Exchange-Traded Funds (ETFs): Definition, Types, Pros and Cons
Want the ease of stock trading, but diversification benefits of mutual funds? ETFs combine the best of both.
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Exchange-traded funds are a type of investment fund that offers the best attributes of two popular assets: They have the diversification benefits of mutual funds while mimicking the ease with which stocks are traded.
What is an ETF?
An exchange-traded fund (ETF) is a basket of investments made up of assets such as stocks or bonds, which allow you to invest in many securities all at once. They often have lower fees than other types of funds and are traded more easily, too.
But as with all financial products, ETFs aren’t a one-size-fits-all solution. It's important to evaluate them on their own merits, including management costs and commission fees (if any), how easily you can buy or sell them, how they fit into your existing portfolio and their investment quality.
How do ETFs work?
Exchange-traded funds work like this: The fund provider owns the underlying assets, designs a fund to track their performance, and then sells shares in that fund to investors. Shareholders own a portion of an ETF, but they don’t own the underlying assets in the fund. Even so, investors in an ETF that tracks a stock index may get dividend payments for any dividend stocks in the index.
While ETFs are designed to track the value of an underlying asset or index — be it a commodity like gold or a basket of stocks such as the S&P 500 — they trade at market-determined prices that usually differ from that asset. What’s more, because of things like expenses, longer-term returns for an ETF will vary from those of its underlying asset.
Just like stocks, ETFs can be bought or sold at any time throughout the trading day (9:30 a.m. to 4 p.m. Eastern time), letting investors take advantage of intraday price fluctuations. This differs from mutual funds, which can only be purchased at the end of the trading day for a price that is calculated after the market closes.
» Ready to learn more? How to invest in ETFs
Types of ETFs
Exchange-traded funds may trade like stocks, but under the hood, they more closely resemble mutual funds and index funds, which can vary greatly in terms of their underlying assets and investment goals.
Below are a few common types of ETFs. These ETFs aren’t categorized by management type (passive or active) but rather by the types of investments held within the ETF. Interested in a general overview instead? See our full list of the best ETFs.
Sector ETFs: The U.S. stock market is divided into 11 sectors, and each is made up of companies that operate within that arena. Sector ETFs provide a way to invest in specific companies within those sectors, such as the health care, financial or industrial sectors. These can be especially useful to investors tracking business cycles, as some sectors tend to perform better during expansion periods and others better during contraction periods. Often, sector ETFs can carry higher risk than broad-market ETFs. Sector ETFs can give your portfolio exposure to an industry that intrigues you, such as gold ETFs or marijuana ETFs, with less risk than investing in a single company. (Learn more: Best semiconductor ETFs.)
Commodity ETFs: Commodities are raw goods that can be bought or sold, such as gold, coffee and crude oil. Commodity ETFs let you bundle these securities into a single investment. With commodity ETFs, it’s especially important to know what’s inside them — do you have ownership in the fund’s physical stockpile of the commodity, or do you own equity in companies that produce, transport and store these goods? Does the ETF contain futures contracts? Is the commodity considered a “collectible” in the eyes of the IRS? These factors can come with serious tax implications and varying risk levels. (Learn more: Best commodity ETFs.)
Stock ETFs: These comprise stocks and are usually meant for long-term growth. While typically less risky than individual stocks, they often carry slightly more risk than some of the others listed here, such as bond ETFs. (Learn more: ETFs vs. stocks.)
Exchange-traded notes (ETNs): ETNs are technically not ETFs but are often confused with them due to their similar names and characteristics. Like ETFs, ETNs trade on exchanges throughout the trading day and track a basket of assets. ETNs often track commodities, bonds, derivatives such as futures, or more exotic assets such as carbon credits rather than stocks.
Bond ETFs: Unlike individual bonds, bond ETFs don’t have a maturity date, so the most common use for them is to generate regular cash payments to the investor. These payments come from the interest generated by the individual bonds within the fund. Bond ETFs can be an excellent, lower-risk complement to stock ETFs. (Learn more: Best bond ETFs.)
International ETFs: Foreign stocks, along with U.S. stocks and bonds, are widely recommended for building a diverse portfolio. International ETFs, which may include investments in individual countries or specific country blocs, are an easy — and typically less risky — way to find these foreign investments. (Learn more: Best China ETFs.)
Bitcoin or crypto ETFs: In January 2024, the Securities and Exchange Commission approved a handful of spot Bitcoin ETFs, which directly track the price of Bitcoin. This makes the cryptocurrency more accessible to the average investor, as Bitcoin ETFs can be bought and sold directly in brokerage accounts. ETFs that offer exposure to other cryptocurrencies are still limited. Most crypto ETFs hold futures contracts or the stock of companies that either deal in or invest in the cryptocurrency markets. (Learn more: Best Bitcoin ETFs.)
Leveraged ETFs: Leveraged ETFs are exchange-traded funds that track an existing index. Rather than match that index’s returns, they aim to increase them by two or three times. (It's important to note that they don't just amplify that index's gains by two or three times — they also amplify its losses.) Imagine you had a traditional ETF that followed the S&P 500. If the S&P 500 went up by 2%, your ETF would likely also increase by about 2% because it holds most of the same companies the index tracks. If you had a leveraged S&P 500 ETF, that 2% gain could be magnified and instead be a 4% gain. While that’s great if the market is going up, it’s not so great if the market is going down. This is what makes leveraged ETFs riskier than other types of ETFs. (Learn more: Best leveraged ETFs.)
