What are exchange-traded funds (ETFs) and how do they work? An investor guide

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Some investments for your shopping basket.

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Exchange-traded funds (ETFs) are ready-made collections of stocks, bonds, and/or other assets that trade throughout the day on an exchange. You might buy an ETF as a way to invest in an index, market sector, or other specific strategy. With ETFs, you can trade in or out of the market at a moment’s notice.

ETFs are similar to mutual funds in that you can easily buy a diversified but focused basket of securities. Different ETFs focus on different asset classes, such as stocks, bonds, or commodities. Some ETFs invest in specific niche sectors or markets. Some look to capture returns that reflect major market indexes. A few attempt to deliver returns that are the opposite of a particular index.

Most ETFs are set up to track an index, such as the S&P 500, making them similar in nature to index mutual funds. But here’s where ETFs and mutual funds diverge: A mutual fund sets its settlement price once—and only once—per day, at what’s called the net asset value (NAV). All customer flows in and out of the fund (i.e., purchases and redemptions) take place at the day’s NAV.

In contrast, ETFs trade like stocks. Bids and offers are posted throughout the trading day, which means you can buy or sell whenever the market is open, and you can also track the value of your ETF investment down to the penny.

When ETFs first launched at the beginning of the 21st century, they were primarily popular with traders, who took advantage of the ability to buy and sell them throughout the day.

But ETFs have since become popular with more casual investors because of their simplicity, ease of trading, and low fees. Because most ETFs are based on indexes, the larger ETFs can charge very low management fees compared with the average mutual fund.

But mutual funds still hold the lion’s share of assets. Although the total ETF investment in the U.S. grew from $1 trillion in 2012 to $7.2 trillion in 2022, according to the Investment Company Institute, U.S.-registered mutual funds hold $27 trillion (as of 2022).

Index ETFs—byfar the most common ETF strategy—invest in broad indexes that can include hundreds or even thousands of stocks, such as the Russell 3000. Index ETFs can offer an easy way to invest in the market as a whole.

But beyond the index-based universe, there’s a wide array of ETFs that target specific stock sectors and industries, bonds and other fixed-income securities, emerging markets, and more. Here’s a sampling:

Note: Although the term exchange-traded fund (ETF) is commonly used to describe these products, some—particularly those that use derivatives to target the performance of an index—are technically exchange-traded notes (ETNs). ETFs are backed by the shares in a fund; ETNs are a tradable loan issued by a bank or other financial entity.

Regardless of the structure—ETF or ETN—it’s important to read the fund prospectus before investing.

With more than 8,500 ETFs to choose from globally (as of 2022), if you have investable assets, there’s probably an ETF or two worth considering. ETFs offer an easy, cost-effective way to build a highly diversified portfolio and tweak it as necessary over time. And these days, most online brokers allow their clients to buy and sell ETFs commission free.

You just need to know what your objectives are: widespread diversification, targeted exposure, a global reach, or something in between. Happy ETF hunting!