Investors have never been less starved for choice. The investment landscape is increasingly more like an all-you-can-eat buffet than a carefully curated menu. That may sound great in theory, but anyone who’s stared down a dozen trays of desserts knows that more choice doesn’t always make choosing easier.
“The ETF landscape is confusing, and only getting more so as new and complex products come to market at a rapid pace,” says Elizabeth Kashner, director of global funds research and analytics at FactSet. But she says investors can make the selection more manageable by focusing on what actually belongs on their plate.
Fortunately, choosing an ETF doesn’t have to be overwhelming. Once you understand how ETFs work, what types of ETFs are available and which factors actually matter, you can narrow the buffet into a much more manageable menu.
Here’s everything you need to know about ETFs to start investing in them:
An ETF is an investment vehicle that holds other investments. You can think of an ETF like a smoothie made from many different ingredients. The fund may hold hundreds or even thousands of investments, but when you take a sip – or buy a share – you’re not getting just one of those ingredients. You get a proportional serving of the whole blend.
What goes into that smoothie blend depends on the ETF. Some hold only stocks, others only bonds and still others a mix of both. They can also own commodities or other financial securities. But just because ETFs can hold many different investments doesn’t mean they’re all diversified. Some concentrate on a single industry, geography or niche. That’s why understanding what’s actually inside the fund matters.
ETFs have two layers working together. Under the hood, the fund owns various investments, like shares of certain stocks. Meanwhile, shares of the ETF itself trade on a stock exchange where investors can buy and sell them throughout the trading day.
This creates two different ways to view an ETF’s value: Its net asset value, or NAV, is the cumulative value of the investments held inside the fund divided by the number of shares of the ETF. You can think of this as the value of all the smoothie ingredients divided by the servings. In an ideal world, this is the same price investors pay for each share of the ETF, but that’s not always the case. When the market price is higher than NAV, it trades at a premium. When the market price is lower, it trades at a discount.
You may also notice two different prices for an ETF: a bid and an ask. The bid is the highest price someone is willing to pay for a share and the ask is the lowest price someone is willing to accept. The difference between these is called the bid-ask spread.
“The smaller the gap, the better,” Kashner says.
Like smoothies, ETFs can come in many different flavors. One of the easiest ways to sort them is by what they invest in. The primary types of ETFs are:
- Stock ETFs hold primarily stocks. They can cast a wide net across the entire U.S. or global stock market, or they can focus on a smaller segment, such as companies of a specific size or industry, like technology or healthcare. For example, the State Street SPDR S&P 500 ETF (ticker: SPY) tracks the S&P 500, which includes 500 of the largest U.S. companies. Meanwhile the State Street Technology Select Sector SPDR ETF (XLK) narrows that to only technology companies in the S&P 500.
- Bond ETFs hold fixed-income securities like U.S. Treasury, corporate, municipal or high-yield bonds. For example, the Vanguard Total Bond Market ETF (BND) provides exposure to U.S. investment-grade bonds.
- International ETFs invest in companies outside of the U.S. They can include companies from many different regions or focus on only one. For example, the iShares Core MSCI Total International Stock ETF (IXUS) invests across developed and emerging markets outside the U.S., while the iShares MSCI Japan ETF (EWJ) invests only in Japanese companies.
- Thematic ETFs choose their investments around a certain trend, like artificial intelligence, cybersecurity or clean energy. For instance, the Global X U.S. Infrastructure Development ETF (PAVE) invests in companies that may benefit from infrastructure activity in the U.S.
Within these categories, ETFs can also be categorized by their investment strategy. Passive, or index, ETFs simply track a benchmark index, like the S&P 500. Actively managed ETFs let their fund managers decide what to buy and sell based on their research. Factor, or smart beta, ETFs focus on one or more factors, or attributes of a company or stock, such as quality, company size, trading momentum or volatility.
The key takeaway here is that labeling something as an ETF tells you how it’s packaged and traded, not necessarily what it invests in. To understand the individual ingredients, you need to look at the type of ETF.
ETFs are popular for a good reason. They provide investors a host of benefits, from accessibility and diversification to cost and tax advantages. Here are some of the main benefits of ETFs:
- Diversification. A single share of an ETF can be invested across many individual investments. Of course, the level of diversification depends on the type of ETF and how narrow its focus is.
- Low cost. ETF fees are generally very low, often half of what you’d pay for a comparable mutual fund.
- Accessibility. ETFs are widely available and can be purchased for as little as $1 thanks to fractional shares.
- Professional management. Most ETFs are overseen by professional fund managers. However, the degree of management varies depending on whether it’s actively or passively managed.
- Tax advantages. ETFs typically have fewer capital gains distributions than mutual funds, which means investors receive lower tax bills at year end.
ETFs are great investment vehicles for all levels of investors, but they aren’t always the right choice. Some of the risks and disadvantages of ETFs to be aware of include:
- Risk level varies. ETFs vary widely in the level of risk they take. A broad market ETF may be highly diversified and thus relatively safer than a more concentrated ETF. ETFs can also use leverage, which involves borrowing money to purchase investments and greatly increases the potential return and loss.
- Trading costs. While ETFs often carry low expense ratios, they aren’t free. In addition to the annual expense fee, bid-ask spreads and the costs fund managers incur while buying and selling investments can erode returns.
- Market price can differ from NAV. An ETF may trade above or below the market value of its underlying holdings. This is known as paying a premium (when it’s above) or discount (when it’s below).
- Some ETFs are complex. Leveraged, inverse and other specialized ETFs can behave very differently from a traditional stock or bond fund and require considerably more research before investing.
This is where the terminology can get confusing. ETFs are often discussed alongside mutual funds, stocks and index funds, but these terms don’t describe the same products.
A stock represents an ownership stake in a single company. If you buy a share of Apple Inc. (AAPL), for example, you own a tiny sliver of Apple. When you buy a share of an ETF, you own part of the fund itself, not the companies within the fund. You’ll still benefit indirectly when the fund’s holdings do well, but you don’t directly own Apple or whatever stocks are within the fund. Rather, the fund owns the stocks.
Mutual funds are very similar to ETFs in that they own a collection of investments within one wrapper. The biggest difference between mutual funds and ETFs is how they trade. ETFs trade on stock exchanges throughout the day, so their prices can change from one minute to the next. Mutual funds are generally not exchange-listed. Instead, investors buy or sell shares directly from the fund manager once per day at the closing price.
The last distinction is especially important: An ETF is not the same thing as an index fund, although some ETFs are index funds.
“Both ETFs and traditional funds can be either index-linked or active,” says Aniket Ullal, senior vice president and head of ETF research and analytics at CFRA. In other words, an index fund is defined by its investment approach, not by whether it’s an ETF or mutual fund. Index-linked funds are passively managed, meaning they simply track an underlying benchmark.
“On average, most index-linked ETFs tend to be cheaper and more diversified than active ETFs,” he says. “They also on average tend to hold more securities, since active ETFs tend to take more concentrated bets.” However that’s not always the case: Some index funds can be expensive or narrowly focused, he says, so it’s important to look under the hood.
ETFs can be very low-cost, but there are some expenses to be aware of. The primary one is the expense ratio. This is an annual management fee to cover the cost of running the fund. It’s deducted from the fund’s assets rather than being charged to you as a separate bill. You’ll see it expressed as a percentage of the money you invest. For example, a 0.1% expense ratio means you’d pay $10 per year for every $10,000 you invest in the fund.
Costs can also come from the bid-ask spread. A higher bid-ask spread means that there is a bigger gap between what buyers are paying and sellers are receiving. The wider the spread, the more it can effectively cost to buy or sell the ETF.
It’s also worth paying attention to the tracking difference, Kashner says. This is the “performance gap” between the ETF’s performance and that of the index it’s designed to follow. A larger gap means investors aren’t getting quite the same return the benchmark delivered.
Some brokers may also charge trading commissions – a fee you pay every time you place a trade. However, commission-free ETF trading is now very common.
ETFs can pay dividends or interest if the investments they hold generate either. The fund then passes this along to shareholders as a distribution. In a taxable account, these distributions may create a tax bill, as can selling ETF shares for a profit. Not every ETF pays a distribution, though.
Generally speaking, ETFs can be more tax-efficient than comparable mutual funds. But the taxation depends on what the ETF owns and the type of account you hold it in, so not every ETF receives the same treatment.
With thousands of ETFs competing for your money, choosing the right one for you can be the hardest part of the equation. The trick is not to start by looking for the fund with the best recent return. Instead, start by asking what you need the investment to accomplish for you.
“Ask ‘what problem do I need to solve?’ and then look for products that align,” Kashner says. For example, you might want broad exposure to the U.S. market for long-term growth, income and stability from bonds or international stocks for geographic diversification.
Once you know what type of exposure you want, Kashner says to use an E-T-F framework:
- Efficiency: How can you minimize holding costs and risks? This involves looking for low expense ratios, small tracking differences and large funds. Kashner recommends assets under management, known as AUM, of more than $100 million, but over $1 billion is even better.
- Tradability: How can you get a fair price when buying and selling the ETF? Look for a tight bid-ask spread.
- Fit: How does what the fund actually owns provide the exposure you’re looking for?
“In general, diversified index-linked ETFs are best suited as low-cost core building blocks for a portfolio, while active ETFs are good for concentrated, high-conviction trades in a specific asset class or strategy, typically as satellite holdings in a portfolio,” Ullal says.
As Kashner puts it, choosing an ETF deserves at least as much thought as another purchase you might research: “Think about what you do before buying a toaster oven – the investment decision is a lot more important.”
You can buy an ETF inside a brokerage account or investment app. All you need to do is search for the fund’s ticker symbol, like “SPY” for the State Street SPDR S&P 500 ETF. Then decide how much you want to invest and place the order. Ideally, you’ll do this during the trading day so you can see the live prices. If you don’t have enough money to buy a full share, look for a broker that offers fractional shares.
When you place the trade, you’ll need to choose between different order types. A market order is the simplest approach for new investors as it means you’ll get the next available price. A limit order lets you specify the maximum price you’re willing to pay. But this means that if the shares never fall below your limit price, your trade won’t go through.
That said, Kashner recommends using limit orders rather than market orders when trading ETFs. “Often, a little patience goes a long way,” she says.
Make sure to double-check everything before you press “buy,” then submit the trade and get on with your day. After that, remember that investing is a long-term game. Even the best ETFs will fluctuate in value day to day. The important thing is that you give your investments time to work so you can benefit from their potential long-term growth.