WHAT IS
AN ETF?

Exchange-traded funds (ETFs) are collections of stocks, bonds, or other investments, essentially combining the diversification benefits of a mutual fund with the flexibility of single stocks. In this guide, we’ll discuss the fundamentals of ETFs: what they are, how they work, and why you may want to consider investing in them.

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If you’re just starting your investing journey, you may be overwhelmed by all of the potential options. Without the right knowledge, it can be intimidating to start managing your portfolio yourself. 

Exchange-traded funds are a great place to start for those new to investing — they provide access to multiple markets with minimal fees and maximum diversification.

What are ETFs? 

Exchange-traded funds, or ETFs, are a type of investment that tracks the performance of a specific stock market index, industry sector, or asset.  You can buy and sell ETFs through a brokerage firm on a stock exchange. 

Think of an ETF like a basket of investments. Instead of investing in each individual asset, each with its own fees and levels of risk, you can invest in the basket.

ETFs are similar to mutual funds, but with a few key differences. Like a mutual fund, ETFs are a collection of stocks and bonds. Most mutual funds are actively managed; however, ETFs passively track the performance of an index. Because of this, ETFs often have lower fees and lower minimums to invest. 

ETFs also fluctuate in price and can be traded throughout the day, while mutual fund orders can only be placed once a day. This gives investors greater control over managing their portfolio and better access to the changing market conditions.

There are many different types of ETFs for virtually any asset class, including stocks, bonds, real estate, and cryptocurrencies. We’ll dive into that later on.

[ETFs] are mechanisms to achieve a certain goal, like phones. Traditional mutual funds were rotary phones. ETFs are smartphones: They do the same thing but are in a better package.

Dave Nadig

Why you may want to invest in ETFs 

ETFs provide access to both large and small businesses across the globe in various industries, allowing you to benefit from diverse growth opportunities. They provide immense flexibility, offering the opportunity to tailor your portfolio to fit your preferences. 

For example, you could invest in a specific sector — such as healthcare or technology. Or, you could invest in a particular trend (known as thematic investing), such as climate change or artificial intelligence. 

ETFs give you instant diversification without worrying about having to rebalance your portfolio or select the right individual stocks.

What are the benefits of ETFs?

Exchange-traded funds have become one of the most popular forms of investing for a reason. Some of the benefits of ETFs include: 

• Diversification: An ETF typically holds hundreds of individual securities, meaning you get exposure to many markets and asset classes at the same time. This helps to reduce the risk of large losses from an individual security or company.
• Easy management: ETFs are very easy to buy and sell on an exchange and come with low minimums. 
• Low costs: The cost of owning an ETF is considerably lower than managing a traditional mutual fund portfolio because they aren’t actively managed. Investors can construct portfolios quickly and easily without having to pay the extra fees associated with actively managed funds.
• Tax efficient: Because ETFs trade less frequently than actively managed funds, they generate fewer capital gains and less tax consequences for the investor. This allows investors to keep more of what they earn over time. 

Risks to investing in ETFs

There are, however, some facts to consider before you invest in ETFs. While they’re less risky than investing in individual stocks, ETFs are not without risk. Investors must understand their potential exposure and the types of risks they may face:

• Market risk: Like with most investments, you can’t guarantee how an ETF will perform. If investment prices drop due to market conditions, the price of the ETF will drop as well. 
• Liquidity risk: While ETFs are more liquid than mutual funds, investors may find it difficult to sell the fund quickly without loss during periods of volatile trading. 
• Tracking error: In some situations, an ETF’s performance does not match its underlying index. This may lead to discrepancies between the fund’s performance and its benchmarks.

Being educated about such risks can help to limit your overall losses. Adopting a long-term investment strategy can also help to reduce your risk. In the short term, stocks can be highly volatile. However, markets historically rise in the long run. 

How to get started investing with ETFs

The first step to investing in ETFs is to assess your goals and determine your risk tolerance. Before creating a plan, it’s important to do thorough research so that you can make well-informed decisions on the best investments for you. Here are a few tips to getting started: 

• Stay informed. Keeping up with industry news and trends can help you to identify a sector or theme you want to invest in. 
• Understand the fees associated with certain ETFs. Remember, not all brokers or trading platforms charge fees for ETF trading.
• Track the past performance of the ETF you’re researching and decide if it aligns with your personal investing goals and values. 
• Consider what the ETF is tracking. Is it following the broader market or a specific industry? 

Ultimately, creating a balanced portfolio of investments combined with an understanding of your goals will help you to select the most suitable ETF for you.

Final thoughts

Exchange-traded funds offer a great way for beginners to get started in the stock market. While they are not completely without risk, ETFs do offer many advantages and it’s likely you can find one to match your specific investment goals. 

With the sheer number of ETFs available, it may be hard to choose, but taking the time to do research and create a plan can help you to reach your goals. 

Start trading ETFs on eToro.

FAQs

What are the alternatives to ETFs?

ETFs are just one way to invest. There are many assets similar to ETFs you could consider adding to your portfolio, depending on your risk tolerance and financial goals. This includes Individual stocks, mutual funds and index funds.

Should beginners invest in ETFs?

Exchange-traded funds are often considered a good option for less experienced traders who may otherwise struggle to pick individual stocks and assets to invest in. ETFs are a cost-effective solution for portfolio diversification, but they are not without risks. New investors should ensure they understand how ETFs work before committing real funds to a trade.

What are the most popular ETFs?

There are a range of ETFs available across a variety of asset classes. For example, the price of the SPDR S&P 500 ETF corresponds with the price and yield of the S&P 500 Index, while the SPDR Gold ETF is the world’s largest physically-backed gold exchange-traded fund. These are two of the most popular ETFs, but there are plenty of options available to investors interested in the financial, real estate or healthcare sectors, to name but a few.