Investing basics
What is an ETF?
Exchange-traded funds hold a basket of investments and trade like a single stock. How they work, what they cost, and the risks that are easy to miss.
Wenlo EditorialHow we write our guides5 min read
On this page
A basket you can buy like a stock
An exchange-traded fund (ETF) is a fund that owns a collection of investments, such as stocks or bonds, and whose shares trade on an exchange all day, just like a single company’s stock. Buy one share of a broad stock-market ETF and you own a small slice of every company the fund holds.
That is the main appeal: diversification in a single purchase. If one company in a fund of 500 has a terrible year, it is a small part of the whole. Compare that with putting the same money into one stock, where a single bad result can do real damage.
ETFs cover almost anything: the whole US stock market, a single sector such as healthcare, international markets, government bonds, commodities, or a particular style such as companies that pay dividends. The name gives you a hint; the fund’s documents tell you exactly what it holds.
How an ETF tracks its index
Most ETFs are index funds. They don’t try to pick winners; they copy a published list of holdings (an index) and its weights. When the index changes, the fund adjusts. This is called passive investing, and it is one reason many ETFs are cheap to run.
Some ETFs are actively managed: a manager chooses what to hold and aims to do better than a benchmark. They usually charge more, and there is no guarantee they succeed.
An ETF’s market price stays close to the value of what it owns because of a behind-the-scenes process. Large firms called authorized participants can create new ETF shares by handing the fund the underlying holdings, or redeem shares for them. If the ETF’s price drifts above or below its holdings’ value, they can profit by closing the gap, which pulls the price back in line.
ETFs, mutual funds and single stocks
| ETF | Mutual fund | Single stock | |
|---|---|---|---|
| When it trades | All day, at market prices | Once a day, at the closing value | All day, at market prices |
| Holds | A basket | A basket | One company |
| Ongoing fee | Expense ratio, often low | Expense ratio, often higher | None |
| Minimum | One share (or less, with fractional shares) | Often a set dollar amount | One share (or less) |
ETFs and mutual funds that track the same index can hold almost the same things. The differences are mostly practical: how and when you trade, the fees, and, in some countries, how they are taxed.
What it costs: expense ratio and spread
The expense ratio is the yearly fee the fund charges, as a percentage of your investment. You never get a bill; it is taken out of the fund’s value a little at a time.
Example
Small fees add up
On $10,000, an expense ratio of 0.03% costs about $3 a year. An expense ratio of 0.50% costs about $50 a year.
Over time the gap compounds. Suppose two funds hold the same investments and those grow 6% a year before fees (a hypothetical figure, not a forecast). After 20 years, $10,000 grows to about $31,890 in the 0.03% fund and about $29,178 in the 0.50% fund: a difference of roughly $2,710, from a fee gap that looked tiny.
You also pay the bid-ask spread when you trade, just as with a stock. Popular ETFs often have spreads of a cent or two. Small or specialized ETFs can have much wider ones, which matters most if you trade often. A limit order helps you avoid paying more than you meant to.
Reading an ETF’s page: NAV, holdings and yield
- NAV (net asset value): the value of everything the fund owns, minus what it owes, per share. The market price normally sits very close to it. A noticeable gap is called a premium (price above NAV) or a discount (below).
- Holdings: the list of what the fund owns. Check the top ten: in some funds a handful of companies make up a large share of the total.
- Assets under management: how much money is in the fund. Very small funds are more likely to close, which forces a sale at an inconvenient time.
- Yield: income paid out from the holdings’ dividends or interest, after fees, as a percentage of the price.
Risks to know
Diversification spreads out the risk of any one company; it doesn’t remove market risk. If the whole market falls 20%, a fund that tracks it will fall about 20% too. Other risks are specific to certain funds:
- Concentration: a sector or theme fund can be as volatile as a few stocks, because its holdings tend to move together.
- Thin trading: small ETFs can have wide spreads and trade further from NAV, especially in a fast market.
- Leveraged and inverse ETFs aim for a multiple (such as 2×) or the opposite of an index’s move over a single day. Over longer periods their results can drift far from what you’d expect.
Risk
Why daily resets matter
Suppose an index starts at 100, rises 10% one day (to 110), then falls 10% the next (to 99): down 1% overall. A fund designed to return 2× the daily move goes from 100 to 120 (+20%), then to 96 (−20%): down 4%, not 2%. In choppy markets this gap tends to grow, which is why these funds are generally meant for short holding periods.
A short checklist
- What does it hold, and does that match what you think you’re buying?
- What is the expense ratio, and how does it compare with similar funds?
- How wide is the spread, and how much is in the fund?
- Is it leveraged, inverse or narrowly focused?
Answering those four questions takes a few minutes on the fund provider’s website and avoids most of the surprises people run into with ETFs.
Try it with real numbers
Whatever you hold, it helps to see how it actually did. The journal reads your broker’s CSV and shows realized profit and loss with fees included. Try it with sample data; no account needed.