ETF is an acronym that stands for “exchange-traded fund,” a relatively new type of investment that can make it simpler and more accessible for individual investors to enter the market.
In a nutshell, an ETF is a basket of investments that trades on the stock exchange like a stock, meaning you can purchase or sell shares of it just as you would shares of a stock. ETFs are typically tied to the performance of an underlying index. For example, the SPDR S&P 500 ETF Trust (SPY)—the oldest and largest ETF (launched in January 1993 by State Street Global Investors and boasting nearly $270 billion of assets under management as of 2019)—tracks Standard & Poor’s 500-stock index. That means its goal is to mimic the performance of the S&P 500 by investing in the same large U.S. company stocks and in the same proportions. Acorns portfolios contain the SPY ETF, among others.)
Is it good for a portfolio to track an index?
For the most part, yes. This investing strategy is called indexing, and many great investors—including Warren Buffett and the late John Bogle (who created the index fund, as well as financial firm Vanguard)—swear by it. That’s because, by definition, it combines two key elements of successful investing: low costs and diversification.
Since copying an index is a simple approach that’s less labor intensive than active management, index funds—including index ETFs and index mutual funds—tend to come with very low expense ratios. So investors get to keep more of their gains rather than pay it out to cover operating costs and management fees. And an index can track hundreds of different investments, so investing in one means spreading your money across all of them. Plus, if investing in a broad market index, you benefit from the fact that the general direction of the stock market has been up, albeit with plenty of volatility along the way. So if you’re investing for the long term, copying the market tends to work out favorably.
(Note that there are actively managed ETFs, too—259 of them, to be exact, as of the end of 2018, according to the Investment Company Institute. They started coming on the scene in early 2008 and, a decade later, have $69 billion in net assets. By comparison, there were 1,660 index ETFs with $3.2 trillion in net assets at the end of last year.)
So what’s the difference between an index ETF and an index mutual fund?
It’s easy to confuse ETFs and mutual funds. They both offer the advantage of diversification, allowing you to own hundreds of investments within each fund, and their fees are often much less than the cost of buying (and selling) all those investments individually. They also both come with the expertise of a professional fund manager, who handles any investment analysis and other busywork for you.
But there are a couple of big differences, too. First is the way they’re priced for buying and selling. ETFs are traded on an exchange (hence the name), just like stocks, as mentioned above. That means the prices fluctuate throughout the day, and you can buy and sell at any of those various price points. Shares of mutual funds, on the other hand, can only be purchased at the end of the trading day at their net asset value price. (To get that, the value of the fund’s underlying positions are added up based on the closing prices and used to determine the value of all the fund’s holdings.)
Second, there may be a minimum requirement, often $1,000, to start investing in a mutual fund, though you can typically add to your investment (like if you practice dollar-cost averaging) in smaller increments. With ETFs, you can invest any amount you'd like.
How do I buy and sell ETFs?
You can purchase shares of ETFs through any investment account (including an Acorns account), just as you would individual stocks. You can specify either the number of shares you want to purchase or the amount of money you’d like to invest at a given time or share price. (Acorns portfolios include a mix of seven ETFs with exposure to thousands of stocks and bonds.)
Tell me more about ETF fees.
The major fee associated with investing in a fund is known as the “expense ratio.” It’s charged as a percentage of the money you invest. For stock ETFs, the average expense ratio is 0.20 percent, according to the ICI. So if you invest $1,000 in an ETF with that average charge, you’ll pay $2 for the year. (The average expense ratio for stock mutual funds is 0.55 percent.) You aren’t charged a direct fee for the expense ratio. It’s typically taken directly out of the returns that fund’s investments generate.
Beyond that, you should also watch out for “hidden” costs like transaction fees for buying and selling shares and the tracking difference, which is how much better or worse an ETF performs compared with its underlying index. That last one’s not a direct cost, but you do pay a price if an ETF consistently underperforms its index. (Acorns does not charge transaction fees.)
Why would I invest in ETFs over individual stocks or mutual funds?
Many experts would say ETFs give you the best of both worlds: They have the tradability of individual stocks and the relatively low-cost diversification of a mutual fund. Those things combined make it particularly easy to start investing with just a little bit of seed money. In fact, through Acorns, you can start investing in an ETF portfolio designed to fit your particular needs with as little as $5.
Plus, ETFs are considered more tax efficient than mutual funds because they aren’t required to sell assets—and realize capital gains—as often as mutual funds might have to. So they don’t face as many taxable events.
What are the risks of ETFs?
While the basket-of-investments aspect of ETFs dampens risk, it doesn’t completely erase it. First of all, an ETF can be as risky as its underlying investments. For example, going the ETF route to invest in emerging markets is still riskier than investing in developed markets. And investing in a specific sector is riskier than sticking with a broad market index like the S&P 500.
Finally, remember that index ETFs—and index investing, in general—are designed to track their benchmarks, not beat them. In good times, like during this long-running bull market, that should generally turn out solid gains that’d make any investor happy. But in bad times, following an index down may not seem like such a good idea.
Still, if you focus on the long-term and maintain a well-diversified portfolio, investing in ETFs can be a smart, low-cost way to grow your money.
* Investing involves risk including loss of principal. This information is presented for educational purposes only and is not a recommendation to buy or sell a specific security or engage in a particular strategy.