What an ETF is and how it differs from a stock

An ETF (exchange-traded fund) is a basket of investments bundled together and sold as a single thing you can buy and sell like a stock. Instead of owning one company's shares, you own a small piece of many companies — or bonds, or commodities — all at once. The fund itself is managed by a company that decides what goes in the basket, and you pay a small yearly fee for that management.

The main difference from buying individual stocks: when you buy a stock, you own a piece of one company and your return depends entirely on how that company performs. When you buy an ETF, your return depends on how all the holdings inside it perform together. If one holding drops, others might rise, which can reduce your overall loss. This is called diversification.

ETFs trade on stock exchanges during market hours, just like stocks do. You can buy and sell them through a brokerage account at any time the market is open. The price changes throughout the day based on what buyers and sellers are willing to pay.

Key Takeaways

  • An ETF holds many investments inside it, so buying one ETF gives you exposure to dozens or hundreds of companies or bonds instead of just one.
  • ETFs trade like stocks during market hours, and their price moves up and down throughout the day based on supply and demand.
  • You pay an annual fee (called an expense ratio) to the fund company for managing the ETF, usually between 0.03% and 1% per year.
  • Some ETFs track a fixed list of holdings (passive), while others are actively managed by a fund manager who buys and sells holdings to try to beat the market.

Common types of ETFs and what they hold

ETFs come in many varieties depending on what you want exposure to. An index ETF tracks a specific list of companies — for example, an S&P 500 ETF holds the same 500 large U.S. companies as the S&P 500 index. A sector ETF focuses on one industry, like technology or healthcare. A bond ETF holds bonds instead of stocks. An international ETF holds companies based outside the U.S.

There are also actively managed ETFs, where a fund manager picks and changes the holdings to try to outperform the market, versus passive ETFs that simply hold a fixed list and rarely change it. Passive ETFs usually have lower fees because they require less work to run.

Some ETFs are designed for specific goals: dividend ETFs focus on companies that pay dividends, growth ETFs focus on companies expected to grow quickly, and value ETFs focus on companies considered underpriced. The type you choose depends on what you are trying to achieve with your money.

How much it costs to own an ETF

The main cost is the expense ratio, a yearly percentage fee taken from your investment automatically. A 0.10% expense ratio on a $10,000 investment costs $10 per year. A 0.50% ratio on the same amount costs $50 per year. Index ETFs typically charge between 0.03% and 0.20% per year, while actively managed ETFs often charge 0.50% to 1.50% or more.

You may also pay a trading commission when you buy or sell the ETF through your brokerage, though many brokerages now offer commission-free trading on ETFs. Some ETFs have a bid-ask spread — the difference between what buyers will pay and what sellers are asking — which affects the price you actually pay when you trade.

Over time, even small expense ratios add up. An ETF charging 0.50% per year costs twice as much as one charging 0.25% per year, and that difference compounds over decades. This is why many investors pay attention to expense ratios when choosing between similar ETFs.

Tax treatment and how ETFs compare to mutual funds

ETFs and mutual funds are similar in structure — both hold baskets of investments — but they differ in how they trade and how they are taxed. Mutual funds are priced once per day after the market closes, while ETFs trade throughout the day like stocks. Mutual funds often require a minimum investment (sometimes $1,000 or more), while ETFs can be bought one share at a time.

ETFs are generally more tax-efficient than mutual funds because of how they are structured. When other investors sell their shares of a mutual fund, the fund may have to sell holdings to pay them, which can trigger capital gains taxes for remaining shareholders. ETFs avoid this through a mechanism called in-kind redemption, which means fewer taxable events for you.

If you hold an ETF in a regular taxable brokerage account, you will owe taxes on any dividends the ETF pays and on any gains when you sell. If you hold it in a tax-advantaged account like an IRA or 401(k), those taxes are deferred or eliminated depending on the account type.

How to buy an ETF and where to start

You need a brokerage account to buy ETFs. Many brokerages — including Fidelity, Charles Schwab, Vanguard, and others — allow you to open an account online in minutes. You fund the account by transferring money from your bank, then search for the ETF by its ticker symbol (a short code like SPY or VOO) and place an order to buy a certain number of shares.

Your order executes during market hours at whatever price the ETF is trading at when your order reaches the exchange. If you place an order after the market closes, it will execute the next time the market opens. You can set up automatic investments to buy the same ETF on a regular schedule, which is a common way people build long-term positions.

Before you buy, research the ETF's holdings, expense ratio, and trading volume. Higher trading volume means you can buy and sell more easily without the bid-ask spread working against you. Many brokerages provide fact sheets and holdings lists for every ETF they offer.

Risks and things that can go wrong

ETFs are not risk-free. The value of your investment can drop if the companies or bonds inside the ETF perform poorly. Even diversified ETFs lost significant value during major market downturns like 2008 and 2020. If you need your money soon, a market downturn could force you to sell at a loss.

Some ETFs are more complex than they appear. Leveraged ETFs use borrowed money to amplify gains and losses, which can cause them to lose value faster than the underlying index during downturns. Inverse ETFs are designed to go up when the market goes down, which can confuse investors about how they work. These are generally not suitable for long-term buy-and-hold investing.

Concentration risk is also possible. An ETF that holds only technology stocks is less diversified than one holding companies across many industries. If that sector falls out of favor, your entire investment suffers. Reading the fund's prospectus and holdings list before you buy helps you understand what you actually own.

Frequently Asked Questions

Can I lose all my money in an ETF?

You can lose a significant portion of your investment if the holdings inside the ETF drop in value, but losing everything is unlikely unless the ETF holds very risky assets or uses leverage. Diversified ETFs that hold many companies across different sectors are less likely to go to zero than individual stocks.

Do I get dividends from an ETF?

Many ETFs pay dividends if the companies or bonds inside them pay dividends. The ETF collects those payments and distributes them to shareholders, usually quarterly. You can choose to reinvest dividends automatically or receive them as cash, depending on your brokerage.

What is the difference between an ETF and an index fund?

An index fund is a type of mutual fund or ETF that tracks a specific index like the S&P 500. Not all ETFs are index funds — some are actively managed. Index ETFs and index mutual funds do similar things, but index ETFs trade like stocks and are usually cheaper.

How long should I hold an ETF?

ETFs work best as long-term holdings because short-term trading costs add up and market timing is difficult. Most investors hold ETFs for years or decades as part of a retirement or investment plan. Holding longer also means you benefit from compound growth and pay fewer trading commissions.

Can I buy ETFs in a retirement account?

Yes, most retirement accounts like IRAs and 401(k)s allow you to buy ETFs. In fact, many 401(k) plans offer ETFs as investment options. Holding ETFs in a retirement account means you do not pay taxes on dividends or gains until you withdraw the money, which can significantly increase your long-term returns.