What Is an ETF Fund - and Is It a Smart Investment Option for You?

As difficult as it may seem, you don’t have to be a math whiz to learn how to invest money. As long as you have an understanding of where to put your money, you can start building a portfolio of quality investments in no time.

ETFs (exchange-traded funds) offer beginner investors and seasoned investors alike a simple, low-cost option for investing in the stock market. If you’re interested in learning more about ETFs and how they might benefit you, we’re here to explain the basics and answer your questions.

What is an ETF (exchange-traded fund)?

An ETF is an investment product that pools money from multiple investors to buy stocks, bonds, or other assets. In return, each investor shares in the profits and losses in proportion to their holdings in the fund. If the value of individual securities in the fund increases, the value of the fund also increases, as does the value of your share. Most simply, ETFs give you a way to buy and sell a basket of securities without having to buy each security individually.

ETFs combine the ease of stock trading with the diversification benefits of mutual funds. Unlike mutual fund shares, ETF shares cannot be sold directly to individual investors. Instead, ETF shares are sold in blocks of shares (e.g., 50,000 ETF shares) to major brokerages. These brokerages then sell the ETF shares on the open market, where individual investors buy and sell them as they would individual stocks.

The price at which investors buy and sell ETF shares fluctuates during the trading day as a result of several factors, such as the underlying prices of the individual securities in the fund and the overall demand for the ETF itself. Beyond the share price, which could cost as much as several hundred dollars per share, ETFs are generally considered to be inexpensive investments. Most ETFs are designed to track a specific market index such as the Nasdaq 100, Dow Jones Industrial Average, or S&P 500 index. Fund managers use a buy-and-hold strategy that results in less research and fewer trades, and this helps keep the ongoing costs of investing in ETFs low.

An ETF is a low-cost basket of securities that can be traded on the open market. So what are some of the different types of ETFs?

Types of ETFs

• Index ETFs
• Bond ETFs
• Commodity based ETFs
• Currency ETFs
• Inverse and leveraged ETFs
• Sector and industry ETFs

ETFs come in a variety of shapes and sizes. With thousands of ETFs across specific asset classes, it can be challenging for investors to know which types to add to their portfolios. The following are six common types of ETFs:

1. Index ETFs

Most ETFs are index-based ETFs (or stock ETFs). Index-based ETFs aim to track a stock index, such as the S&P 500, by investing in many of the same securities of the index. Because they are often passively managed, index ETFs provide investors with low-cost access to a diversified investment strategy.

2. Bond ETFs

Bond ETFs, or fixed-income funds, are a type of ETF that offers investors a low-cost way to buy a diversified basket of bonds. A bond fund can be made of many different types of bonds, so the return and risks can vary dramatically. However, this diversification can help reduce the potential volatility of owning just a few individual bonds. Investors seeking a steady stream of income might add a bond fund to their portfolio as these funds regularly pay out interest.

3. Commodity-based ETFs

Commodity ETFs are comprised of investments in physical commodities, such as livestock, natural gas, or precious metals. A commodity ETF might concentrate on either a single commodity that is held in physical storage — such as gold or silver — or a diversified basket of commodities. Investing in commodities can give your portfolio an even greater layer of diversification.

4. Currency ETFs

A currency ETF is a type of ETF that gives investors exposure to a single currency or a basket of currencies. You might buy a currency ETF if you thought the underlying currency might strengthen or to hedge your investment portfolio. Foreign currency ETFs give investors a way to diversify outside the U.S. dollar.

5. Inverse and leveraged ETFs

An inverse ETF tracks an index much like an index ETF, except it aims to deliver the opposite, or inverse, of the performance of the index in which it tracks. The idea is to give investors a way to hedge their exposure to declining markets. On a day when a specific market rises, such as the S&P 500, the inverse ETF tracking that index would decline by the same percentage. If the S&P 500 drops in value, an inverse ETF tracking the S&P 500 would increase by the same percentage. A leveraged fund aims for a return that is a multiple of the performance of the index it tracks. For example, a 2x leveraged ETF seeks to deliver double the return of the index it tracks.

6. Sector and industry ETFs

This type of ETF is made up of securities within a particular industry or sector, such as energy, technology, or financials. Sector and industry ETFs give the investor a means of investing in an entire sector or industry in one fund.

ETF advantages and disadvantages

ETFs offer investors several benefits, but they have a couple drawbacks as well.

