ETFs Explained: The Basket That Made Investing Easy

An ETF (exchange-traded fund) is an investment that bundles many others, typically dozens, hundreds, or even thousands of securities, into a single package that trades on the stock market. Buy one share of an ETF and you own a fraction of everything it contains. That single characteristic is the source of the ETF's appeal, and it explains the rise from a niche product of the 1990s to a standard building block of many investors' portfolios.

What is inside one

In most cases, an ETF tracks a particular market index, which is a list of securities forming a benchmark, such as the 500 largest US companies, the investment-grade bond market, or all the stocks in a segment like technology. A fund that tracks an index holds the securities in the same proportions as the index, aiming to mirror its performance. There are also actively managed ETFs, where fund managers pick the holdings trying to beat the market, but they are a small part of the market because of their higher costs. Most money goes into the index trackers, which are diversified and cheap.

How it differs from a stock

An ETF trades like any stock. It can be bought and sold during market hours, it has a price, and its value rises and falls. The difference is what you own. A stock represents one company, and one company is never diversified, so its risk is concentrated. An ETF is a collection of many securities, so an S&P 500 ETF keeps most of its value even when some of the companies inside it perform poorly. When you buy the ETF, you effectively buy a small slice of all of them at once.

How it differs from a mutual fund

An ETF resembles a mutual fund, since both pool many securities for easy one-purchase diversification. The practical differences come from how they trade. Mutual funds trade once per day, at a price set after the market closes, while ETFs trade throughout the day like stocks. Buying and selling ETF shares is generally cheaper and more convenient, with no investment minimums beyond a single share (or less, with fractional shares). In taxable accounts, ETFs also tend to be more tax-efficient, partly due to the way fund shares are created and redeemed. Those advantages make ETFs the better default for most investors buying in a regular brokerage account, and the full comparison is in ETFs vs. Mutual Funds.

Why the fees matter

All funds charge for their services, usually as an expense ratio, which is a yearly percentage quietly withheld from the fund's returns. For broad market ETFs, expense ratios run about 0.03 to 0.1% per year, which amounts to a few dollars annually per $10,000 invested. Actively managed and specialized funds charge many times more, often around ten times as much, and that gap compounds against you year after year. The difference between an active fund and a cheap index tracker deserves real weight in the decision. Our investment fee calculator shows what a fund's expenses will cost you over time.

Picking one without getting overwhelmed

For most purposes, a small handful of diversified ETFs is all anyone needs: a broad US stock market ETF, an international stock ETF, and a bond ETF. Combined, they cover essentially the whole market. There is even a classic premade recipe, the three-fund portfolio, built from exactly those three. Buy them inside a brokerage account or a retirement account, automate the contributions, and let time do the work. Past that point, each additional ETF adds little, because the broad funds already contain nearly everything a new specialty fund would.

The risks involved

An ETF is not exempt from market risk. A fund's value drops when its holdings drop, and an investor in an S&P 500 ETF rode the full downturns of 2008 and early 2020. That volatility is inherent to owning the market. Diversified funds swing less than individual stocks, but they still swing. Leveraged ETFs, narrow sector ETFs, and funds holding exotic assets carry considerably more risk and are generally best left alone by the average investor. For most people, a broad, diversified market ETF is one of the best tools available, and drops along the way are survivable.

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This article is for general educational purposes only and does not constitute personal financial, investment, tax, or legal advice. Consult a qualified financial professional before making major financial decisions. See our Disclaimer.