An ETF is a fund that holds many stocks or bonds and trades on a stock exchange like a single stock

ETF stands for exchange-traded fund. It is a basket of securities — usually stocks, bonds, or a mix — that you can buy and sell during the trading day at a price that changes minute to minute, just like buying shares of Apple or Microsoft. You own a small piece of everything inside the fund, not the individual securities themselves.

The key difference from a mutual fund is timing and price. A mutual fund's price is set once per day after the market closes. An ETF's price updates constantly while the market is open. This means you can sell an ETF at 10:30 a.m. if you need cash when ready, whereas a mutual fund sale settles at that day's closing price, which you won't know until after 4 p.m.

ETFs are managed by companies like Vanguard, BlackRock, and Invesco. These companies decide what goes inside each fund — for example, all 500 stocks in the S&P 500, or all bonds issued by the U.S. Treasury. You pay a small annual fee (called an expense ratio) to hold the fund, usually between 0.03% and 0.50% per year depending on the fund.

Key Takeaways

  • An ETF is a collection of stocks, bonds, or other securities bundled into one investment you can buy and sell like a stock during market hours.
  • ETF prices change throughout the trading day, while mutual fund prices are set once at the end of each day.
  • You pay an annual expense ratio to hold an ETF, which is the fund company's fee for managing it and is deducted automatically from your returns.
  • Most ETFs track an index — a fixed list of securities — so the fund's holdings rarely change unless the index itself changes.
  • You can hold an ETF in any brokerage account: a regular taxable account, an IRA, a 401(k), or a 529 college savings plan.

How an ETF holds your money

When you buy one share of an ETF, you own a fractional piece of every security inside it. If an ETF holds 500 stocks and you own one share, you own 1/500th of each stock (adjusted for the fund's weighting, which means some stocks make up a larger portion than others). You do not receive stock certificates or own the stocks outright — the fund company holds them in your name.

Dividends and interest paid by the securities inside the ETF are collected by the fund company. Most ETFs distribute these earnings to you quarterly or annually, either as cash or by reinvesting them back into the fund. Some ETFs are set up to reinvest automatically; others let you choose.

If the value of the securities inside the ETF rises, the price of the ETF share rises with it. If they fall, so does the ETF price. You make money when you sell the ETF for more than you paid, or when you receive dividend distributions.

Index-tracking ETFs versus actively managed ETFs

Most ETFs are index-tracking, meaning they follow a predetermined list of securities. An S&P 500 ETF, for example, holds the same 500 stocks in the same proportions as the S&P 500 index itself. The fund company does not pick which stocks to include — the index does. This is why index-tracking ETFs have low expense ratios: there is little active decision-making involved.

A smaller number of ETFs are actively managed, meaning a fund manager or team decides which securities to buy and sell to try to beat the market. These ETFs have higher expense ratios because you are paying for the manager's research and decisions. Actively managed ETFs are less common than index-tracking ones.

The choice between them affects your costs and your expectations. An index-tracking ETF will match the performance of its index minus the expense ratio. An actively managed ETF might outperform or underperform its benchmark, depending on the manager's skill and market conditions.

Where you can hold an ETF

You can buy an ETF in almost any investment account. The most common are taxable brokerage accounts (regular investment accounts with no contribution limits), IRAs (retirement accounts with tax advantages), 401(k)s (employer retirement plans), and 529 plans (college savings accounts). Some workplace retirement plans offer a limited selection of ETFs; others offer none.

To buy an ETF, you need a brokerage account with a firm like Fidelity, Charles Schwab, Vanguard, E-Trade, or dozens of others. You place an order during market hours (9:30 a.m. to 4 p.m. Eastern time on weekdays when the market is open), and the trade settles in two business days. You can also place orders before or after market hours, but the price will be set when the market opens the next day.

The account type you choose determines the tax treatment of your gains. In a taxable account, you owe capital gains tax when you sell an ETF for a profit. In a traditional IRA or 401(k), gains are tax-deferred until you withdraw money in retirement. In a Roth IRA, may have access to withdrawals are tax-free.

