The Meaning and Functioning of Exchange Traded Funds (ETFs)

Exchange traded funds are a type of investment fund that offer the best attributes of two popular assets: They have the diversification benefits of mutual funds while mimicking the ease with which stocks are traded.

What does “ETF” mean?

An exchange traded fund, or ETF, is a basket of investments like stocks or bonds. Exchange traded funds let you invest in lots of securities all at once, and ETFs often have lower fees than other types of funds. ETFs are traded more easily too.

But like any financial product, ETFs aren’t a one-size-fits-all solution. Evaluate them on their own merits, including management costs and commission fees (if any), how easily you can buy or sell them, how they fit into your existing portfolio and their investment quality.

Types of ETFs

• Index ETFs: Designed to track a particular index like the S&P 500 or NASDAQ
• Fixed Income ETFs: Designed to provide exposure to virtually every type of bond available; US Treasury, corporate, municipal, international, high-yield and several more
• Sector and industry ETFs: Designed to provide exposure to a particular industry, such as oil, pharmaceuticals, or high technology
• Commodity ETFs: Designed to track the price of a commodity, such as gold, oil, or corn
• Style ETFs: Designed to track an investment style or market capitalization focus, such as large-cap value or small-cap growth
• Foreign market ETFs: Designed to track non-US markets, such as Japan’s Nikkei Index or Hong Kong’s Hang Seng index
• Inverse ETFs: Designed to profit from a decline in the underlying market or index
• Leveraged ETFs: Designed to use leverage to amplify returns
• Actively managed ETFs: Designed to outperform an index, unlike most ETFs, which are designed to track an index
• Exchange-traded notes (ETNs): In essence, debt securities backed by the creditworthiness of the issuing bank, which were created to provide access to illiquid markets; they have the added benefit of generating virtually no short-term capital gains taxes
• Alternative investment ETFs: Innovative structures, such as ETFs that allow investors to trade volatility or gain exposure to a particular investment strategy, such as currency carry or covered call writing

How do ETFs work?

Exchange traded funds work like this: The fund provider owns the underlying assets, designs a fund to track their performance and then sells shares in that fund to investors. Shareholders own a portion of an ETF, but they don’t own the underlying assets in the fund. Even so, investors in an ETF that tracks a stock index may get lump dividend payments, or reinvestments, for the stocks that make up the index. (Related: Learn how to invest in index funds, or compare index funds and ETFs.)

While ETFs are designed to track the value of an underlying asset or index — be it a commodity like gold or a basket of stocks such as the S&P 500 — they trade at market-determined prices that usually differ from that asset. What’s more, because of things like expenses, longer-term returns for an ETF will vary from those of its underlying asset.

Here is the abbreviated version of how ETFs work:

1. An ETF provider considers the universe of assets, including stocks, bonds, commodities or currencies, and creates a basket of them, with a unique ticker.

2. Investors can buy a share of that basket, just like buying shares of a company.

3. Buyers and sellers trade the ETF throughout the day on an exchange, much like a stock.

Jump to learn how to start investing in ETFs.

ETF Pros

Investors have flocked to exchange traded funds because of their simplicity, relative cheapness and access to a diversified product. Here are the pros:

Diversification

While it’s easy to think of diversification in the sense of the broad market verticals — stocks, bonds or a particular commodity, for example — ETFs also let investors diversify across horizontals, like industries. It would take a lot of money and effort to buy all the components of a particular basket, but with the click of a button, an ETF delivers those benefits to your portfolio. Diversification can help safeguard your portfolio against market volatility. If you invested in just one industry, and that industry had a really bad year, it's likely your portfolio would have performed poorly too. By investing across different industries, company sizes, geographies and more, you give your portfolio more balance. Because ETFs are already well-diversified, you don't have to worry about creating it within your portfolio.

Transparency

Anyone with internet access can search the price activity for a particular ETF on an exchange. In addition, a fund’s holdings are disclosed each day to the public, whereas that happens monthly or quarterly with mutual funds. This transparency allows you to keep a close eye on what you're invested in. Say you really don't want to be invested in oil. You'd be able to spot those additions to your ETF more easily than with a mutual fund.

Tax benefits

ETFs have two major tax advantages over mutual funds.

If you invest in a mutual fund, you may have to pay capital gains taxes (or, the profits from the sale of an asset, like a stock) through the lifetime of your investment. This is because mutual funds, particularly those that are actively managed, often trade assets more frequently than ETFs. Most ETFs, on the other hand, only incur capital gains taxes when you go to sell the investment. This means you'll pay less tax on your ETF investment overall.

As mutual fund managers are actively buying and selling investments, and incurring capital gains taxes along the way, the investor may be exposed to both long-term and short-term capital gains tax. If you're invested in an ETF, you get to decide when to sell, making it easier to avoid those higher short-term capital gains tax rates.

ETF cons

Exchange traded funds may work well for some investors, but they aren't perfect. Here are the cons:

Trading costs

ETF costs may not end with the expense ratio. Because ETFs are exchange-traded, they may be subject to commission fees from online brokers. Many brokers have decided to drop their ETF commissions to zero, but not all have.

Potential liquidity issues

As with any security, you’ll be at the whim of the current market prices when it comes time to sell, but ETFs that aren’t traded as frequently can be harder to unload.

Risk the ETF will close

The primary reason this happens is that a fund hasn’t brought in enough assets to cover administrative costs. The biggest inconvenience of a shuttered ETF is that investors must sell sooner than they may have intended — and possibly at a loss. There’s also the annoyance of having to reinvest that money and the potential for an unexpected tax burden.

How much do ETFs cost?

Exchange traded funds can vary significantly when it comes to cost. The median price of the most popular ETFs by trading volume is $59.42. The most expensive ETF in that list tops out at $473.56 and the lowest comes in at $3.43. That range may feel intimidating, but it also means there is an ETF for every budget. It may help to outline how much you're willing to spend on an ETF before you dive in.

When researching ETFs you'll also need to consider the fund's expense ratio, or the fee the fund charges to manage and maintain it. Because most ETFs are passively managed, ETF expense ratios are typically pretty low compared with other types of funds.

» Need more info? Learn about passive investing

ETF examples

For all their simplicity, exchange traded funds have nuances that are important to understand. Armed with the basics, you can decide whether an exchange traded funds makes sense for your portfolio, embark on the exciting journey of finding one — or several.

There are lots of great ETFs out there, but here are a few picks from our list of the top-rated ETFs.

• SPDR S&P 500 ETF (SPY)

• BNY Mellon US Large Cap Core Equity ETF (BKLC)

• SoFi Select 500 ETF (SFY)

• JP Morgan Betabuilders U.S. Equity ETF (BBUS)

• iShares Core S&P 500 ETF (IVV)

» Check out our full list of the best ETFs

ETFs vs. mutual funds vs. stocks

When comparing exchange traded funds with other investments, exchange traded funds stand out in a number of ways. Lower investment costs, better diversification and an increasing number of options are just a few of the benefits of ETFs.

ETFs vs. mutual funds

Generally speaking, exchange traded funds have lower fees than mutual funds — and this is a big part of their appeal.

ETFs also offer better tax-efficiency than mutual funds. There's generally more turnover within a mutual fund (especially those that are actively managed) relative to an ETF, and such buying and selling can result in capital gains. Similarly, when investors go to sell a mutual fund, the manager will need to raise cash by selling securities, which also can accrue capital gains. In either scenario, investors will be on the hook for those taxes.

The two products also have different management structures (typically active for mutual funds, passive for ETFs, though actively managed ETFs do exist).

ETFs vs. stocks

ETFs are made up of stocks, but there is no such thing as an “ETF stock.” You can purchase a share of an ETF, but you cannot purchase stock in an ETF. ETFs are made up of individual stocks and other investments.

Like stocks, ETFs can be traded on exchanges and have unique ticker symbols that let you track their price activity. Unlike stocks, which represent just one company, ETFs represent a basket of stocks. Since ETFs include multiple assets, they may provide better diversification than a single stock. That diversification can help reduce your portfolio’s exposure to risk.

ETFs are sometimes focused around certain sectors or themes. For example, SPY is one of the ETFs that tracks the S&P 500, and there are fun ones like HACK for a cyber-security fund and FONE for an ETF focused on smartphones.

Here are a few of the key differences between ETFs, mutual funds and stocks.

Source for fee information: The Investment Company Institute, Trends in the Expenses and Fees of Funds.