ETFs: What They Are, How They Work & How to Invest

What Is an ETF?

ETF stands for exchange-traded fund. An ETF is an investment fund that pools money from investors and uses that money to hold a portfolio of investments.

Depending on the fund, an ETF may hold stocks, bonds, short-term money-market instruments, commodities or other investments. Each ETF share represents an investor's portion of the fund's portfolio.

The "exchange-traded" part of the name refers to how ETF shares are bought and sold. Unlike traditional mutual fund transactions, ETF shares generally trade on securities exchanges throughout the trading day.

How Do ETFs Work?

An ETF pools money from many investors and uses it to purchase the investments specified by the fund's strategy.

For example, an ETF could be designed to provide exposure to a broad group of U.S. companies, a particular industry, government bonds, corporate bonds or international markets.

Investors generally purchase ETF shares through a brokerage account. The shares trade on an exchange, and their market price can change throughout the trading day.

Large financial institutions known as authorized participants play an important role in the ETF creation and redemption process. They generally transact directly with the ETF in large blocks of shares, helping the market price remain relatively close to the fund's net asset value.

ETF vs. Stock

ETF shares and individual stocks can both trade on an exchange, but they represent different types of investments.

Diversification varies significantly among ETFs. A broad fund can hold many securities, while a narrowly focused ETF may concentrate on a particular industry, asset class, geographic region or even a single security.

ETF vs. Mutual Fund

ETFs and mutual funds can both pool investor money into portfolios of stocks, bonds or other assets. One of the major differences is how their shares are traded and priced.

Neither structure automatically makes an investment appropriate for every investor. The fund's objective, holdings, costs, risks and the investor's circumstances all matter.

Types of ETFs

ETFs come in many forms. The investment strategy and underlying holdings can be very different from one ETF to another.

Index ETFs

Many ETFs are designed to track an index. An index ETF generally attempts to achieve approximately the performance of its chosen index before fees and expenses.

Instead of relying on a manager to continuously select individual securities with the goal of outperforming an index, an index ETF generally follows a defined portfolio methodology.

Index ETFs can therefore provide exposure to many securities through a single investment. However, an index ETF can still fall in value when the investments in its underlying index decline.

Learn more about this approach in our index funds guide .

Actively Managed ETFs

Not every ETF tracks an index. Some ETFs are actively managed.

An actively managed ETF has a portfolio manager or management team making investment decisions according to the fund's stated strategy rather than simply attempting to replicate an index.

Active ETFs can have different objectives, holdings, turnover and costs from index-based ETFs. Investors should review the fund's prospectus and other available information to understand the strategy.

ETF Diversification

One reason investors use ETFs is the ability to gain exposure to multiple investments through one fund.

For example, an ETF could hold shares of hundreds of companies rather than requiring an investor to purchase each company's stock individually.

ETF Price vs. NAV

Two important concepts when evaluating ETFs are market price and net asset value (NAV).

NAV represents the value of the fund's underlying assets, after liabilities, on a per-share basis. The ETF's market price is the price at which its shares trade on an exchange.

The market price can be higher or lower than NAV. The difference is commonly described as a premium or discount to NAV.

During periods of market volatility, the relationship between an ETF's market price and NAV can change.

How Much Do ETFs Cost?

ETFs have expenses, and those costs can affect long-term investment results.

Expense ratio

The expense ratio represents the fund's ongoing operating expenses as a percentage of assets. These expenses are generally deducted from the fund's assets rather than being presented as a separate bill to the investor.

Bid-ask spread

The bid is the price a buyer is willing to pay, while the ask is the price at which a seller is willing to sell. The difference between them is the bid-ask spread.

Brokerage costs

Depending on the brokerage and transaction, investors may encounter trading commissions or other account-related costs. Check the brokerage's current fee schedule.

Premiums and discounts

Investors can also receive a price above or below an ETF's NAV when trading shares.

Do ETFs Pay Dividends?

Some ETFs distribute income generated by the securities they hold.

For example, a stock ETF may receive dividends from companies in its portfolio. A bond ETF may receive interest from bonds it owns.

Depending on the fund and circumstances, investors may also receive capital gains distributions.

Distribution policies vary by ETF, so investors should review the fund's documentation before assuming when or how much an ETF will distribute.

ETF Taxes

Taxes depend on the type of account, the ETF, the distributions received and the investor's individual tax situation.

