Offering low-cost access to virtually every corner of the market, ETFs allow investors big and small to build institutional-caliber portfolios with lower costs and better transparency than ever before.
But what exactly is an ETF? And how does it provide these benefits?
Want To Know How ETFs Work? First Understand How Mutual Funds Work
To understand how ETFs work, the best place to start is with something familiar, like a traditional mutual fund.
Imagine half a dozen investors, sitting at home, each trying to figure out the best way to invest in the stock market. They could each go out and buy a few stocks on their own, but who has the time or resources to manage a portfolio of 50 or 100 stocks?
Instead, they decide to band together. They pool all of their money and hire a professional investment manager to invest it for them.
To keep track of who invested what, each investor receives “shares,” representing their stake in the total investment.
Because it’s your money, you want to know how much your investment is worth … every day. So every day, the mutual fund tallies up the value of everything it owns and divides it by the number of shares that exist. Whammo-presto: You know exactly what each share is worth.
If you want to buy more shares, you know the amount of cash to send the mutual fund for each share. If you want to sell shares, you know exactly how much cash to expect in return.
It’s an elegant system, and mutual funds have existed for close to 100 years. They currently provide exposure to stocks, bonds, commodities and other assets.
But What About ETFs?
All that’s great, but you didn’t come to this website to learn about mutual funds. You came to learn about ETFs.
So what is an ETF? Well, it’s a mutual fund too. It’s a pooled investment vehicle that offers diversified exposure to a particular area of the market. It can invest in stocks, bonds, commodities, currencies, options or a blend of assets. Investors buy shares, which represent a proportional interest in the pooled assets.
It’s a mutual fund in every aspect … except one.
And that’s a big one, which is hinted at in its very name: exchange-traded funds.
As an exchange-traded fund, you buy shares in an ETF directly from any brokerage account. Just like you buy shares in a stock, you can enter a buy order in your Schwab or Fidelity account and buy any ETF you want.
You can also do it whenever you want. Whereas orders to buy or sell a traditional mutual fund can be processed only once per day (after the close of trading), ETF trades can take place any time the market is open. You can buy shares in the morning and sell them in the afternoon. You can buy them at 10 a.m., sell them at 11 a.m. and buy them again after lunch if you want.
You can also perform all sorts of stocklike strategies with ETFs that you never could with mutual funds: selling short, placing stop-loss or limit orders, even buying on margin.
And that’s just the beginning: The fact that ETFs are “exchange-traded” creates a series of other benefits that, according to many market observers, makes them a better overall choice than traditional mutual funds for many reasons: lower costs, better tax efficiency and more. Of course, in other situations, they can be worse: commissions, trading spreads and other risks (as covering in our article, What Risks Are There In ETFs?)
What is an ETF? In sum, it’s a tool that allows investors to access different corners of the market—everything from U.K. equities to Chinese tech stocks to high-yield bonds, spot gold bullion and more—at low costs, from the comfort of a traditional brokerage account.
It’s like a mutual fund. Or, perhaps, a mutual fund: version 2.0.
Next: What Is An ETN?
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