What You Need to Know About ETFs

Table of Contents

What is an ETF and How Does it Work?

ETFs, or exchange-traded funds, are a type of fund that owns various kinds of securities, often of one type. For example, a stock ETF holds stocks, while a bond ETF holds bonds. One share of the ETF gives buyers ownership of all the stocks or bonds in the fund. For instance, if an ETF held 100 stocks, then those who owned the fund would own a stake — a very tiny one — in each of those 100 stocks.

ETFs are typically passively managed, meaning that the fund usually holds a fixed number of securities based on a specific preset index of investments.
For example, the Standard & Poor’s 500 index is perhaps the world’s best-known index, and it forms the basis of many ETFs. Other popular indexes include the Dow Jones Industrial Average and the Nasdaq Composite index. ETFs based on these funds — they’re called index funds — just buy and hold whatever is in the index and make no active trading decisions.

The Benefits of ETFs

ETFs offer a number of important advantages to investors, especially in terms of investment choice, ease, and expense. Some of the key benefits include:

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Investment choice: ETFs give investors new investment choices, because they create new securities as funds. With an ETF, you can invest in an S&P 500 index fund right on the exchange, rather than having to buy a small piece of each stock.
Diversification: ETFs allow investors to easily achieve objectives such as diversification. One fund can provide instant diversification, either across an industry or across the entire market. Investors can easily buy multiple funds that target each sector they’d like to own.
Low cost: ETFs can be relatively cheap, and they’ve only gotten cheaper over time. The asset-weighted average expense ratio of a stock index ETF was 0.14 percent in 2024, according to the Investment Company Institute, and the number has been falling for the last decade.
Focused investments: ETFs are also popular because they allow investors to create exposure to specific sectors or investing themes. For example, ETFs can focus on high-yield stocks or value-priced stocks.
More tax-efficient: ETFs are structured so that they make only minimal distributions of capital gains, keeping tax liabilities lower for investors.

ETFs vs. Mutual Funds

While mutual funds and ETFs have similar goals to own a wide variety of assets in one security, they have many key differences. Here are some of the main areas where these two kinds of funds differ:

Category	Mutual Fund	ETF	Average Annual Expense (2024)	Commission	Initial Minimum	Management Style
Category	Active and passive	Passive	0.64 percent for actively managed stock funds; 0.47 for active bond funds; stock and bond index funds average 0.05 percent	Commission may run as high as $50 at major brokers, though many brokers offer free trades on select funds	Usually a few thousand dollars unless purchased as part of a 401(k) or other retirement plan	Mainly passive

ETFs vs. Stocks

While ETFs and stocks both trade throughout the day, there are some key differences between the two types of securities. For example:

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A stock represents an ownership interest in a single company, while an ETF holds a number of different stocks or other assets. A stock ETF may hold stock in hundreds of different companies, allowing its investors to hold a diversified portfolio by owning just one security: the ETF.

That diversification reduces the risk for investors, compared to holding a single stock or just a few individual stocks. An ETF is generally less volatile than an individual stock, as well.

Are ETFs Good for Beginners?

ETFs are popular among investors because they offer a lot of valuable traits. And that’s especially good for beginning investors. Some of the reasons why ETFs are good for beginners include:

Low minimum investment: The minimums for ETFs are usually the cost of just one share, which can vary from very little to perhaps a couple hundred dollars.
Usually commission-free: On top of that, many brokers allow you to trade ETFs without a commission.
Thematic: ETFs also allow investors to buy into a specific investing theme easily, even if they don’t know much about it.
Diversification: ETFs also offer instant diversification. You can buy one fund and own a specific set of companies that are focused on one area of the market, or even own the whole market.
Own the market: Finally, ETFs also allow you to buy popular indexes such as the S&P 500, letting you “own the market” and get the market return, which has averaged about 10 percent annually over time.

Conclusion

ETFs have proven incredibly popular in the last few decades, and that popularity is set to continue. One of the most popular investing strategies — buying and holding an S&P 500 index fund — has been recommended by legendary investor Warren Buffett. While the influx of cash to ETFs might hiccup when the market fluctuates, the long-term trend toward ETF investing looks clear. Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision.