It's become cheaper and easier to invest in the stock market during the past 10 years—and the explosion of exchange-traded funds deserves some credit.
The amount of money invested in exchange-traded funds (or ETFs, for short) has quintupled in the past decade, from just over $1 trillion to more than $5 trillion globally as of June, according to research firm ETFGI. And ETFs listed on U.S. exchanges just crossed the $4 trillion mark in July, according to figures from ETF.com.
Why have ETFs become so popular? Because they're a low cost, tax efficient way to easily invest in the stock market. Here's what you need to know.
An ETF is an array of investments like stocks, bonds, and commodities, or even a combination of these assets. ETFs typically track an underlying index, such as the S&P 500, and are traded on stock exchanges like individual stocks.
ETFs make it easy to quickly buy a collection of assets, which provides diversification without the hassle of buying each individual security. For example, you can currently buy one share of an ETF that tracks the S&P 500 for about $300 (or less). That means you can invest in the performance of these 500 companies without buying each stock individually.
ETF providers set up a fund to track the performance of a particular index and buy the underlying assets. In turn, the provider sells shares in that fund to investors. When you buy an ETF, you own a portion of that fund—but not the underlying assets.
The three largest ETF providers in the U.S. are BlackRock (it manages ETFs with iShares in the name), State Street (its products are labeled as SPDR), and Vanguard.
ETFs have grown in popularity largely because they have three attractive qualities: They're low-cost, they offer tax efficiency, and they can be easily bought and sold. These funds have also become an alternative to mutual funds because ETFs don't require a minimum amount for investment.
Annual administrative costs, what's known as an expense ratio, are much lower for ETFs than mutual funds—0.2% versus 0.55%, according to figures from the Investment Company Institute. That comes out to paying $2 instead of $5.50, for every $1,000 invested.
Because most ETFs track an index, there's less turnover in the stocks or other assets contained in these funds. That's an advantage because any time a fund provider (ETF or mutual fund) sells an asset that has appreciated in value, it will incur capital gains—and investors are on the hook to pay taxes on those gains.
Finally, ETFs are as easy to buy and sell as an individual stock because they trade on exchanges. That's different from mutual funds, which can only be traded at the end of the day.
There are more than 2,000 different ETFs listed on U.S. exchanges—and they track everything from broad market indexes like the S&P 500 to specialized themes like the spending preferences of millennials. You can buy ETFs that track a specific industry, like technology, or one that follows top stocks in a particular country, like Japan.
That variety gives investors a lot of choice when investing in ETFs, which can be good or bad. Very niche ETFs don't provide the same type of diversification as ones tracking broader indexes, and they often charge higher-than-average fees—and they could risk closing if they don't attract sufficient investment. More than 150 ETFs closed in 2018, a record for the industry, according to ETF.com.
ETFs will have the same risks as the underlying investments they contain. That's why experts typically recommend index funds or other diversified securities make up the bulk of your portfolio—and your ETFs.
More from Grow: