participants create and redeem large blocks of ETF shares. This process helps support the fund's trading and pricing.
How Is an ETF Different From a Stock?
An ETF usually owns a collection of investments, while a stock usually represents ownership in one company.
| ETF | Individual stock |
|---|---|
| Can hold dozens, hundreds or thousands of investments | Usually represents one company |
| Provides built-in diversification, depending on its holdings | Exposes you mainly to one company |
| Trades throughout the day | Trades throughout the day |
| Can track an index or follow an active strategy | Reflects the performance of a company's business |
| Can still be narrowly focused or highly risky | Risk depends mainly on the individual company |
An ETF is not automatically diversified. A broad-market ETF may hold many companies, while a single-sector ETF may concentrate its holdings in one industry.
How Is an ETF Different From a Mutual Fund?
ETFs and mutual funds both pool investor money into portfolios of securities. The main difference is how their shares are bought and sold.
| ETF | Mutual fund |
|---|---|
| Trades on an exchange during market hours | Usually bought or sold at the fund's end-of-day net asset value |
| Market price can move above or below net asset value | Transactions generally use the calculated net asset value |
| Can often be bought or sold like a stock | Orders are generally processed by the fund company or broker |
| May have bid-ask spreads and trading costs | May have different fees, share classes or sales charges |
An ETF's net asset value, or NAV, is the value of its assets minus its liabilities, divided by the number of shares. Because an ETF trades in the market, its share price can be higher or lower than its NAV. A price above NAV is called a premium, while a price below NAV is called a discount.
What Does an ETF Cost?
The main operating cost of an ETF is its expense ratio. This is the fund's annual operating cost, expressed as a percentage of the money invested. The expense ratio is deducted from the fund's assets rather than usually being billed separately.
Investors may also pay or encounter:
- The bid-ask spread between the price buyers offer and sellers accept
- Brokerage commissions, depending on the platform
- Trading costs when buying or selling
- Higher expenses for some actively managed or complex ETFs
A commission-free trade is not necessarily free. The ETF can still have an expense ratio and a bid-ask spread. More liquid ETFs usually have narrower spreads, while less actively traded ETFs can cost more to trade.
What Are the Main Types of ETFs?
Broad-Market ETFs
Broad-market ETFs invest across a large portion of a stock or bond market. Investors often use them for long-term diversification.
Sector ETFs
Sector ETFs focus on industries such as financial services, technology, healthcare or energy. They provide targeted exposure but can be less diversified than broad-market funds.
Bond ETFs
Bond ETFs invest in government, corporate, municipal or international bonds. Their prices can change when interest rates, credit conditions or bond values change.
Commodity ETFs
Commodity-related ETFs may provide exposure to assets such as gold, oil or agricultural products. Their structures and risks can differ, so investors should read the fund's prospectus.
International ETFs
International ETFs invest in companies or bonds outside the United States. They can add geographic diversification but may also involve currency, political and foreign-market risks.
Leveraged and Inverse ETFs
Leveraged ETFs seek a multiple of an index's daily performance. Inverse ETFs seek the opposite of an index's daily performance.
These funds are generally designed for short-term strategies. Over longer periods, their results can differ substantially from multiplying or reversing an index's total return.
What Are the Advantages of ETFs?
ETFs can offer several benefits:
- Diversification: A broad ETF can spread exposure across many securities.
- Trading flexibility: ETF shares trade throughout the market day.
- Accessibility: Investors can often buy a single share through a brokerage account.
- Transparency: Many ETFs regularly disclose their holdings and investment objectives.
- Potentially lower costs: Index ETFs often have relatively low operating expenses, although costs vary by fund.
- Tax efficiency in some cases: ETF structures can reduce capital-gains distributions compared with similarly invested mutual funds. Tax treatment varies by fund and account type.
What Are the Risks of ETFs?
An ETF can lose money. Its value usually reflects the performance of the assets, index or strategy it follows.
Important risks include:
- Market risk: The ETF can decline when its investments decline.
- Concentration risk: A narrow sector or theme ETF may depend heavily on a small group of companies.
- Tracking error: An index ETF may not exactly match the performance of its benchmark.
- Liquidity risk: Less actively traded ETFs can have wider bid-ask spreads or become harder to sell efficiently.
- Premium or discount risk: The market price may differ from the ETF's NAV.
- Complexity risk: Leveraged, inverse, commodity and certain crypto-related products can work differently from a standard stock ETF.
- Tax risk: Different ETF structures can produce different tax consequences.
How Do You Buy an ETF?
You buy an ETF through a brokerage account by searching for its ticker symbol and placing an order.
Before investing, review:
- The ETF's investment objective
- Its holdings and level of diversification
- Expense ratio
- Bid-ask spread and trading volume
- Historical premium or discount to NAV
- Index or strategy methodology
- Use of leverage, derivatives or futures
- Prospectus and stated risks
The SEC recommends reviewing an ETF's prospectus, portfolio holdings, fees, NAV and historical premiums or discounts before investing.
Bottom Line
An ETF is a fund that owns or tracks a portfolio of investments while trading on a stock exchange like a stock. Broad, low-cost ETFs can help diversify a portfolio, but every ETF carries investment risk. The right choice depends on the fund's holdings, strategy, costs, tax treatment and fit with your investment goals.