What is an ETF? Options for Low-Cost Diversification

An exchange-traded fund, or ETF, is an investment that gives investors the ability to pool their money into a fund, spreading it across an array of stocks, bonds or other asset classes. While ETFs are similar to mutual funds, they trade on an exchange like stocks. They’re a good choice for investors seeking diversification with low investments minimums and are a great way to track an index at relatively low cost.

Because of their baked-in diversification, ETFs have quickly become the bread and butter of investing. This article explores how ETFs work, common types of ETFs and the advantages and disadvantages of ETFs as an investment.

What is an ETF?

An ETF is a basket of securities, which can range from traditional assets, such as stocks and bonds, to alternative assets, like commodities and real estate. You can buy or sell ETFs from a brokerage firm through a stock exchange. They are traded like stocks, with a ticker symbol and price fluctuations throughout the day. Instead of having to buy and sell each security individually, however, an ETF conveniently bundles all of the securities into one fund.

An ETF can include tens, hundreds or even thousands of stocks, bonds or other asset classes, or a mix of multiple types. ETFs are designed to track the underlying value of an index (like the S&P 500) or an asset class (like gold).

The beauty of ETFs is that they combine the core benefit of mutual funds — diversification — with the liquidity of stocks. ETFs really started to gain traction as an investment product in the early 1990s and have since exploded in popularity; currently, there is an estimated $1 trillion invested in ETFs, with over 1,000 ETF products available on U.S. stock exchanges.

Do ETFs pay dividends?

There are a number of ETFs that pay out dividends — portions of a company’s profits that are paid out to its shareholders — but not all do. If you own stock through your ETF, the company will pay out its dividends to your ETF, which are then passed along to you through a fund dividend.

Depending on your ETF, dividends may be paid out quarterly or at another time interval, and they can be qualified or nonqualified, which impacts how they are taxed. Qualified dividends can be taxed at the capital gains rate, while nonqualified dividends are taxed at ordinary income rates.

How are ETFs taxed?

With an ETF, you will have to pay taxes on earnings from any dividends, interest or capital gains earned, as it is considered taxable income. You will need to report those earnings as income on your 1099 form come tax time.

ETFs vs. mutual funds: What’s the difference?

ETFs operate in a similar fashion to mutual funds. Both are investment products that allow you to invest in a wide array of securities all at once, giving you instant diversification. The biggest difference between ETFs and mutual funds, though, is how they are traded.

Like stocks, you can buy and sell ETFs at any time throughout the day, meaning investors have the freedom to react to news or price changes, and buy or sell as they wish. Meanwhile, traditional mutual funds can only be bought and sold once a day, after the market closes at 4 p.m. EST.

Additionally, ETFs tend to have lower investment minimums and charge lower management fees than mutual funds, as they are more passively managed. Mutual funds are typically considered actively managed because they use a fund manager who will buy and sell securities with the goal of beating the market. Meanwhile, ETFs typically don’t aim to beat the market, but mirror it, often by tracking a particular index.

ETFs are also considered more tax-efficient because they are structured to trigger a smaller number of taxable events since index-tracking ETFs don’t make a lot of trades.

Pros and cons of ETF Investing

What types of ETFs can I invest in?

ETFs are not one-size-fits-all, and they come in a myriad of flavors. Below is just a small sampling of the types of ETFs that you can invest in.

How to invest in ETFs

If you’re in the market for an ETF, here’s what you need to do to get started.

1. Open a brokerage account: You will need to pick an account provider (or brokerage firm) to purchase your ETF from. Prioritize brokers that offer commission-free trades, no account service fees, the availability of research and educational tools and superior customer service. ETFs are offered by household names including Vanguard, Fidelity, E*TRADE and TD Ameritrade. Check out our ranking of the best online brokers to start your search.
2. Select an ETF: With thousands of ETFs available in the U.S., selecting the ETF that is right for you can be a daunting process. Start by deciding which underlying index you’d like your ETF to track (such as the S&P 500 or NASDAQ), and then opt for funds with low fees and strong performance records. Your brokerage firm will likely offer tools that would enable you to sift through the thousands of ETFs available to you based on factors like strategy, asset class, industry and more.
3. Invest: Once you’ve selected your desired ETF, it’s time to invest. The process of investing in ETFs is the same as investing in stocks: You will place your trade with your brokerage firm, where it will buy and sell shares of your ETF within your account. Since it is so easy to trade ETFs, be wary of frequent trading, which is an ill-advised investing practice. Instead, sit back and relax.

The “Find a Financial Advisor” links contained in this article will direct you to webpages devoted to MagnifyMoney Advisor (“MMA”). After completing a brief questionnaire, you will be matched with certain financial advisers who participate in MMA’s referral program, which may or may not include the investment advisers discussed.