An exchange-traded fund, or ETF, is an investment fund whose shares trade on a stock exchange. An ETF can hold a basket of stocks, bonds, commodities or other assets, allowing investors to buy exposure to many holdings through a single tradable security.
Key takeaways
- An ETF is a fund that trades on an exchange like a stock.
- Many ETFs track an index, sector, commodity or investment strategy.
- Buying an ETF can provide diversification across multiple holdings.
- ETFs have costs and risks, including fees, tracking differences, market risk and liquidity considerations.
- An ETF is not the same thing as the index it tracks.
How does an ETF work?
An ETF pools assets under a defined investment objective. Investors buy and sell shares of that fund on an exchange during market hours. The value of those shares is linked to the underlying portfolio, although the market price can trade slightly above or below the value of the fund’s assets.
ETF vs index: what is the difference?
An index is a calculated benchmark. It does not hold assets and cannot be purchased directly. An ETF can be designed to track an index by holding securities that approximate the index’s composition.
For example, an ETF may seek to track the S&P 500, while the S&P 500 itself remains a benchmark calculation.
ETF vs individual stock
An individual stock represents ownership in one company. An ETF can hold dozens, hundreds or even thousands of securities. That can reduce exposure to one company-specific event, although it does not remove overall market risk.
What are common types of ETFs?
Broad-market ETFs seek exposure to large indexes. Sector ETFs focus on areas such as technology, financials or energy. Bond ETFs hold fixed-income securities. Commodity-related ETFs can provide exposure to assets such as gold, though the legal structure and method of obtaining that exposure can vary significantly between products.
What is an expense ratio?
Fund providers charge operating expenses. These costs are commonly expressed as an annual expense ratio. Even a small percentage can matter over long investment periods, so costs should be considered alongside the fund’s objective and tracking quality.
What is tracking error?
An ETF designed to follow an index may not match its benchmark perfectly. Fees, rebalancing, taxes, cash holdings and portfolio implementation can create differences between the fund’s return and the index return.
Does ETF liquidity matter?
Yes. ETF shares trade in the market with bids and asks. The liquidity of both the ETF itself and its underlying holdings can affect spreads and execution. Highly traded broad-market ETFs may have tight spreads, while specialized products can be less liquid.
Are leveraged ETFs the same as normal ETFs?
No. Leveraged and inverse ETFs use derivatives or borrowing to target amplified or opposite daily returns. Their path-dependent structure can produce results over multiple days that differ significantly from simply multiplying an index’s long-term return. They require additional understanding and risk control.
Bottom line
ETFs make it possible to trade or invest in a basket through one exchange-listed instrument. They can be efficient tools, but investors still need to understand the underlying exposure, costs, liquidity and structure.
Continue with What Is a Stock Market Index?.
This article is educational only and is not financial advice.