What Is an Exchange Traded Fund (ETF)?
The Pros and Cons of ETFs as an Investment Choice
Exchange-traded funds (ETFs) are investment securities that are similar to mutual funds but trade like stocks. Investors typically buy ETFs to passively track an index, such as the S&P 500, and to invest at a lower cost than many index funds.
What Is an ETF?
An ETF is a type of investment security that passively tracks an underlying benchmark index, such as the S&P 500. ETFs are baskets of securities that have multiple stocks, bonds, and other assets, or sometimes even just one asset like gold . This quality makes ETFs similar to mutual funds, especially index funds. However, unlike mutual funds, ETFs trade like stocks, meaning that investors can buy and sell shares on an exchange.
The versatility of ETFs makes them good tools for investing either in broad market indices like the S&P 500 or in sectors, such as technology or health, and in sub-sectors, such as social media. Other ETFs have taken advantage of investment trends, such as cannabis stocks and robotics.
A few ETFs include the Vanguard Total Stock Market ETF (VTI), Schwab U.S. Large-Cap ETF (SCHX), Global X Robotics & Artificial Intelligence ETF (BOTZ), and iShares Global Clean Energy ETF (ICLN).
How to Buy and Sell ETFs
Buying and selling ETFs can be easy. You can buy and sell ETFs through brokerages such as Fidelity, Charles Schwab or Robinhood. You can also buy and sell at any time during normal trading hours, just like with stocks.
When you place an ETF trade, you’ll have to choose a certain number of shares to buy or sell, just like you would with a stock. For example, if you want to buy $1,000 of a particular ETF and it trades at $100 per share, you’ll need to place a buy order for 10 shares, using the ETF’s ticker symbol.
NOTE: While ETFs trade on an exchange like stocks, they have a unique process of share creation and redemption. A third party, known as “authorized participants,” or APs, handles the buying and selling of the underlying securities of the ETF, generally in large chunks of shares known as creation units. That way, the ETF doesn’t absorb those trading costs, and the price of the fund stays closely tied to that of the underlying index, regardless of supply and demand.
Pros and Cons of ETFs
ETFs can be smart investment tools for all types of investors. However, they are not ideal for everyone. Before investing in ETFs, it’s wise to know the pros and cons.
Trading costs can add up
May be narrowly focused
Temptation to trade
Like a mutual fund, an ETF is a collection or basket of securities, such as stocks or bonds. Investors can gain access to dozens, or even hundreds, of stocks or bonds in one ETF. Holding multiple investment securities in one fund reduces volatility, compared to buying just one or a few individual securities.
Most ETFs are passively managed, so there is no need for costly research or analysis. That, in turn, reduces management costs. These expenses must be considered as you determine if an exchange-traded fund is performing well enough to work in your portfolio.
ETF expense ratios, on average, are significantly lower than mutual funds. Many ETFs have expenses below 0.25%, or $25 for every $10,000 invested. Some ETFs have expenses as low as 0.03%. By contrast, the expense ratio for the average mutual fund in 2018 was about 0.76%.
Actively managed mutual funds trade within the fund, which creates capital gains distribution that is often taxable to the shareholder. While ETF gains are also taxable, their structure generally makes them more tax-efficient than mutual funds.
Like stocks, ETFs trade throughout the day on exchanges. That means that investors can place market orders, such as stop-loss orders and limit orders. An investor can put in a stop-loss order to automatically sell their ETF when it reaches a certain price.
Trading Costs Can Add Up
Like stocks, ETFs sometimes generate a small trading commission every time an investor buys or sells shares. Although the commission or transaction fees are very low, such as $3 per trade , the costs add up quickly if you’re making frequent trades. Some brokers also offer a selection of ETFs with no commissions.
Too Narrowly Focused
Many ETFs track a very specific sector benchmark or similar niche area of the market, such as technology. Those types of ETFs tend to have wider swings in price than a broader market index, such as the S&P 500.
Temptation to Trade
ETFs can be traded during the day, like stocks. But the ability to buy and sell so quickly can make it tempting to dabble in market-timing, which can be more harmful than good.
The Bottom Line
ETFs can be smart investment tools for almost any kind of investor. They offer low expenses, diversification, and versatility in trading. In some cases, that makes them a better choice than stocks, bonds, and mutual funds. In other cases, the trading costs and lack of diversification in niche area funds make ETFs less than ideal.
Short-term investors and day-traders who need the ability to trade intraday and use market orders benefit the most from ETFs. Long-term investors that do not trade frequently can also take advantage of the low expense ratios of ETFs while minimizing trading costs. Finally, investors with taxable brokerage accounts may also take advantage of the tax-efficiency of ETFs.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.
Investor.gov: Exchange-Traded Funds
FINRA: ETFs: What You Need to Know
Securities and Exchange Commission: Investor Bulletin: Exchange-Traded Funds (ETFs)
U.S. Securities and Exchange Commission: Beginners Guide to Asset Allocation, Diversification, and Rebalancing, "Diversification 101"
Investment Company Institute: Trends in the Expenses and Fees of Funds
Vanguard: Vanguard S&P 500 ETF
Investment Company Institute: Expense Ratios of Actively Managed and Index Funds Have Declined for More Than Two Decades
U.S. Securities and Exchange Commission: Mutual Funds and Exchange-Traded Funds (ETFs) – A Guide for Investors
FINRA: ETFs: What You Need to Know
Merrill Lynch: Merrill Edge Self-Directed Brokerage Fees, Accessed Nov. 15, 2019
ETrade: Exchange Traded Funds
U.S. Securities and Exchange Commission: Fast Answers, Exchange-Traded Funds (ETFs)