Exchange-Traded Funds For Dummies (2024)

FAQs

What is an exchange-traded fund in simple terms? ›

ETFs or "exchange-traded funds" are exactly as the name implies: funds that trade on exchanges, generally tracking a specific index. When you invest in an ETF, you get a bundle of assets you can buy and sell during market hours—potentially lowering your risk and exposure, while helping to diversify your portfolio.

"ETFs are similar to mutual funds in that they hold a collection of stocks and bonds in a single fund," writes Kiplinger contributor Will Ashworth in his feature "How to Invest in ETFs for Beginners." However, unlike mutual funds, ETFs "are bought and sold on stock exchanges, can be traded anytime the exchange is open, ...

The low investment threshold for most ETFs makes it easy for a beginner to implement a basic asset allocation strategy that matches their investment time horizon and risk tolerance. For example, young investors might be 100% invested in equity ETFs when they are in their 20s.

Most ETF income is generated by the fund's underlying holdings. Typically, that means dividends from stocks or interest (coupons) from bonds. Dividends: These are a portion of the company's earnings paid out in cash or shares to stockholders on a per-share basis, sometimes to attract investors to buy the stock.

ETFs have several advantages for investors considering this vehicle. The 4 most prominent advantages are trading flexibility, portfolio diversification and risk management, lower costs versus like mutual funds, and potential tax benefits.

A hedge fund can provide high returns, but with higher risk. An ETF will generally provide lower, more predictable returns but with a much lower risk profile. A hedge fund offers an outsized risk/return profile, although they are restricted to institutions and accredited investors.

Lower dividend yield

Some ETFs pay dividends, but investors may receive higher returns on specific securities, such as stocks with large dividends. That's partly because ETFs track a broader market and therefore have lower yields on average.

When you buy an ETF, you are actually buying a small portion of a portfolio of securities (such as shares or bonds) built up with the aim of tracking a specific market index and therefore offering the same risks and return as this index.

ETFs can be a great investment for long-term investors and those with shorter-term time horizons. They can be especially valuable to beginning investors. That's because they won't require the time, effort, and experience needed to research individual stocks.

Stock-picking offers an advantage over exchange-traded funds (ETFs) when there is a wide dispersion of returns from the mean. Exchange-traded funds (ETFs) offer advantages over stocks when the return from stocks in the sector has a narrow dispersion around the mean.

Is an ETF better than a stock? ›

Because of their wide array of holdings, ETFs provide the benefits of diversification, including lower risk and less volatility, which often makes a fund safer to own than an individual stock. An ETF's return depends on what it's invested in. An ETF's return is the weighted average of all its holdings.

ETF trading generally occurs in-kind, meaning they are not redeemed for cash. Mutual fund shares can be redeemed for money at the fund's net asset value for that day. Stocks are bought and sold using cash.

Holding an ETF for longer than a year may get you a more favorable capital gains tax rate when you sell your investment.

Exchange-traded funds are similar to mutual funds in that they hold a collection of stocks and bonds in a single fund. Unlike mutual funds, they are bought and sold on stock exchanges, can be traded anytime the exchange is open, and you can start your ETF investing even if all you have to invest is $50.

By participating in an exchange fund, you are essentially swapping your concentrated stock position(s) for a diversified portfolio of stocks selected by professional managers. There is no guarantee that the portfolio will outperform your original stock position(s), but diversification can reduce portfolio volatility.

Passive, or index, ETFs generally track and aim to outperform a benchmark index. They provide access to many companies or investments in one trade, whereas individual stocks provide exposure to a single firm. As such, ETFs remove single-stock risk, or the risk inherent in being exposed to just one company.

Some ETFs follow a particular approach of investing like value or growth investing. Certain ETFs combine style with the size or market capitalization (large-cap, mid-cap, and small-cap). Examples include Schwab U.S. Large-Cap Value ETF (SCHV), Vanguard Small-Cap ETF (VB), and Vanguard Small-Cap Growth ETF (VBK).

How are ETFs and mutual funds different? How are they managed? While they can be actively or passively managed by fund managers, most ETFs are passive investments pegged to the performance of a particular index. Mutual funds come in both active and indexed varieties, but most are actively managed.