Imagine you could buy and sell “shares” of a mutual fund on a stock exchange. That’s a simple description of an exchange-traded fund (ETF). To be more specific, an ETF is an investment fund that owns large swaths of investments (stocks, bonds, real estate, etc.) that are selected and managed by a fund manager; those investments are then sliced up into millions of pieces and sold to individual investors on exchanges.
An ETF combines the diversification of a mutual fund with the flexibility of a stock, all with much lower fees than mutual funds. Different ETF track different markets.
If that sounds a little confusing, consider this example: You want to invest in the stock markets. Blue chips sound like a good investment. But instead of investigating and tying your fortunes to a single stock, you can invest in an ETF that owns stock in lots of blue chip companies. Then your ETF can be said to “track” blue chips.
What are the pros?
One of the central advantages to ETFs is low fees. ETFs charge fractions of a percentage point (typically in the range of 0.05 to 0.25%), while most mutual funds charge more than 2% a year. ETFs are cheap because they aren’t trying to guess individual winners in the stock or bond markets; instead they track an entire genre of investments. That means fund managers don’t need to make large numbers of trades, and trading is what costs money.
Buying and selling ETFs is also very easy and affordable to do. There is no minimum to invest (just the price of a single share of the ETF). And since ETFs trade on the stock market, buying a unit is as simple as buying a share in a company.
Scared about losing out on dividend payments? Don’t worry, ETF funds collect dividends from the various companies and pass the money onto you. Lots of people consider ETFs to be the best of both stocks and mutual funds.
Is there anything to be careful about?
ETFs are still funds and still have fees. While these fees are much lower than those of mutual funds, you could technically avoid those fees by going out and buying all the individual stocks or bonds the fund invests in. It would be time-consuming, but it would cost less.
As with all diversified funds, the chances for big gains are smaller than if you’re buying an individual stock (as are the chances of losing your shirt).
And finally, buying and selling units usually cost a small commission fee—the same as buying or selling shares of a stock—the size of which depends on the broker.
What's the difference between an ETF and a mutual fund?
The main difference between an ETF and a mutual fund is that a mutual fund is actively managed by a fund manager, who picks specific stocks with the goal of trying to outperform the market. Mutual funds have higher management fees than ETFs, and more often than not, don't succeed in beating the market. An ETF, on the other hand, looks to replicate market returns and is part of a more passive investment strategy. Examples of popular ETFs include S&P 500 or the Russell 2000.