An ETF is a fund that holds many stocks or bonds and trades like a single stock on an exchange

ETF stands for exchange-traded fund. It is a basket of investments — usually stocks, bonds, or a mix of both — bundled together and sold as one unit. You buy and sell ETF shares through a stock exchange, the same way you would buy shares of Apple or Microsoft. The price moves throughout the trading day based on what buyers and sellers are willing to pay, unlike mutual funds, which price once per day after the market closes.

The main appeal is simplicity. Instead of buying 50 different stocks one by one, you can buy one ETF that already holds those 50. You own a piece of all of them instantly. ETFs also tend to charge lower fees than actively managed mutual funds because most ETFs simply track an index — a pre-set list of stocks or bonds — rather than paying a manager to pick winners.

Key Takeaways

  • An ETF holds many investments in one package and trades on a stock exchange during market hours, so its price changes throughout the day.
  • Most ETFs track an index, meaning they hold the same stocks or bonds in the same proportions as a published list, rather than relying on a manager to choose what to buy.
  • You can buy an ETF through any brokerage account, and the cost to trade is usually a flat commission or nothing at all.
  • ETFs spread your money across many holdings, which reduces the risk that one bad investment will hurt you badly.

How an ETF differs from a mutual fund

Both ETFs and mutual funds hold a collection of investments, but they work differently. A mutual fund pools money from many investors and a manager decides what to buy and sell. You place an order to buy or sell shares, but the price is set once per day after the market closes, based on the total value of everything in the fund that day.

An ETF also pools money from many investors, but most ETFs do not have a manager making picks. Instead, they track an index — such as the S&P 500, which is 500 large U.S. companies — and hold exactly what the index holds. Because there is no manager actively trading, ETF fees are usually lower. And because ETFs trade on an exchange, you can buy or sell at any time during market hours and see the price change in real time.

Mutual funds can be a better choice if you want professional management or if you prefer to set a price and let the order execute at day's end. ETFs work better if you want lower costs, more control over when you trade, and transparency about exactly what you own.

Types of ETFs and what they track

ETFs exist for almost every investment category. The most common are stock ETFs, which hold shares of companies. An S&P 500 ETF holds the 500 largest U.S. companies. A total U.S. stock market ETF holds thousands of companies of all sizes. International stock ETFs hold companies outside the United States.

Bond ETFs hold debt issued by governments or corporations. A Treasury ETF holds U.S. government bonds. A corporate bond ETF holds bonds from companies. Bond ETFs tend to move less dramatically than stock ETFs and can provide steadier income through interest payments.

There are also sector ETFs that focus on one industry — technology, healthcare, energy, or finance, for example. Dividend ETFs hold stocks known for paying regular cash to shareholders. Commodity ETFs track the price of oil, gold, or agricultural products. Some ETFs mix stocks and bonds in a single fund, designed for a specific goal or time horizon.

How to buy an ETF and what it costs

You buy an ETF through a brokerage account — an account you open with a company like Fidelity, Vanguard, Charles Schwab, or many others. You log in, search for the ETF by its ticker symbol (a short code like SPY or VOO), and place a buy order just as you would for a stock. The order executes during market hours at the current market price.

The cost to buy or sell an ETF share is usually nothing — most brokerages no longer charge commissions. However, there is an ongoing cost called the expense ratio, expressed as a percentage of what you have invested. If an ETF has a 0.03% expense ratio and you own $10,000 of it, you pay about $3 per year. This fee is deducted automatically and is already reflected in the price you see. Stock index ETFs often charge 0.03% to 0.20% per year. Bond ETFs and specialty ETFs may charge more.

When you buy an ETF, you also need to consider the bid-ask spread — the tiny difference between what buyers are willing to pay and what sellers are asking. For popular ETFs, this spread is very small, sometimes just a penny per share. For less popular ETFs, the spread can be wider, meaning you pay a bit more to buy and receive a bit less to sell.

Why people use ETFs for diversification

Diversification means spreading your money across many different investments so that if one performs poorly, it does not sink your entire portfolio. Buying individual stocks means you have to research and buy dozens of companies yourself. Buying an ETF does the diversification work for you instantly.

A single S&P 500 ETF gives you ownership in 500 companies across many industries. If one company has a bad year, it is a small part of your total holding. If you bought only that one stock, a bad year could cut your investment in half. ETFs make broad diversification simple and cheap.

You can also diversify across asset types by owning both a stock ETF and a bond ETF. Stocks tend to grow faster over long periods but swing up and down more. Bonds are more stable but grow slower. Holding both can smooth out your returns over time.

Tax considerations when holding ETFs

ETFs are generally more tax-efficient than mutual funds. When a mutual fund manager buys and sells stocks throughout the year, those trades can create capital gains — profits that get passed to you as a shareholder, and you owe tax on them even if you did not sell anything. Most ETFs track an index and trade less frequently, so they generate fewer capital gains to pass along.

When you sell an ETF share yourself, you owe tax on any gain between what you paid and what you sold it for. If you hold the ETF for more than one year, the gain is taxed at the long-term capital gains rate, which is usually lower than the rate for short-term gains. If you hold it in a retirement account like a 401(k) or IRA, you do not owe tax on gains until you withdraw money from the account.

Frequently Asked Questions

Can I lose money in an ETF?

Yes. If the stocks or bonds in the ETF fall in value, your shares are worth less. However, because an ETF holds many investments, you are unlikely to lose everything unless the entire market crashes. Diversification reduces but does not eliminate risk.

Do I get dividends from an ETF?

Many ETFs pay dividends — cash distributions from the companies or bonds they hold. You can choose to receive the cash or have it reinvested automatically to buy more shares. The dividend amount varies by ETF and changes over time.

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

An index fund is a mutual fund that tracks an index. An ETF can also track an index. The main difference is how they trade: index mutual funds price once per day, while ETFs trade throughout the day like stocks. ETFs usually have lower fees.

Can I buy an ETF in a retirement account?

Yes. You can hold ETFs in a 401(k), IRA, or other retirement account. Many people use ETFs as the core holdings in retirement accounts because of the low fees and broad diversification.

How do I know which ETF to choose?

Start by deciding what you want to own — U.S. stocks, international stocks, bonds, or a mix. Then compare the expense ratios of ETFs that track that category. Lower fees mean more of your money stays invested. Read the fund description to confirm it holds what you think it does.