ETF expense ratios and costs

The expense ratio is the annual percentage fee you pay to hold an ETF. It covers the fund company's costs for managing the fund, keeping records, and handling customer service. This fee is deducted automatically from the fund's returns — you do not write a check for it.

Expense ratios vary widely. A broad index-tracking ETF like one tracking the S&P 500 might charge 0.03% to 0.10% per year. A more specialized ETF — one tracking a narrow sector, international bonds, or commodities — might charge 0.20% to 0.75%. An actively managed ETF typically charges 0.50% to 1.50% or higher.

On a $10,000 investment, a 0.05% expense ratio costs $5 per year. A 0.50% ratio costs $50 per year. Over decades, this difference compounds. You may also pay a commission when you buy or sell an ETF, though many brokerages now offer commission-free ETF trading.

How ETF prices are set

An ETF's price is determined by supply and demand during the trading day, just like a stock price. If many people want to buy a particular ETF and few want to sell, the price goes up. If the reverse is true, the price falls. The price can drift slightly above or below the actual value of the securities inside the fund — a gap called the bid-ask spread or premium/discount.

For most popular ETFs, this gap is tiny — a few cents on a $100 share. For less-traded ETFs or those holding less-liquid securities (like bonds or international stocks), the gap can be wider, meaning you might pay slightly more to buy or receive slightly less when you sell.

The fund company publishes the net asset value (NAV) — the true value of all securities inside the ETF divided by the number of shares outstanding — throughout the trading day. Most ETFs trade very close to their NAV because large investors called authorized participants buy and sell the underlying securities to keep the ETF price in line with its true value.

ETFs versus stocks and mutual funds

An ETF sits between a stock and a mutual fund in terms of how it works. Like a stock, an ETF trades throughout the day at a changing price and you can sell it when ready if you need cash. Like a mutual fund, an ETF gives you when ready diversification — one purchase gives you exposure to many securities instead of just one.

Compared to a mutual fund, an ETF typically has a lower expense ratio and is more tax-efficient because of how it is structured. Compared to buying individual stocks, an ETF reduces the risk that any single company's poor performance will hurt your portfolio significantly. The trade-off is that you own a piece of everything in the fund, including the underperformers.

If you want to own a specific company's stock because you believe in its future, you buy the stock directly. If you want broad exposure to a market or sector without picking individual winners and losers, an ETF is usually the simpler choice.

Frequently Asked Questions

Do I own the actual stocks if I buy an ETF?

No. The ETF company owns the stocks and holds them in your name. You own shares of the ETF itself, which represents a fractional claim on all the securities inside it. You receive the economic benefit of ownership — dividends and price appreciation — but you do not hold the stock certificates or have direct voting rights.

Can I lose money in an ETF?

Yes. If the value of the securities inside the ETF falls, the ETF price falls with it. You lose money if you sell for less than you paid. However, if you hold the ETF long-term and the market recovers, you may recoup losses. Diversification within an ETF reduces the risk that a single bad investment will wipe out your money, but it does not eliminate market risk.

What is the difference between an ETF and a stock?

A stock is a share of ownership in a single company. An ETF is a fund holding many securities. When you buy a stock, your return depends entirely on that one company's performance. When you buy an ETF, your return depends on the average performance of all the securities inside it, minus the expense ratio. ETFs offer diversification; stocks do not.

How often do ETF holdings change?

For index-tracking ETFs, holdings change only when the underlying index changes. The S&P 500 index adds and removes companies occasionally, so an S&P 500 ETF's holdings shift a few times per year. Actively managed ETFs may trade more frequently as the manager buys and sells to try to beat the market. You can see an ETF's current holdings on the fund company's website.

Can I buy an ETF with a small amount of money?

Yes. Most brokerages let you buy a single share of an ETF, and many ETFs trade for $20 to $150 per share. Some brokerages also offer fractional shares, so you can invest any dollar amount, even $1. There are no minimum investment requirements at most brokerages, though some retirement accounts may have minimums set by the plan sponsor.