Everything you need to know about ETFs: what they are, how they work, and why they have become the most popular investment vehicle.
- How ETFs Work An ETF is created by an asset management company that decides what the fund will hold.
- Mutual funds sometimes offer the advantage of being able to invest exact dollar amounts (you can invest exactly $500), while ETFs are purchased in share quantities (you might need to buy 2.3 shares at $217 each to get close to $500, though fractional share investing has largely eliminated this distinction).
- Dividend ETFs focus on companies that pay above-average dividends.
ETF stands for Exchange-Traded Fund, and it has become the default investment vehicle for a generation of investors. An ETF is a fund that holds a collection of investments, such as stocks, bonds, or commodities, and trades on a stock exchange just like an individual stock. When you buy a share of an ETF, you are buying a small piece of everything the fund holds.
How ETFs Work
An ETF is created by an asset management company that decides what the fund will hold. A total stock market ETF holds shares in thousands of companies. An S&P 500 ETF holds shares in the 500 largest U.S. companies. A bond ETF holds a portfolio of bonds. The fund manager assembles the portfolio, and shares of the fund are then listed on a stock exchange where anyone with a brokerage account can buy or sell them.
When you buy a share of an ETF, you do not directly own the underlying stocks or bonds. You own a share of the fund, which in turn owns those securities. Your share entitles you to a proportional claim on the fund’s assets and income. If the fund holds 500 stocks and you own one share out of a million, you effectively own a tiny piece of each of those 500 companies.
ETFs vs Mutual Funds
ETFs and mutual funds are similar in concept. Both are pooled investment vehicles that hold a diversified basket of securities. The key differences are in how they trade and what they cost. ETFs trade on an exchange throughout the day at market prices, just like stocks. You can buy or sell at any time during market hours and see the price in real time. Mutual funds are priced once per day, after the market closes, and all orders placed during the day execute at that end-of-day price.
ETFs tend to be more tax-efficient than mutual funds due to their unique creation and redemption mechanism. They also often have lower expense ratios. Mutual funds sometimes offer the advantage of being able to invest exact dollar amounts (you can invest exactly $500), while ETFs are purchased in share quantities (you might need to buy 2.3 shares at $217 each to get close to $500, though fractional share investing has largely eliminated this distinction).
For most individual investors, ETFs are the preferred choice due to their lower costs, trading flexibility, and tax efficiency. The differences are not enormous, however, and a low-cost index mutual fund is an equally good choice if that is what your brokerage or retirement plan offers.
Types of ETFs
The ETF universe has expanded dramatically and now covers nearly every conceivable investment strategy. Broad market ETFs track entire markets like the total U.S. stock market or total international stocks. Sector ETFs focus on specific industries like technology, healthcare, or energy. Bond ETFs hold government, corporate, or municipal bonds. Dividend ETFs focus on companies that pay above-average dividends. And thematic ETFs target specific trends or themes.
For beginners, broad market ETFs are the most appropriate starting point. A single total stock market ETF provides exposure to thousands of companies across all sectors, which is more diversification than most investors need. Specialty and thematic ETFs are tools for more experienced investors who want to fine-tune their exposure to specific areas of the market.
Costs and Fees
ETFs charge an expense ratio, which is an annual fee expressed as a percentage of your investment. The best broad market ETFs charge expense ratios of 0.03% or less, making them among the cheapest investment products available. Specialty and actively managed ETFs charge higher fees, sometimes 0.50% to 1.00% or more.
Most brokerages charge zero commissions to buy and sell ETFs, meaning the only ongoing cost is the expense ratio. This combination of zero trading commissions and minimal expense ratios makes ETFs remarkably cost-effective, particularly for long-term investors who buy and hold.
Getting Started With ETFs
If you are new to investing, start with one or two broad market ETFs. A total U.S. stock market ETF gives you domestic exposure. Add a total international stock ETF for global diversification. If you want to include bonds, add a total bond market ETF. This three-ETF portfolio covers the entire global investment landscape and can be assembled in minutes through any brokerage account.
All investments carry risk, including loss of principal. ETF prices fluctuate with market conditions. See our financial disclaimer for important disclosures.
A worked example
Imagine investing $500/month for 30 years at an average 8% annual return. Total contributions: $180,000. Final balance: roughly $745,000. The first $180,000 is yours; the other $565,000 is compounded growth. Now imagine starting 10 years later - same $500/month for 20 years at 8%: contributions $120,000, balance $295,000. The 10 years cost you about $450,000 in foregone growth. Time in the market beats timing the market by an enormous margin.
Common mistakes to avoid
- Trying to time the market. Studies consistently show that missing just the 10 best market days over 20 years cuts returns roughly in half. You can't reliably know which days those will be.
- Picking individual stocks based on news or tips. By the time it's news, the price already reflects it. Index funds aren't exciting but they outperform most retail stock-picking by a wide margin.
- Panic-selling in a downturn. Selling locks in losses. Markets have always recovered. The investors who do worst are the ones who sell low and re-buy high.
Frequently asked questions
How much money do I need to start investing?
Less than you think. Most major brokerages (Fidelity, Schwab, Vanguard) have no minimum balance. Fractional shares mean you can buy a $1 slice of any stock or ETF. Realistically, $50-100/month into a low-cost index fund is enough to start building real wealth over decades.
Is it too late to start investing at 40, 50, or 60?
No - but the strategy changes. At 40 you still have 25 years of compounding ahead. At 50 the focus shifts to maximizing 401(k) contributions (you can contribute extra after age 50). At 60 it's about preserving what you have and shifting to a more conservative allocation. The worst day to start was 20 years ago; the second-best is today.
Should I invest in individual stocks or index funds?
Index funds for nearly everyone. Over 20-year periods, 80%+ of professional fund managers fail to beat the index - and they have PhD analysts and millions in research budgets. A target-date retirement fund or a total-market index ETF will outperform what almost any retail investor can do picking individual stocks.
What is the safest investment?
FDIC-insured savings accounts and CDs (up to $250,000 per bank per ownership type) and US Treasury bills/bonds are the safest. They won't make you rich but they won't lose principal. For real (inflation-adjusted) safety, TIPS and I-Bonds protect against inflation, which traditional bonds don't.
How much should I have in stocks vs bonds?
A starting heuristic is 'your age in bonds' - so a 30-year-old holds 70% stocks / 30% bonds. Many financial planners now suggest something more aggressive given longer lifespans: 110 or 120 minus your age in stocks. Target-date funds do this automatically based on your retirement year.
Where this guide fits in
This article is part of the Chase The Dollar editorial library of practical money guides. We update guides as rules and rates change. If you spot a mistake or want us to cover a topic, the contact form is the fastest way to reach us.