Skip to main content
Updated:
Original:

What Are ETFs and How Do They Work?

ETFs are collections of securities that can be traded on centralized exchanges just like stocks. Many different types exist, and they are a great way for investors to diversify their holdings.
Skyward view of three skyscrapers from from below with text overlay that reads "What Is an ETF? Exchange-Traded Funds Explained"

ETFs allow investors to buy into many securities with just one trade, and unlike mutual funds, they trade on centralized exchanges like the NYSE. 

What Is an ETF (Exchange-Traded Fund) in Simple Terms?

An exchange-traded fund, or ETF, is a collection of securities that can be bought and sold in shares on a stock exchange just like an individual stock. Like normal stocks, ETFs have tickers (e.g., SPY), are listed on stock exchanges, and can be traded by individual and institutional investors during normal trading hours.

Some ETFs are designed to track index funds like the Nasdaq Composite. Others focus on specific industries like electric vehicles or specific segments of the stock market like companies with high market capitalization.

While normal stocks have a set number of shares in circulation (for the most part), the number of outstanding shares of a particular ETF can change daily because new ETF shares can be created out of the fund’s underlying securities, and existing shares can be redeemed for the fund’s underlying securities. This is done frequently to keep the value of an ETF in line with the value of its underlying securities. 

What’s the Difference Between an ETF and a Mutual Fund? 

Since ETFs and mutual funds are both curated collections of securities, both instruments allow investors to diversify their portfolios by buying into multiple securities with a single investment. Because they comprise many different securities, both ETFs and mutual funds are less risky than individual stocks. Additionally, both mutual funds and ETFs can be designed to track specific stock indexes or industries.

There are, however, several notable differences between these two types of assets. While ETF shares can be freely traded whenever the market is open, mutual funds shares can only be traded after financial markets close at 4 p.m. EST. Since mutual funds only trade once per day, every trader who buys or sells on a given day does so at the same price.

Because ETFs trade like stocks, they can be traded throughout the day as their price fluctuates. Investors can place margin, stop, and limit orders or even short an ETF depending on their investment strategy. Mutual funds only allow investors to put money into a fund or take it out.

Some (but not all) mutual funds require a minimum investment of a particular dollar amount, whereas ETF investors need only purchase a single share (or less, if their brokerage allows for the trading of fractional shares).

ETFs vs. Mutual Funds

ETFsMutual Funds

Can be traded whenever the market is open

Can only be traded at final price after market close

No minimum investment amount (aside from share price if fractional shares not available on a particular broker)

May have a minimum investment amount

Can be shorted; can be bought on margin; stop and limit orders possible

Can only add or remove capital (i.e., invest/disinvest) 

Common Types of ETFs

There are between two and three thousand ETFs traded on the U.S. stock market and between seven and eight thousand traded worldwide. Since every ETF is a custom collection of securities, there are many different types that have emerged to suit a variety of investor needs. Below are some of the most common types. Note that these types may—and often do—overlap to some degree.

Index ETFs

Index ETFs are designed to track particular stock indexes like the S&P 500 or the Russell 3,000. Many investors—especially those seeking modest but stable returns, relatively low risk, and a passive investment style—like to invest in funds that track stock indexes. Index ETFs allow investors to do this without the restrictions that come with investing in an index-tracking mutual fund (e.g., minimum investments, once-per-day trading, inability to place stop or limit orders, etc.).

Industry ETFs 

Industry ETFs are collections of stocks from a particular industry, like renewable energy or digital media. These can be good investments for individuals who want to invest in a particular industry but lower their risk by spreading their dollars across a variety of companies within the industry rather than cherry-picking individual stocks.

Investment Style ETFs 

Investment style ETFs are designed to match particular investment styles (e.g., small-cap vs. large-cap, value vs. growth, etc.). For instance, a risk-averse investor who likes regular income payments might invest in a low-risk, dividend-income-themed ETF rather than taking the time to seek out a variety of individual bonds and low-risk stocks that pay regular dividends.

Socially or Environmentally Conscious ETFs

For those who like to combine morality or activism with their investing, there also exist ETFs curated to include companies that invest in things other than their bottom line. Some are environmentally focused, and others consist of companies aiming to uplift traditionally underrepresented communities. 

Inverse ETFs (AKA Short ETFs or Bear ETFs)

Inverse ETFs are collections of derivative contracts—usually futures—designed to allow investors to profit from securities losing value (usually in the relatively short term). In other words, inverse ETFs allow investors to short securities in groups instead of individually. These types of ETFs tend to be actively managed and thus tend to come with higher fees than others. They also tend to be somewhat riskier than other ETFs due to the speculative nature of their construction. 

TheStreet Dictionary Terms

Bond ETFs

Bond ETFs are funds that consist exclusively of bonds. Typically, bonds are not traded on stock markets. Instead, they are exchanged over the counter (OTC) with the aid of brokers. Bond ETFs allow investors to easily buy into the bond market on centralized exchanges like the Nasdaq and NYSE. Some bonds ETFs track bond indexes, while others track only corporate, treasury, municipal, convertible, or floating-rate bonds (or some combination of these). Bond ETFs offer investors the least risk compared to stock, commodity, and mixed ETFs.