Here are some of the pros and cons of investing in ETFs:

Pros of ETFs

• Diversification: One ETF can give you exposure to a variety of securities, market segments, and even countries. If, for instance, the majority of your portfolio is made up of investments primarily in North America and other developed markets, you can purchase an emerging markets ETF to quickly add exposure to the developing world.
• Accessibility: ETFs offer the diversification benefits of a mutual fund with the ease of trading that you find with stocks. ETFs can be traded throughout the day on the open market.
• Low fees: Because most ETFs are passively managed, they have much lower fees compared to actively managed funds. Low expense ratios are essential to receiving the best returns.
• Low minimum investment: ETFs have no minimum investment amounts. The price you pay for an ETF share depends on its current market price, which fluctuates throughout the trading day. Brokerages that offer fractional shares allow you to invest in ETFs for as little as $1.
• Tax efficiency: ETFs tend to be a tax-efficient investment due to the way they're structured. Because ETFs are essentially a basket of securities, investors aren't exposed to capital gains taxes on individual securities. This can make ETFs less expensive than other investments.

Cons of ETFs

• Outperformance: Passively managed ETFs that track a specific index don’t offer the same potential to outperform the market as actively managed funds. As a result, an ETF might not be a good option if your goal is to beat the market.
• Costs: Although ETFs are generally low-cost, they do have ongoing fees. These fees are known as the expense ratio, and they will ultimately reduce your potential returns. According to the Investment Company Institute, the average expense ratio for index equity ETFs was .18% in 2019.

ETFs vs. mutual funds: How are they different?

ETFs and mutual funds share some similarities. However, ETFs are not mutual funds. Mutual funds and ETFs work differently in the following ways:

1. How they’re traded

Unlike with mutual funds, ETF shares can be bought and sold throughout the day on the stock exchange. However, individual investors cannot buy or sell shares directly from the ETF as they can with mutual funds. As mentioned earlier, ETF shares are sold in blocks to brokerages who then turn around and sell the shares on the market to individual investors.

Investors who buy shares in an ETF pay the market price of the share, which can be more or less than the ETF’s net asset value. A fund’s NAV is the difference between its assets and liabilities and is usually calculated at the close of market each day. The share price of an ETF fluctuates throughout the day as a result of the value of its underlying holdings and the overall demand for the fund. In contrast, the price that investors pay for a share in a mutual fund is the fund’s current NAV.

2. How they’re managed

ETFs are mostly passively managed, whereas mutual funds are usually actively managed. Typically, ETFs track a specific stock index, while mutual funds often have a dedicated fund manager or team making investment decisions.

3. ETF vs. mutual fund fees

Since ETFs are passively managed, they tend to have lower ongoing management fees than actively managed mutual funds. In addition, there is no minimum investment with an ETF. The cost of a share depends on the market price of the share. Although not always the case, mutual funds can require an initial investment ranging from several hundred dollars to several thousand dollars.

4. How they’re taxed

In the eyes of the IRS, ETFs and mutual funds generally have comparable tax consequences. In any case, selling a share for more than you paid for it triggers a capital gains tax. However, because of the unique structure of ETFs and their lower turnover compared to mutual funds, ETFs are generally considered more tax-efficient.

ETFs are unique in that they have their own mechanism for buying and selling. An authorized participant (usually a large broker-dealer) buys the securities that make up an ETF and exchanges them with the ETF company for a large block of ETF shares of equal value. This is called an in-kind transfer. The authorized participant then sells those ETF shares to investors.

When an investor wants to sell their ETF shares, the authorized participant takes the shares and returns them back to the ETF company in exchange for a basket of individual securities. Because securities don’t have to be sold when an investor wants out of an ETF, it minimizes the capital gains the ETF has to distribute.

FAQs about ETF funds

Investing in ETFs: where to start

ETFs are highly accessible, so you have several options when it comes to investing in ETFs. If you are currently enrolled in an employer-sponsored retirement plan, such as a 401(k), your plan may already offer ETFs as an investment option. ETFs can also be purchased through individual retirement accounts or individual brokerage accounts.

Robinhood, an online brokerage and investing app, is a great option for anyone looking for a convenient platform to start investing in ETFs. Aside from charging no commission fees on trades, Robinhood makes it possible to invest in fractional shares of ETFs. With fractional shares, you can invest with as little as $1. So that ETF you were hoping to add to your portfolio that costs hundreds of dollars may be accessible to you for as little as $1.

Stash is another online brokerage firm that allows you to invest in ETFs with small amounts of money. Stash, however, is unique in that it’s a subscription-based online broker. It offers three subscription options ranging from $1 to $9 per month with each plan offering different investing features.

Regardless of the platform you choose, ETFs are worth a look, whether you’re a beginner or a more experienced investor. Every investment has its risks, so make sure to familiarize yourself with the ETF before you invest.

If you’re interested in learning more about your options for investing, check out our picks for the best investment apps.