ETF Basics: What You Need to Know

Mutual funds are 100 years old this year, but they have a formidable competitor for investor dollars. In recent years, exchange-traded funds (ETFs) have been gaining market share versus mutual funds. This post describes what ETFs are and how they differ from mutual funds.

Like mutual funds, exchange-traded funds (ETFs) are a popular investment that provides broad diversification that helps reduce investment risk. In a sentence, most available ETFs are passively managed portfolios of securities that track a market index and trade like a stock.

More specifically, ETFs, which began in 1993 (vs. 1924 for mutual funds), are a cross between stocks and index mutual funds that track market indices such as the Standard & Poor’s 500 (tracked by ETFs known as SPDRS, ticker symbol SPY).

A big difference between index funds and ETFs is that ETFs are listed on a stock exchange and trade like stocks. Thus, their prices constantly fluctuate throughout each trading day (i.e., intraday trading), unlike the price (net asset value or NAV) of mutual fund shares which is determined once at the close of each trading day.

A second difference is expenses. ETFs generally have lower expense ratios (expenses as a percentage of assets) than comparable index funds. Competition is stiff among ETF providers, which has helped keep a lid on expenses. Some ETFs charge expense ratios as little as 0.03%.

A third difference is their tax efficiency with respect to taxes on investment earnings. With ETFs, investors control the timing of the sale of their shares and resulting taxable income. With mutual funds, decisions to sell securities and distribute capital gains are made by the fund manager and individual investors have no control over their timing.

The most popular ETF, so-called “Spiders” (trading symbol: SPY), an acronym for Standard & Poor’s Depository Receipts, tracks the Standard & Poor’s (S&P) 500 index of large U.S. company stocks. Another popular ETF, trading symbol: QQQ, tracks the NASDAQ 100 index of small U.S. company stocks.  

There are also ETFs that track indexes for various industry sectors (e.g., energy, financial services, healthcare, real estate, and technology), different company sizes (e.g., large-, mid-, and small- capitalization stocks), and dozens of foreign countries or regions of the world.

Experts recommend starting simple with just a few ETFs.  The AAII (American Association of Individual Investors) Journal suggests three types of ETFs as core investments: a total stock market ETF (tracks all U.S. stocks), a total international ETF (tracks stocks from all foreign counties), and an intermediate-term U.S. government or municipal bond ETF. 

More sophisticated investors can add on additional layers such as large-cap, mid-cap, and small-cap ETFs, ETFS from different industry sectors, and ETFs from specific regions such as Europe or emerging markets. 

For additional information about ETFs, review the bulletin Exchange-Traded Funds (ETFs) from the U.S. Securities and Exchange Commission.