What Is an ETF? Some Basics to Help You Get Started

What we’ll cover: 

• An ETF is a type of fund that invests in a large collection of asset classes, which may include stocks, bonds or other types of securities 
• Though they may be similar in some ways, ETFs are not mutual funds, and there are important differences to be aware of
• ETFs can provide a low-cost way for investors to build a diversified portfolio
• You need a brokerage account to invest in ETFs

You hear about ETFs a lot. That’s because along with stocks and bonds, Exchange Traded Funds (ETFs) are one of the basic building blocks of a diversified portfolio.

ETFs can be appealing to new and veteran investors alike given their potentially low investment costs and built-in diversification. 

If you’re interested in adding ETFs to your portfolio, here are some basics you should know before getting started.

What is an ETF?

ETF stands for exchange-traded fund. 

And from the name itself, you can probably start to put two and two together. An ETF is a type of investment fund that can be traded on a stock exchange. 

If you take a peek inside one of these exchanged-traded funds, you’ll see that an ETF is basically just a large collection of investments. Some people like to think of an ETF as a basket of investments. 

Basket, cookie jar – or whatever your container of choice, the important thing to know is that a single ETF can hold a variety of bonds (bond ETF), stocks (stock ETF), commodities (commodity ETF) or other types of assets.

When you invest in, say, a stock ETF, you’re not buying shares of an indiviual stock. Instead, when you buy shares of an ETF, you're investing in a number of different stocks all at once. An ETF can include stocks from companies across various industries or from just one sector (like energy). 

All this is to say ETFs can be structured in many different ways. For example, they can even be built to track (or follow) certain indices, such as the S&P 500. 

Because of their range of assets, ETFs have a certain degree of diversification already built in. This makes them a popular option for investors looking to diversify their investments. 

Also, since you don’t have to buy the underlying assets (translation: assets inside the fund) individually, investing in different types of ETFs could be a time-saving, cost-effective way to build a diversified portfolio. 

Now that doesn’t mean ETFs are completely risk-free – no investment ever is. But ETFs are generally less risky than investing in a single stock or bond because they can help spread risk across a large number of different investments.

That being said, keep in mind that certain ETFs can be concentrated in specific industries or geographies (sometimes dicusssed as international and emerging markets ETFs, for example), so some funds may be less diversified than others. If you want to get a better sense of an ETF’s level diversification, you can take a look at the fund’s prospectus, which you can get from your broker or on the SEC's EDGAR site. But remember: Diversification doesn’t guarantee a profit nor can it protect you against loss.

Wait, so far, ETFs sound a lot like mutual funds

You’re not wrong. ETFs and mutual funds are similar in that they can help you invest in a variety of stocks, bonds and other securities. 

But ETFs are not mutual funds. Here are three key ways these investments differ: 

• How they are traded. ETFs can be traded on exchanges, including stock markets like NASDAQ and NYSE, during the day when the markets are open. Mutual funds, on the other hand, are not traded on an exchange. Shares are bought and sold once per day when the market closes. And transactions are done directly through the mutual fund company (or a broker for the fund). 
• Pricing. Because ETFs are traded on an exchange, their share prices can fluctuate throughout the day as shares are bought and sold. So if you're seeing volatility, you can expect the price of your ETF to bounce around with the rest of the market during trading hours. With mutual funds, however, their share prices are based on the fund’s net asset value, which is calculated at the end of each trading day. 
• Reporting. Another key difference has to do with the frequency of reporting when it comes to disclosing a fund’s investment holdings. Many ETFs provide a daily disclosure of their holdings, while mutual funds are only required to report their holdings quarterly.

ETFs and mutual funds also come with different tax considerations, so it’s a good idea to consult a tax professional if you have any questions. Whether you choose to go with ETFs or mutual funds (or a combination of both) will depend on your personal investing goals and preferences.

Things to consider before investing in ETFs

With so many types of ETFs out there to consider, doing some research before you invest could help you avoid taking on more risk than you’re comfortable with. Or any unwanted surprises when it comes to costs and fees – and here we’re talking about things like trading costs and management fees (like the expense ratio).

Keep in mind that while ETFs could provide an affordable way to access a variety of investments, not every ETF is considered “low-cost.” For example, actively-managed ETFs tend to have higher fees compared to passively-managed funds. 

In addition to understanding costs and risks, here are some other things to pay attention to when evaluating ETFs (and really any investment you’re thinking about).

• Investment philosophy and investment objectives of the fund’s sponsor (or provider). A company’s investment philosophy gives you an idea of their overall approach to investing. (This information will be in the ETF's prospectus). By understanding the thinking and investment strategies at work behind the scenes, you can decide whether their investing style makes sense for you, your risk tolerance and financial goals. Think of this as a…vibe check. 
• Performance. This includes asking questions like: When was the fund created? How has the fund performed over time (under both good and volatile market conditions)? In other words, you're looking for the expected return on investment, and the prospectus can help you get some of these insights. 
• Taxation. Different ETFs are taxed differently, so it’s important to consult a tax advisor to understand how your returns from a particular fund will be taxed.

How to invest in ETFs

To invest in ETFs, you’ll need a brokerage account. And how you choose to invest will depend on your personal investing style and preferences. 

For example, you could build your own ETF portfolio by handpicking ETFs yourself. Some brokerage firms offer their own proprietary ETFs that you can choose from. These proprietary funds are typically managed by the firm’s own team of investment professionals. 

Or you could take a more hands-off approach and invest in ETFs through an automated investing service, like a robo-advisor. Automated investing typically uses algorithms to help you choose an appropriate investment strategy and manage your portfolio.

Either way, before making any investment decisions, talk to a financial advisor to see how ETFs can fit into your overall investment strategy.

And if you’re interested in learning more, we got you. Check out this article on “4 Reasons to Consider ETFs for Your Portfolios.”