Commodity ETFs

Commodity ETFs are funds that consist exclusively of derivative contracts (like futures) for commodities like crude oil, corn, lumber, etc. Typically, commodities must be received if purchased, so commodity ETFs are a great way for individual investors (who don’t necessarily have grain silos or oil-storage facilities) to gain exposure to the commodities market without actually having to take delivery. Some commodity ETFs consist of commodity-related equities rather than derivative contracts for commodities themselves. 

Cryptocurrency ETFs

Cryptocurrency ETFs, which first hit the market in 2021, track the price of one or many cryptocurrencies but are traded on centralized exchanges like stocks. These funds allow investors to diversify their portfolios by gaining exposure to the crypto market without buying or holding actual tokens via a cryptocurrency wallet. Cryptocurrencies are volatile to crypto ETFs come with more risk than most others.

 Actively Managed ETFs

Most ETFs are passively managed, meaning they track something—like an index or a set group of stocks—and the assets they track don’t change much over time. Actively managed ETFs, on the other hand, involve a person or group conducting research and making strategic decisions about the fund’s composition on a regular basis. Because of the effort that goes into their management, actively managed funds often come with higher expense ratios (fees) than passively managed funds. Both types of ETFs tend to have lower expense ratios than mutual funds. 

How Risky Are ETFs? 

Because they provide a degree of diversification, stock-based ETFs are less risky than individual stocks but riskier than fixed-income assets like bonds, treasury bills, and certificates of deposit (CDs). That being said, some ETFs include a mix of stocks and bonds, and others include either bonds or stocks exclusively. The higher the ratio of bonds to stocks in an ETF, the lower the risk (and potential return). ETFs may also include commodities (like oil) and currencies (like the riyal), which are also riskier than bonds. The riskiness of an ETF depends on the asset class(es) it includes.

How to Invest in ETFs 

Investors interested in ETFs should start by figuring out what they want from their portfolios. Slow and steady growth? A focus on emerging technologies? A commitment to companies dedicated to socially and environmentally responsible practices? Thousands of ETFs with different focuses exist. Some track stock indexes, some focus on particular industries or market segments, and some are based on specific investment strategies.

Once an investor knows what they want from their portfolio, they can conduct research and identify one or more ETFs that are a good fit for their needs. Because ETFs trade on stock exchanges, they can be bought and sold easily on popular trading platforms like eTrade, Fidelity, and Robinhood. For those looking to invest passively and consistently, dollar-cost averaging may be a simple and sustainable ETF investment strategy.

Advantages and Disadvantages of ETF Investing

ProsCons

Easy way to build a diversified a portfolio

Not ideal for day traders or those who prefer to trade individual stocks 

Lower fees than mutual funds

May come with fees

Allow for exposure to asset classes not otherwise available on centralized exchanges

Many types exist for different investment strategies

Frequently Asked Questions (FAQ)

Below are the answers to some of the most common questions investors have about exchange-traded funds that have not already been addressed in this article.

Do ETFs Have Fees? 

Like mutual funds, ETFs typically carry fees known as expense ratios, although the fees for ETFs tend to be lower than those for mutual funds. These fees cover the costs associated with the fund’s management and administration. ETF expense ratios tend to average around 0.4 to 0.5% (or 40 to 50 cents per $100 investment) annually. These fees are deducted automatically, so ETF investors don’t need to remember to pay them.

It’s important to look at the expense ratio of any ETF (or mutual fund) you’re interested in investing in, as this fee will take a small bite out of your gains (or slightly increase your losses) each year.

Who Creates and Manages ETFs? 

Fund managers, or “sponsors,” create ETFs by filing proposals with the Securities and Exchange Commission (SEC). Another party, known as an “authorized participant,” then borrows the stock shares that the ETF will represent and places them in a trust, which then converts them into ETF shares that the authorized participant can sell to the public. In the case of actively managed ETFs, this process may happen again and again as securities are added to or removed from the fund based on its manager’s strategic decisions.

How Do ETFs Affect Investors’ Taxes? 

When investors sell stocks that have risen in value since they were purchased, they are taxed on their capital gains. These gains are considered short-term and taxed at a higher rate if the stocks were held for less than one year. Gains are considered long-term and taxed at a lower rate if the stocks were held for more than one year. These same rules apply to ETF shares since they are traded on centralized exchanges like stocks.

The transactions that go into the creation and management of ETFs are considered “in-kind,” meaning they are exempt from taxes, so the only tax implications individual ETF investors need to worry about are those that come with selling shares.

Do ETFs Pay Dividends? 

If the stocks included in an ETF pay dividends, then that ETF must pass those dividend payments off to shareholders. These dividends may be paid out in cash or automatically reinvested as additional ETF shares. Different stocks pay dividends at different frequencies and at different times, so typically, ETFs hold all dividends paid during a quarter then pass them out to shareholders at the end of the quarter. Dividends paid by ETFs are taxed at the long-term gains rate.

Do ETF Investors Actually Own the Fund’s Component Securities? 

ETF shareholders do not own the underlying assets included in the ETFs they invest in. For this reason, they do not get the voting rights that normal stock shares might come with. ETF shareholders are, however, eligible to receive any dividends paid out by stocks included in the ETFs they own. In contrast, mutual fund investors do actually own the underlying securities in the fund. 

Expensive Healthcare Lead

Pear Therapeutics Stock to Begin Trading After SPAC Merger

Pear Therapeutics received its second breakthrough device designation from the Food and Drug Administration for its reSET-A product candidate that is designed for the treatment of alcohol substance use disorder.