What is an ETF and Why Buy It?

Like a stock, an ETF is a security listed on an exchange. Its share price moves up and down during the trading day, based on how interested — or not — investors are in owning that ETF. You can buy some ETFs on margin, or use stop or limit orders to control the price you pay or receive. When you sell, another investor buys.

Like a mutual fund, an ETF gains or loses net asset value (NAV) based on changes in the value of its holdings, minus expenses, divided by the number of shares. However, unlike a mutual fund, ETFs are not bought at NAV. The price of an ETF, like the price of a stock, is set by the market. Like an index fund in particular, an ETF holds a portfolio of investments that are included in a particular index to which the ETF is linked. So you know exactly what the ETF owns all the time. That's called transparency.

You buy ETFs for the same reason you buy any investment. Owning them can increase the value of your portfolio and may provide income, now or in the future.

Price first. The price you pay per share for an ETF is always less than the cost of buying all its holdings — think of the 2,000 stocks in an ETF linked to the Russell 2000 Index or even the 30 stocks in an ETF linked to the Dow Jones Industrial Average. ETFs are also generally less expensive to own than mutual funds. That's because the annual asset‐based fees index‐based ETFs charge are lower than the asset‐based fees for actively managed mutual funds that make similar investments.

Convenient? Do you want to manage a portfolio of 2,000 stocks and 1,500 bonds when two ETFs will do it for you? Enough said.

The big point here is the diversification that ETFs can offer, both individually and as a group.

  • There are ETFs that invest in every asset class — stocks, bonds, real estate investment trusts (REITs), commodities, and precious metals.
  • There are US‐only ETFs and international ETFs.
  • There are ETFs linked to broad indexes, like the S&P 500 that tracks 500 of the biggest US companies.
  • There are ETFs linked to narrow indexes. They hold a limited number of securities in a single sector of the economy, like medical devices or wind power, so they're less diversified than some others.

When investing in an ETF, the first step is reading the prospectus. It's a detailed overview of the ETF's management, investment objective, portfolio holdings, fees, past performance, and risk profile conveniently located all in one place.

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