ETF Beginners Guide: What Are Exchange-Traded Funds?

Although trading stocks seems glamorous, the truth is most people are better off safely and successfully investing only in exchanged-traded funds (ETFs). But what are these investments, commonly referred to as ETFs?

Exchange-traded funds work like mutual funds in many ways. Your funds are pooled with funds from other investors to buy stock, bonds and other underlying assets. But unlike mutual funds, ETFs are bought and sold like stocks.

There are many benefits to ETFs, and they could be a perfect fit for your investment needs. Read on to learn more about what exchange-traded funds are, how they work and how you can get started with this popular investment.

Table of Contents

What Is an ETF?What to look for in an ETF?Different Types of Exchange-Traded FundsETF Costs and FeesETFs Are a Great Idea for Retirement Accounts and More

What Is an ETF?

An exchange-traded fund is a type of investment fund that trades like a stock. You can buy and sell ETFs on the same exchanges as shares of stock, most commonly the New York Stock Exchange and Nasdaq.

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Like mutual funds, a single purchase can give you access to diverse underlying assets. With an S&P 500 index fund, for example, buying a single share gives you exposure to 500 stocks at once. That makes ETFs great for newer investors who don’t have the assets to build a diverse portfolio on their own.

Each ETF has a name and ticker symbol. Using that ticker, you can trade during market hours. The biggest and oldest ETF is the SPDR S&P 500 from State Street Global Advisors. Also called the Spider or its ticker, SPY, it holds a massive $278 billion in assets.

At the end of 2018, all ETFs held a total of $4.7 trillion, according to data from Statista. That compares to $17.7 trillion in traditional mutual funds.

While they are not as big as mutual funds, they may be a better choice for many investors due to low costs, high liquidity and their relative performance compared to actively managed funds. That could translate to a higher retirement account balance down the road.

What to look for in an ETF?

Low expenses – First and foremost, an exchange-traded fund should be inexpensive to carry. As an individual investor, you likely find ETFs attractive because of their low costs. Luckily for you, competition is holding down fees, and many investors find that they can get a better deal just by shopping around. Want exposure to the Russell 2000 index? There are actually two ETFs that track this same index. One from Vanguard has an expense ratio of .22%, whereas one from iShares charges .28%. Both being the same and liquid enough for individual investors, the lower fee fund is an obvious choice.Reliable tracking – Exchange-traded funds are designed to track an index. Tracking error results when the ETF fails to keep the pace with the underlying index. Tracking errors happen for a variety of reasons – the underlying index constituents may be illiquid (such is the case in emerging market funds), the index may be impossible to replicate with an ETF (ETFs have diversification requirements that indexes may not have), or because the fund itself is illiquid and thus moves less accurately with the underlying index. Always compare an ETF to the return of its underlying index over a period spanning a few years.Low or no commissions – If at all possible, look for ETFs that you can invest in without paying a trading commission. Brokers like Fidelity, Charles Schwab, and TD Ameritrade offer a select list of zero-commission ETFs that investors can buy at no cost to them.Low bid/ask spreads – Some ETFs are launched only to find little to no interest from the public. These small funds trade sporadically, often failing to attract enough interest that the ETF can go hours or even days without a single trade. Be aware of the spread between bid and ask prices on smaller funds as the spread represents a cost that you will have to pay to buy or sell a fund. The most liquid ETFs have bid/ask spreads equal to a penny or less. Always buy ETFs with a limit order so that your order is filled at the price you want to pay, not the price at which the market wants to sell the fund to you.A known index – Hands off passive investors will want to stick to funds with a known index. The S&P SmallCap index is a well known index, as is the S&P 500. Fund companies like Vanguard are going down the rabbit hole, leaving well-known and understood indexes to use less tested and less researched indexes to drive down fees for investors. A good investment requires that you can do your due diligence – stick with indexes that are well-known in the investment community and avoid new indexes that lack the track record and public name.

Different Types of Exchange-Traded Funds

ETFs come in broad categories, just like mutual funds. Major asset classes include equity (stocks), bonds, commodities, money markets, precious metals and real estate. There are ETFs focused on different regions, countries, market sectors, assets and themes. There’s an ETF for just about any investment plan or focus.

A large number of ETFs are index funds. This means they go up and down with major indices like the S&P 500, Russel 3000, or Dow Jones Industrial Average. For example, if the S&P 500 goes up 2% in a day, all S&P 500 index funds will go up the same 2%.

ETFs can fill many different roles in your portfolio. For example, if you are looking to earn money from your portfolio, you could buy dividend and fixed-income ETFs that make regular payments to shareholders. Not too long ago, I bought a real estate ETF because I didn’t have enough cash to buy actual real estate.

If you think the dollar is about to fall and gold will go up, there are gold and other precious metals ETFs. If you are gung-ho on agriculture, you could invest in a commodities or agriculture stock ETF.

In total, there are about 2,000 ETFs to choose from. That’s a ton of options to customize your ETF portfolio.

ETF Costs and Fees

Another similarity with mutual funds: ETFs are not free. However, they can be incredibly cheap. At most popular discount brokerages, there is a list of ETFs you can buy and sell with no trade fees or commissions.

Once you own them, each ETF charges an expense ratio. This is a fee based on the total size of your portfolio. An ETF with a 0.10% expense ratio charges you $1 per year for every $1,000 invested in that ETF.

The cheapest ETF right now charges 0.02%. The most expensive charges over 9%, though only 17 of about 2,000 ETFs charge anything over 2%, according to a list of ETFs at EFTdb.

ETFs Are a Great Idea for Retirement Accounts and More

I have a goodly portion of my family’s retirement funds in ETFs. For most investors, a long-term focus with a portfolio containing mostly low-fee index funds is the best plan. Those can include ETFs, mutual funds or a combination of the two.

While not all investors should buy single stocks, most investors should invest in ETFs. That’s why popular robo advisors, finance gurus and so many people use ETFs in building investment plans and strategies. They are probably right for you too. We recommend checking out TD Ameritrade and E*TRADE for ETFs.

What do you look for in an ETF, and which are your favorites?