What Is an ETF?

An exchange traded fund, or ETF, is a basket of investments that trades on a stock exchange as a single share. Buying one share of an S&P 500 ETF gives you a small slice of all 500 companies in that index. ETFs combine the diversification of a fund with the convenience of a stock: you can buy or sell them any time the market is open, at a live price.

How an ETF works#

An ETF company creates a fund that holds a portfolio, usually designed to track an index. The fund is divided into shares that trade on an exchange. Their price stays close to the value of the underlying holdings, called the net asset value or NAV, through a mechanism involving large trading firms known as authorised participants.

The first US ETF, the SPDR S&P 500 ETF Trust (ticker SPY), launched in 1993 and is still one of the most traded securities in the world.

Types of ETFs#

ETFs vs mutual funds#

For most index investors, both can work. ETFs suit traders better because of intraday pricing, the ability to use limit and stop orders and, for popular funds, very tight spreads.

What ETFs cost#

• Expense ratio: a yearly fee taken from the fund's assets. Broad index ETFs can cost well under 0.1% a year; specialised ETFs often cost more.
• Spread: the gap between bid and ask when you trade. Large ETFs often trade one cent wide; small ones can be much wider.
• Tracking difference: how far the fund's return differs from its index over time, from fees and trading costs.

How to choose an ETF#

1. Know what it holds. Read the fund's index and top holdings, not just its name.
2. Check the expense ratio and compare with similar funds.
3. Check liquidity: average daily volume, assets under management and typical spread.
4. Understand the structure: leveraged, inverse and futures based funds behave differently from simple stock funds.
5. Look at tracking: how closely past returns matched the index.

Frequently asked questions#

Are ETFs good for beginners?#

Broad, low cost index ETFs are one of the simplest ways for beginners to invest in many companies at once. Leveraged and complex ETFs are not beginner products.

Can an ETF go to zero?#

A broad index ETF would only go to zero if every company in it became worthless, which is extremely unlikely. Narrow, leveraged or inverse ETFs can lose most of their value.

Do ETFs pay dividends?#

Many do. ETFs holding dividend paying stocks or interest paying bonds usually pass that income to shareholders, often quarterly or monthly.

Sources#

• U.S. Securities and Exchange Commission, Exchange traded funds
• Wikipedia, Exchange traded fund