ETF benefits
Investors have flocked to exchange-traded funds because of their simplicity, relative cheapness and access to a diversified product.
Diversification: While it’s easy to think of diversification in the sense of the broad market verticals — stocks, bonds or a particular commodity, for example — ETFs also let investors diversify across horizontals, like industries. It would take a lot of money and effort to buy all the components of a particular basket, but with the click of a button, an ETF delivers those benefits to your portfolio.
Diversification can help safeguard your portfolio against market volatility. If you invested in just one industry, and that industry had a really bad year, it's likely your portfolio would have performed poorly too. By investing across different industries, company sizes, geographies and more, you give your portfolio more balance. Because ETFs are already well-diversified, you don't have to worry about creating diversification within your portfolio.
Transparency: Anyone with internet access can search the price activity for a particular ETF on an exchange. In addition, a fund’s holdings are disclosed each day to the public, whereas that happens monthly or quarterly with mutual funds. This transparency allows you to keep a close eye on what you're invested in. Say you really don't want to be invested in oil — you'd be able to spot those additions to your ETF more easily than with a mutual fund.
Tax benefits: ETFs have two major tax advantages over mutual funds.
If you invest in a mutual fund, you may have to pay capital gains taxes (which are taxes on profits from the sale of an asset, like a stock) throughout the lifetime of your investment. This is because mutual funds, particularly those that are actively managed, often trade assets more frequently than ETFs. Most ETFs, on the other hand, only incur capital gains taxes when you go to sell the investment. This means you'll pay less tax on your ETF investment overall.
As mutual fund managers are actively buying and selling investments and incurring capital gains taxes along the way, the investor may be exposed to both long-term and short-term capital gains tax. If you're invested in an ETF, you get to decide when to sell, making it easier to avoid those higher short-term capital gains tax rates.
ETF drawbacks
Exchange-traded funds may work well for some investors, but they aren't perfect.
Trading costs: ETF costs may not end with the expense ratio. Because ETFs are exchange-traded, they may be subject to commission fees from online brokers. Many brokers have decided to drop their ETF commissions to zero, but not all have.
Potential liquidity issues: As with any security, you’ll be at the whim of the current market prices when it comes time to sell, but ETFs that aren’t traded as frequently can be harder to unload.
Risk that the ETF will close: The primary reason this happens is that a fund hasn’t brought in enough assets to cover administrative costs. The biggest inconvenience of a shuttered ETF is that investors must sell sooner than they may have intended, possibly at a loss. There’s also the annoyance of having to reinvest that money and the potential for an unexpected tax burden.
How to choose the right ETFs for your portfolio
It's important to be aware that while costs generally are lower for ETFs, they also can vary widely from fund to fund, depending on the issuer as well as on complexity and demand. Even ETFs tracking the same index have different costs.
Most ETFs are passively managed investments; they simply track an index. Some investors prefer the hands-on approach of mutual funds, which are run by a professional manager who tries to outperform the market. There are actively managed ETFs that mimic mutual funds, but they come with higher fees. So consider your investing style before buying.
The explosion of this market has also seen some funds come to market that may not stack up on merit — borderline gimmicky funds that take a thin slice of the investing world and may not provide much diversification. Just because an ETF is cheap doesn’t necessarily mean it fits with your broader investment thesis.
ETFs vs. mutual funds vs. stocks
When comparing exchange-traded funds with other investments, ETFs stand out in a number of ways. Lower investment costs, better diversification and an increasing number of options are just a few of the benefits of ETFs.
Here are a few of the key differences between ETFs, mutual funds and stocks.
Exchange-traded funds (ETFs) | Mutual funds | Individual stocks | |
|---|---|---|---|
Fees | Average equity ETF expense ratio: 0.15%. | Average equity fund expense ratio: 0.42%, plus any additional fees. | Commission fee: Often $0, but can be as high as $5. |
How to buy | Traded during regular market hours and extended hours. | At the end of the trading day after markets close. | Traded during regular market hours and extended hours. |
Source for fee information: The Investment Company Institute, Trends in the Expenses and Fees of Funds.
ETFs vs. mutual funds: Generally speaking, ETFs have lower fees than mutual funds, which is a big part of their appeal. ETFs also offer better tax efficiency than mutual funds. There's generally more turnover within a mutual fund (especially those that are actively managed) relative to an ETF, and such buying and selling can result in capital gains.
Similarly, when investors go to sell a mutual fund, the manager will need to raise cash by selling securities, which can also accrue capital gains. In either scenario, investors will be on the hook for those taxes. The two products also have different management structures — typically active for mutual funds and passive for ETFs, though actively managed ETFs do exist. (Learn more about the differences between ETFs and mutual funds.)
ETFs vs. stocks: ETFs are made up of individual stocks and other investments, but there is no such thing as an "ETF stock." You can purchase a share of an ETF, but you cannot purchase stock in an ETF.
Like stocks, ETFs can be traded on exchanges and have unique ticker symbols that let you track their price activity. Unlike stocks, which represent just one company, ETFs represent a basket of stocks. Since ETFs include multiple assets, they may provide better diversification than a single stock. That diversification can help reduce your portfolio’s exposure to risk. (Learn more about the difference between ETFs and stocks.)
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