What is an ETF?

Along with stocks and mutual funds, ETFs are a popular type of investment. They can offer diversification, and can be cost effective, among other potential benefits. But what exactly is an ETF?

ETF stands for exchange-traded fund. Like a mutual fund, an ETF can invest in a variety, or “basket”, of securities such as stocks or bonds. Also like a mutual fund, an ETF is professionally managed. On the other hand, an ETF is more like a stock in one important way: it can be bought and sold during market hours throughout the day.

Most ETFs are designed to track, or try to match, the performance of a market index, less the fund’s fees. There are numerous market indices of all kinds; they might track mid-sized companies, international stocks, investment grade bonds or even themes like artificial intelligence or sustainable investing. You can find one or more ETFs that try to match the returns of almost all of these indices.

There are three main reasons to consider ETFs.

1. Diversification. Because an ETF can invest in dozens or even hundreds of different securities, it can be inherently diversified. This may reduce risk compared to putting your money in a single stock or bond. With just one ETF, you can also gain a diversified position across a specific investment theme—large-cap stocks, investment grade bonds, or an industry sector like healthcare, for example. With only a few ETFs, you can build a diversified portfolio.
2. Value. ETFs can have low fees. Plus, at E*TRADE from Morgan Stanley you pay zero commissions on ETF trades. Finally, because of the way ETFs work, they are often more tax-efficient than mutual funds.
3. Transparency. With many ETFs, you can know what you own.

And remember, since you can buy or sell ETFs any time the market is open, they may allow you to act quickly on an investing idea.

The price of an ETF share is determined by the market as opposed to the value of the assets held by the ETF. This impacts the liquidity of an ETF’s shares. If few market participants want to buy or sell a particular ETF – i.e., it is “thinly traded” – an investor may have to accept a lower price if they desire to sell their ETF shares in the short-term. This risk may be exacerbated during times of market stress if the trading volume for an ETF decreases, if more participants desire to sell rather than buy an ETF’s shares or for other reasons. Any of these reasons may lead to an investor selling their shares at a “discount” to what the ETF’s underlying holdings are actually worth.