What is an Exchange-Traded Fund?

This article may contain references to some of our advertising partners. Should you click on these links, we may be compensated. For more about our advertising policies, read our full disclosure statement here.

If you’re looking for new ways to invest, you may want to consider exchange-traded funds. These funds have excellent benefits and can diversify your portfolio with a single purchase.

With exchange-traded funds, diversification is practically built in – you get a bundle of stocks, mutual funds, and commodities in a single basket to make adding variety to your portfolio easy.

Since many people struggle to pick the right mix of investments, that’s good news for you as an investor. But just because these come as a package deal doesn’t mean they’re the right choice for you.

Before you fork over your hard-earned cash, you need to know what an exchange-traded fund is and if the benefits will work in your favor.

What is an ETF?

An exchange-traded fund, or ETF, is a basket of investments designed to track an index. Shares of the fund are bought and sold on an exchange, much the same way you trade shares of stock – with some notable exceptions.

When you buy a stock – like Coca-Cola, for example – you only get access to one security – Coca-Cola. ETFs roll several types of securities together into a single investment, and – as an investor – you get to buy the whole basket at once. This way, you have access to a range of assets without the hassle of sorting through individual stocks and bonds.

As a whole, each ETF is set up to follow an index. The index is often designed to mimic the performance of a specific market sector or the market as a whole. The focus of the ETF is decided when the fund is created and guides the type of securities that go into it.

If the index performs well, the value of the ETF goes up. When the index declines, the fund loses value. For reference, here is Nasdaq’s list of over 2,200 ETFs.

Each share you own gives you a claim to the assets in the fund, and the value can change every day. If you want to know how much yours is worth, checking the price is easy when you track the ticker symbol in the market exchange.

If you like to invest in bonds, an ETF that tracks a bond index is great since you can buy into pretty much every type available with a single purchase. One share might consist of everything from corporate and municipal bonds to U.S. Treasury or international bonds.

If commodities are more your style, you can buy a commodity ETF to keep up with the market changes of gold, oil, or corn.

Keep in mind that even though you own part of an ETF, you don’t own any of the assets in the fund. With that said, you will get your portion of profit and dividends as the shares go up and down in price.

ETFs vs. Mutual Funds

Mutual funds and ETFs share a few similarities to help grow your money. First, because they consist of different securities that merge to form a single investment, both can help you diversify your portfolio.

The main difference between ETFs and mutual funds is how value is assigned to each. Mutual funds don’t trade during the day as ETFs do, so the price isn’t set until the end of the trading day.

With a mutual fund, the Net Asset Value (NAV) determines the price. If you add up the assets in the mutual fund and subtract the liabilities, you’re left with the NAV. Then you divide that number by the number of shares in the fund to get the price per share. But remember: This only happens once per day after the market closes.

Because buying and selling ETFs is continuously done throughout the day, rather than only once after trading stops, you have more transparency in pricing.

Benefits of an ETF

• Well-diversified portfolio in each ETF share
• Easy access to stock, bond, and commodity securities
• Low expense ratios reduce your ongoing cost
• Buy and sell any time of day
• More control over capital gains to reduce taxes
• Transparency in pricing
• Unlike mutual funds, can purchase ETFs on margin and short hold
• Most dividends are reinvested automatically

Who Should Use an ETF?

If you want a simple approach to mixing up your investments, ETFs might be the answer. Each fund combines exposure to different classes, regions, or markets without having to research and buy multiple individual securities.

Compared to mutual funds which only trade once per day, ETFs are a fantastic option if you like active trading when the exchanges are open.

They also make sense if you’re tax sensitive. ETFs give you more control over the taxes you pay since managing your transactions can reduce your capital gains.

Finally, depending on which fund you choose, ETFs are often a pretty good way to instantly diversify your investment portfolio – either within a certain sector or across the market as a whole. Keep in mind, though, that all investments come with risk and some ETFs have more risk than others.

Where to Find an ETF

Finding an ETF is pretty straightforward, although you’ll need an online brokerage account to do it. If you prefer to meet with one face to face, traditional brick-and-mortar locations are also an option.

Each broker will have a different selection to choose from, and which one you go with depends on the funds you want to buy. With thousands of funds available, narrowing your choice is the first step.

ETFs that include an assortment of stocks and bonds are popular, although you can center your buying around a location, market niche, growth or value-based funds, or ones with the lowest expense ratios.

After you make your purchase, write down the ticker symbol to follow the daily trends. Just remember that the market goes up and down all the time. Most often, the best strategy is to sit back and relax rather than acting on sudden price shifts.

Bottom Line

Exchange-traded funds are a quick way to add variety to your investments. The costs are typically low, and trading ETFs on the open market gives you greater insight into what your shares are worth during each day.

Going through a brokerage account is the only way to get started with ETFs, but your options are wide open since creating an account is quickly done online or in person.

Though no investment is risk-free, the mix of securities in an ETF can hopefully strengthen your portfolio and help protect against loss.

Now that you know more about ETFs and how they work, would you consider buying them? Why or why not? Share with us in the comment section below!