What Is An ETF? How ETFs Work and What You Need to Know

An exchange-traded fund, or ETF, is a type of mutual fund that trades like a stock on a stock exchange. ETFs are an easy way for individual investors to gain exposure to a sector or theme, like technology or healthcare stocks.
 
But that broad exposure comes with risks as well as rewards. If you understand how an ETF works and the things you need to know, investing in an ETF can be a rewarding way to gain exposure to a sector or theme. Here’s what you need to know about investing in an ETF:

What is an ETF?

An ETF is a type of fund that tracks a stock or commodity index like the S&P 500. ETFs are traded on financial exchanges just like stocks. You can buy and sell ETFs just like stocks and can also own part of an ETF through ETNs (exchange-traded notes).
 
Basically, you can buy and sell ETFs and ETNs just like conventional stocks on your brokerage account. There are three main types of ETFs — passive, tactical, and inverse. Passive ETFs track a specific index and have no management.
 
Tactical ETFs are meant to be used by investors who want to invest in a specific sector to gain exposure to that sector. Inverse ETFs are designed to move opposite the performance of the underlying market.

How ETFs Work

You can read about exactly how an ETF works in our full writeup, but basically, you’re buying a basket of stocks that make up the ETF. The basket of stocks represents the ETF, and you can buy and sell shares in the ETF just like you would a stock.
 
Investors can buy ETFs to get exposure to a broad theme or sector like healthcare, technology, or energy. When you buy an ETF, you’re essentially just buying a basket of stocks that make up the ETF.
 
Because ETFs are just a collection of stocks, they can easily track the underlying theme or sector just like a stock. If healthcare stocks go up, your ETF could go up as well. You’ll have just as much exposure to healthcare as the people who invest in healthcare stocks.
 

Things to Consider before Investing in an ETF

There are a lot of reasons to invest in ETFs, but there are a few things you need to consider before diving in.
 
Expense: ETFs often charge annual expenses, or annual fees, just like funds do. You can research expenses before you invest in an ETF to make sure you’re getting the best deal.
 
Tracking Error: ETFs can have a large tracking error meaning they can deviate from the underlying theme or sector. If that happens, you need to consider if you want to keep investing in the ETF. Otherwise, you’ll likely lose money.
 
Liquidity: ETFs are simply a collection of stocks, so they can be more difficult to trade in large amounts like mutual funds. If you need to trade a lot of ETFs, you may not be able to do it at your local brokerage. You may need to move your ETFs to a larger broker with more liquidity.
 

Pros of Investing in ETFs

Low Expense: ETFs are often much cheaper than mutual funds. That’s because ETFs don’t have the overhead of many investment professionals like fund managers and portfolio managers.
 
Broad Exposure: ETFs are often very broad. They can offer broad exposure to a broad theme or sector like healthcare, technology, or energy.
 
Tracking Error: Tracking errors are much less for ETFs than mutual funds. The best ETFs can have a tracking error of 10% or less.
 
Liquidity: ETFs are usually much more liquid than mutual funds. Brokerage websites like E*TRADE or Scottrade let you trade ETFs just like stocks.
 
Low Ball Wring: You don’t have to invest a lot of money in ETFs. You can start with an ETF with a low initial investment amount.
 

Cons of Investing in ETFs

Tracking Error: Like any investment, tracking errors are a huge potential downside that you need to consider before buying an ETF. You may not get the exposure you want to the theme or sector if a fund has a large tracking error.
Expense: Like any investment, an ETF also comes with a cost. Expense can be a major factor in how much you make from ETFs.
Liquidity: Like any investment, liquid access is important to ETFs. You may not be able to trade ETFs at your local brokerage.
Ball Wring: Like any investment, the amount you need to invest can be a barrier to entry for ETFs. You don’t have to put in a lot of money up front to start.

Final Words: Should You Invest in ETFs?

As with any investment, you need to do your research and understand the risks and rewards before diving in. ETFs can be a great way to gain broad exposure to a theme or sector.
 
But you need to understand the things you need to consider to make sure you’re getting the most out of ETFs. If you decide ETFs are right for you, make sure you understand the tracking error and expense before diving in. You may just find that ETFs are the best investment you’ve made yet.

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