Everything You Need to Know to Sound Smart About ETFs
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"ETFs give you the best of both worlds: They have the tradability of individual stocks and the relatively low-cost diversification of a mutual fund."

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January 2018 marked 25 years since the world’s largest ETF made its debut on Wall Street as the first U.S.-listed investment of its kind.

In the quarter century since, ETFs have experienced massive popularity and growth. Between 2016 and 2017, the total amount of money invested in U.S.-based ETFs increased 34 percent, and has continued growing—reaching a record $3.73 trillion by September 2018.

Back up. What’s an ETF again?

An ETF is a basket of investments that’s often tied to the performance of an underlying index. It’s also traded on the exchange, so you can buy or sell it like a stock.

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For example, you can invest in an ETF that tracks the S&P 500, an index often used as a benchmark for the stock market because it includes a significant portion of the market’s total value. (It tracks 500 large U.S. company stocks.) You can also invest in sector-specific ETFs, which contain stocks of companies in particular segments of the economy—from the communications sector to utilities and health care.

And how is that different from a mutual fund?

Unlike a mutual fund, an ETF is traded on an exchange (hence the name) like a stock. That means you can buy shares any time of the trading day at whatever price they happen to be at the point of sale. Shares of mutual funds, on the other hand, can only be purchased at the end of the trading day at their net asset value price.

How exactly do I buy and sell ETFs?

You can purchase shares through any investment account, just like you would individual stocks. You can specify either the number of shares you want to purchase or the amount of money you’d like to invest at a given time or share price.

What costs are associated with ETFs?

The fee associated with investing in a fund is known as the “expense ratio.” It’s charged as a percentage of the money you invest. (So, if a fund’s expense ratio is 1 percent and you invest $1,000 in the fund, you will pay $10 in fees.) Fortunately, ETFs tend to come with lower expense ratios than mutual funds, on average. Actively managed mutual funds require additional effort to run, and their fees often reflect that. The low-maintenance style of most ETFs—since they’re often designed to track an index—translates to lower costs. It’s not uncommon to find ETF expense ratios of just .03 to .05 percent.

Beyond that, Cinthia Murphy of ETF.com advises looking for “hidden” costs like transaction fees for buying and selling shares and the tracking difference, which is how much better or worse an ETF performs compared with its underlying index. (That one’s not a direct cost, but you do pay a price if an ETF consistently underperforms its index.)

Why would I invest in ETFs over individual stocks or mutual funds?

Many experts would say ETFs give you the best of both worlds: They have the tradability of individual stocks and the relatively low-cost diversification of a mutual fund. And it gives you the chance to invest in dozens—even hundreds—of stocks for one commission fee (since you’re just buying shares in one fund versus buying shares in all the companies it includes).

Plus, ETFs are considered more tax efficient than mutual funds because they aren’t required to sell assets—and realize capital gains—as often as mutual funds might. So they don’t face as many taxable events.

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What are the risks?

While the basket-of-investments aspect of ETFs dampens risk, it doesn’t mean that risk is dialed all the way down to zero. First of all, an ETF can be as risky as its underlying investments. For example, going the ETF route to invest in emerging markets is still riskier than investing in developed markets. And investing in a specific sector is riskier than sticking with a broad index like the S&P 500.

Finally, remember that ETFs move with the market at large—making them subject to all the same volatility. “ETFs are not immune to market noise and excitement,” says Murphy. “Good judgment calls still apply.”

Related: Here's Why It Pays to Invest for the Long Term

This post was updated in October 2018.