What is an exchange-traded fund (ETF)?

An exchange-traded fund (ETF) is a little like an individual stock and a little like a mutual fund, but there are key differences with both.

What is an ETF, and how does it work?

Exchange-traded funds (ETFs) are a relatively new type of investment, and they have grown rapidly over the past few decades. First developed in the 1990s, they were designed to allow individual investors to purchase passive index funds. Now, there are nearly ten thousand ETF options covering many different indexes, industries, and investment strategies.¹ Part of the reason for that growth has been how attractive ETFs have become for investors seeking diversification without the traditionally higher costs of mutual funds. They can make a great addition to any long-term investment strategy by combining some of both the individual stock and mutual fund attributes:

ETFs offer diversification

If you choose to invest in individual stocks, your return is directly tied to how well that specific company does. Similar to mutual funds, ETFs allow you an easy way to diversify your portfolio. Instead of buying one share in one company, you can purchase fractions of shares in hundreds of companies.

There are many types of ETFs

ETFs started as generalized index-fund investment vehicles, but they have rapidly expanded to include several different options that align with different investment strategies. They range from ETFs that track entire indexes (like the S&P 500) to ETFs that track very specific industry segments (like foreign medical technology companies). In addition to just stocks, there are ETFs that specialize in bonds, in commodities like oil or gold, or even in currencies. Each has different risks and rewards and aligns with different investment strategies. Depending on the underlying investment strategy, ETFs can pay dividends as well.

One primary difference to consider is the difference between passively managed vs. actively managed ETFs. Most ETFs are passive and track their specific group of assets over time. Actively managed ETFs have portfolio managers regularly changing what assets are in the ETF. They can offer more aggressive growth, but they also come with higher administrative costs.

Related: Learn more about different types of ETFs

Are ETFs safe investments?

As with any investment, ETFs will fluctuate in value. They will  go up, and they will go down and can lose money. ETFs are regulated by the Securities and Exchange Commission and are subject to many of the same rules that apply to other investment vehicles. Generally, ETFs (and mutual funds) are considered less risky than individual stocks due to diversification. For that reason, many people use ETFs for retirement as part of a balanced portfolio. However, diversification does not assure a profit or protect against market loss. Learn more about different investments.

Pros and cons of ETFs

Are ETFs a good investment? As with all investments, that can vary. Even though ETFs have many attractive qualities, they may not be right for every investor. It’s important to understand potential drawbacks and how they might affect your personal strategy. Here are some things to consider:

ETF pros:

• Trade like stocks

• Offer varying levels of diversification

• Often lower fees

• Tax efficiencies

ETF cons:

• Fewer overall options than with mutual funds

• Intraday trading isn’t always necessary

• Management fees could be higher than for individual stocks

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¹“ETFGI Reports Global ETFs Industry Ended 2021 with a Record US$10.27 Trillion in Assets and Record Net Inflows of US$1.29 Trillion,” ETFGI, January 25, 2022. 

²Mike Piershale, “ETFs vs. Mutual Funds: Why Investors Who Hate Fees Should Love ETFs,” Kiplinger, April 10, 2021.