An exchange-traded fund (ETF) is an investment product whose shares retail investors buy and sell on a stock exchange during market hours. ETFs can hold baskets of securities, but their holdings, risks, fees and liquidity vary; a fund’s market price can also differ from its net asset value (NAV). Before investing, check what the ETF owns, how it works, what it costs and whether it fits your goals and tolerance for loss.
What is an ETF?
An ETF pools investments under a stated objective or strategy. Some ETFs seek to track an index; others use different approaches. Depending on the fund, holdings may include stocks, bonds or other assets. An ETF label alone does not tell you how diversified or risky a particular fund is.
Retail investors generally buy and sell ETF shares through a brokerage account on an exchange. The share price changes during the trading day and may be above or below NAV, the per-share value of the fund’s assets minus its liabilities.
How ETFs work
Retail investors usually trade existing ETF shares with other market participants rather than directly with the fund. Authorized participants—typically large broker-dealers—can create or redeem large blocks of shares directly with the fund. For a creation, they deliver a designated basket of securities and cash and receive ETF shares; for a redemption, they return a large share block for securities or cash equivalent.
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These transactions can help keep an ETF’s market price near its NAV, but they do not guarantee that the price will equal NAV or that a liquid trading market will always exist. Many ETFs disclose holdings daily, but this is not universal.
ETF and mutual fund comparison
| Feature | ETF | Mutual fund |
|---|---|---|
| How investors transact | Usually buy and sell shares on an exchange through a broker | Generally buy shares from or redeem them with the fund, directly or through an intermediary |
| Pricing | Market price fluctuates during the trading day and may differ from NAV | Typically transacts at the next calculated NAV on a business day |
| Costs to examine | Operating expenses, possible brokerage charges, bid-ask spread and premiums or discounts to NAV | Operating expenses and any applicable transaction or shareholder charges |
These are general structural differences; fund features and charges vary. The SEC discusses them in its ETF and mutual fund investor materials.
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What to check before investing
- Objective, strategy and holdings. Read what the ETF aims to do and what it actually holds. Funds with similar names can have different strategies or exposures.
- Risk and fit. Consider whether the fund’s risks suit your goals, financial circumstances and tolerance for losses. ETF shares are not insured or guaranteed, and you can lose money.
- Fees and expenses. Review the prospectus fee table and annual operating expenses. Fees reduce returns, and an expense ratio does not capture every cost.
- Trading costs and price. Check broker charges, the bid-ask spread and whether the market price is above or below NAV. Premiums and discounts can change.
- Liquidity. Review the fund’s median bid-ask spread and historical premiums or discounts. Trading volume is useful, but the liquidity of the underlying holdings also matters.
- Fund documents and performance. Read the summary and full prospectus and the latest shareholder report for the fund’s objective, strategies, risks, costs and performance history, if available. Past performance does not predict future results.
The SEC’s February 2023 ETF bulletin illustrates spread costs with a hypothetical example: a $59.50 bid and $60 ask create a 50-cent spread; buying 200 shares at the ask and immediately selling at the bid would produce a $100 loss from the spread. This is an illustration, not a figure for any specific ETF or current market. Source: U.S. Securities and Exchange Commission, Updated Investor Bulletin: Exchange-Traded Funds (ETFs), 2023.
How to invest in an ETF
- Decide the role it should play. Start with your overall investment plan and risk tolerance, not a trending ticker or recent performance.
- Shortlist funds by exposure and strategy. Compare what each fund holds and how it pursues its objective. Read its prospectus and latest shareholder report.
- Compare the full costs. Consider operating expenses, brokerage charges, bid-ask spreads and premium or discount information.
- Choose a brokerage account. Compare available fund access, fees and account features. Confirm the broker’s charges and order choices before trading.
- Place an exchange-traded order. Verify the ETF’s name and ticker, review the quoted price and spread, and understand how your chosen order type works. The trade executes in the market, not directly at NAV.
- Revisit the fit. Review fund disclosures and whether the investment still suits your circumstances as they change. Do not treat historical returns as a promise of future results.
Benefits and limitations
Depending on its strategy, an ETF can offer diversification, professional management and intraday exchange trading. Those features vary by fund: some ETFs hold broad baskets, while others are concentrated or expose investors to narrower risks. A trading market may not develop, and convenience does not guarantee that shares can be sold at NAV.
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Many ETFs use in-kind creation and redemption, which can mean fewer capital-gain distributions than some mutual funds. This is a potential tax characteristic, not a guarantee. Tax treatment depends on the fund and the investor’s circumstances; consult a qualified tax professional for personal tax advice.
Index ETFs seek to track an index before fees and other costs, but may underperform it because of expenses, trading costs and tracking error. No investment approach guarantees a return.
Independent reader supportYour contribution helps us test, update, and keep practical guides available for everyone.Frequently asked questions
How do I buy an ETF?
Investors commonly use a brokerage account to place an order for ETF shares on an exchange. Before trading, verify the fund, review its disclosures and costs, and understand the broker’s order choices and charges.
Can an ETF’s price differ from its NAV?
Yes. ETF shares trade at market prices, which can be higher than NAV (a premium) or lower (a discount). The difference can change over time.
Are ETFs always diversified or low-cost?
No. Diversification and fees vary by fund. Check the holdings and prospectus rather than assuming the ETF label means broad diversification or low expenses.
Are ETFs guaranteed or risk-free?
No. ETF shares are not insured or guaranteed, and investors can lose some or all of the money invested if the fund’s holdings fall in value. Risks differ among funds.
Does an ETF’s past performance predict its future returns?
No. Historical performance is information about the past, not a promise of future results. Consider the fund’s objective, holdings, risks and costs as well.
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