In a taxable brokerage account, dividends and capital gains distributions may create taxable income. Selling an ETF for more than its tax basis can also create a capital gain.

ETFs can sometimes be more tax-efficient than mutual funds because of differences in their structures, but tax treatment varies and is not guaranteed to be the same for every fund.

Retirement accounts have different tax rules. Consider your account type separately from the investment itself.

ETF Risks

ETFs are investments and are not guaranteed to increase in value.

• Market risk: The value of the ETF can decline when its underlying investments decline.
• Concentration risk: Narrow ETFs can have significant exposure to one industry, country or strategy.
• Interest-rate risk: Bond ETFs can be affected by changes in interest rates.
• Liquidity risk: Some ETFs may trade less actively than others.
• Tracking risk: An index ETF may not perfectly match the performance of its target index.
• Currency and international risk: International investments can be affected by currency movements and country-specific conditions.
• Strategy risk: Specialized, leveraged or inverse ETFs can have significantly different risks from broad market ETFs.

Leveraged and Inverse ETFs

Some ETFs use strategies designed to produce leveraged or inverse exposure to an index or other benchmark.

These products can behave very differently from a traditional broad-market ETF, particularly over periods longer than one trading day.

Investors should understand the fund's objective, methodology, compounding effects, costs and risks before considering these products.

How to Buy ETFs

ETF shares are generally purchased and sold through a brokerage account.

1. Determine your goal. Understand why the investment is being considered and what role it would have in your portfolio.
2. Choose an account. This could be a taxable brokerage account or an eligible retirement account.
3. Research the ETF. Review its objective, holdings, fees, risks and historical information.
4. Read the fund documents. Review the prospectus and other available shareholder information.
5. Check the trading details. Look at the ticker symbol, market price, bid-ask spread and order type.
6. Place the trade. Submit the order through your brokerage account.
7. Monitor your portfolio. Periodically review whether the investment continues to fit your goals and allocation.

ETF Order Types

Market order

A market order generally seeks execution at the best available market price. The execution price may differ from the price you saw when entering the order.

Limit order

A limit order specifies the maximum price you are willing to pay when buying or the minimum price you are willing to accept when selling. A limit order may not execute if the market does not reach the specified price.

Investors should understand the mechanics and risks of an order type before using it.

What to Check Before Buying an ETF

• Fund objective and investment strategy
• Underlying holdings
• Expense ratio
• Bid-ask spread
• Assets and trading activity
• Historical performance
• Investment risks
• Dividend or distribution policy
• Tax considerations
• Prospectus and shareholder information

Simple ETF Example

Imagine an investor has $1,000 available for an investment and chooses an ETF priced at $100 per share.

If the brokerage allows whole-share purchases only, $1,000 could purchase 10 shares before considering trading costs or price changes.

If the ETF's market price later rises, the value of those shares could increase. If the ETF's market price falls, the investment could lose value.

ETFs for Beginners

A beginner researching ETFs can start by understanding the fund before focusing on its recent performance.

Important questions include:

• What does the ETF invest in?
• What index or strategy does it follow?
• How diversified is the portfolio?
• What are the ongoing expenses?
• How actively does the ETF trade?
• What risks could affect the investment?
• Does the ETF fit the role you want it to play in your portfolio?

Avoid choosing an ETF solely because it recently had strong performance. Past performance does not guarantee future results.

Common ETF Investing Mistakes

• Assuming every ETF is broadly diversified.
• Looking only at the expense ratio.
• Ignoring bid-ask spreads.
• Buying an ETF without understanding what it holds.
• Confusing an ETF with a guaranteed investment.
• Ignoring tax consequences in taxable accounts.
• Focusing entirely on recent performance.
• Using leveraged or inverse ETFs without understanding their structure.
• Assuming every ETF behaves like a broad-market index fund.

ETF Investing Checklist

Before investing, read the ETF's prospectus and available shareholder information. Make sure you understand what the fund owns, how it is managed, what it costs and what could cause it to lose value.

Understanding ETFs

ETFs combine a pooled investment portfolio with exchange trading. They can provide exposure to stocks, bonds and other assets through a single fund, but ETFs differ substantially in their strategies, costs and risks.

Understanding the fund's objective, holdings, expenses, trading characteristics and risks can help you evaluate whether a particular ETF fits your financial plan.