What is an ETF? Options for Low-Cost Diversification

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An exchange-traded fund, or ETF, is an investment that gives investors the ability to pool their money into a fund, spreading it across an array of stocks, bonds or other asset classes. While ETFs are similar to mutual funds, they trade on an exchange like stocks. They’re a good choice for investors seeking diversification with low investments minimums and are a great way to track an index at relatively low cost.

Because of their baked-in diversification, ETFs have quickly become the bread and butter of investing. This article explores how ETFs work, common types of ETFs and the advantages and disadvantages of ETFs as an investment.

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What is an ETF?

An ETF is a basket of securities, which can range from traditional assets, such as stocks and bonds, to alternative assets, like commodities and real estate. You can buy or sell ETFs from a brokerage firm through a stock exchange. They are traded like stocks, with a ticker symbol and price fluctuations throughout the day. Instead of having to buy and sell each security individually, however, an ETF conveniently bundles all of the securities into one fund.

An ETF can include tens, hundreds or even thousands of stocks, bonds or other asset classes, or a mix of multiple types. ETFs are designed to track the underlying value of an index (like the S&P 500) or an asset class (like gold).

The beauty of ETFs is that they combine the core benefit of mutual funds — diversification — with the liquidity of stocks. ETFs really started to gain traction as an investment product in the early 1990s and have since exploded in popularity; currently, there is an estimated $1 trillion invested in ETFs, with over 1,000 ETF products available on U.S. stock exchanges.

Do ETFs pay dividends?

There are a number of ETFs that pay out dividends — portions of a company’s profits that are paid out to its shareholders — but not all do. If you own stock through your ETF, the company will pay out its dividends to your ETF, which are then passed along to you through a fund dividend.

Depending on your ETF, dividends may be paid out quarterly or at another time interval, and they can be qualified or nonqualified, which impacts how they are taxed. Qualified dividends can be taxed at the capital gains rate, while nonqualified dividends are taxed at ordinary income rates.

How are ETFs taxed?

With an ETF, you will have to pay taxes on earnings from any dividends, interest or capital gains earned, as it is considered taxable income. You will need to report those earnings as income on your 1099 form come tax time.

ETFs vs. mutual funds: What’s the difference?

Type of InvestmentCostBuying and sellingDiversification
ETFLower fees because they are often passively managedCan be bought and sold throughout the day, with prices fluctuating Offers excellent diversification
Mutual fundHigher fees because they are often actively managedTransactions can only happen once a day, at market closeOffers excellent diversification

ETFs operate in a similar fashion to mutual funds. Both are investment products that allow you to invest in a wide array of securities all at once, giving you instant diversification. The biggest difference between ETFs and mutual funds, though, is how they are traded.

Like stocks, you can buy and sell ETFs at any time throughout the day, meaning investors have the freedom to react to news or price changes, and buy or sell as they wish. Meanwhile, traditional mutual funds can only be bought and sold once a day, after the market closes at 4 p.m. EST.

Additionally, ETFs tend to have lower investment minimums and charge lower management fees than mutual funds, as they are more passively managed. Mutual funds are typically considered actively managed because they use a fund manager who will buy and sell securities with the goal of beating the market. Meanwhile, ETFs typically don’t aim to beat the market, but mirror it, often by tracking a particular index.

ETFs are also considered more tax-efficient because they are structured to trigger a smaller number of taxable events since index-tracking ETFs don’t make a lot of trades.

Pros and cons of ETF Investing

  • Diversification: The hallmark of ETFs is the mass diversification they offer as an investment. Since they can consist of hundreds — even thousands — of stocks, bonds or other asset classes in a single fund, chances are if one stock or bond is performing poorly, there are others that are performing well. In other words, ETFs are an easy way to make sure you don’t put all of your eggs in one basket.
  • Low fees: ETFs are famous for boasting relatively low fees, since they are mainly passively managed. They are also known to not have investment minimums, which mutual funds often have, and they are considered to be more tax-efficient. That being said, some ETFs (like those that hold precious metals) can be taxed at a higher rate.
  • Flexibility: Unlike mutual funds, ETFs have the flexibility of stocks and can be bought and sold throughout the day at fluctuating price points. Investors can also put in a variety of orders — such as buy on margin or limit orders — with ETFs.
  • Trading costs: Despite having relatively low fees, ETFs can still be subject to brokerage commissions. Many ETFs have pivoted to commission-free ETFs to remain competitive, but not all. In fact, commission fees of ETFs can climb to $19.95, which can certainly add up, especially if you are trading frequently.
  • Higher bid-ask spreads: One hidden cost of ETFs has to do with their bid-ask spreads, which is the amount by which the ask price exceeds the bid price. Some ETFs trade at much smaller volumes, which can widen the bid-ask spread. A wider bid-ask spread chips away at potential returns.
  • Outperformance: Since ETFs are passively managed, they are designed to mirror the performance of a particular index unlike mutual funds, which aim to outperform the market. This could mean ETFs miss out on the above-market value appeal that mutual funds could offer.

What types of ETFs can I invest in?

ETFs are not one-size-fits-all, and they come in a myriad of flavors. Below is just a small sampling of the types of ETFs that you can invest in.

Type of ETFWhat it includesReal-world example
Bond ETFsTracks a wide array of bonds, including U.S. Treasury, corporate, municipal, international, high-yield and moreiShares iBoxx Investment Grade Corporate Bond ETF
Market ETFsTracks a particular index, like the S&P 500 or NASDAQSPDR S&P 500 ETF Trust
Commodity ETFsInvests or tracks the price of a particular commodity like gold, oil or corn United States 12 Month Oil Fund
Currency ETFsTracks a single currency or a basket of currencies Invesco DB US Dollar Index Bullish Fund
Industry ETFsTracks a particular industry like banking, health care or technology Vanguard Industrial ETF
Inverse ETFsAttempts to profit off of a decline in the underlying market or indexProShares Short S&P 500

How to invest in ETFs

If you’re in the market for an ETF, here’s what you need to do to get started.

  1. Open a brokerage account: You will need to pick an account provider (or brokerage firm) to purchase your ETF from. Prioritize brokers that offer commission-free trades, no account service fees, the availability of research and educational tools and superior customer service. ETFs are offered by household names including Vanguard, Fidelity, E*TRADE and TD Ameritrade. Check out our ranking of the best online brokers to start your search.
  2. Select an ETF: With thousands of ETFs available in the U.S., selecting the ETF that is right for you can be a daunting process. Start by deciding which underlying index you’d like your ETF to track (such as the S&P 500 or NASDAQ), and then opt for funds with low fees and strong performance records. Your brokerage firm will likely offer tools that would enable you to sift through the thousands of ETFs available to you based on factors like strategy, asset class, industry and more.
  3. Invest: Once you’ve selected your desired ETF, it’s time to invest. The process of investing in ETFs is the same as investing in stocks: You will place your trade with your brokerage firm, where it will buy and sell shares of your ETF within your account. Since it is so easy to trade ETFs, be wary of frequent trading, which is an ill-advised investing practice. Instead, sit back and relax.

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