Stocks are easy to trade, but they only give you ownership in one company. Mutual funds provide diversification and flexibility with professionally managed portfolios, but they are saddled with clumsier trading processes and potentially higher tax bills.
An exchange-traded fund (ETF) delivers the best of both worlds. With ETFs, you get access to large and diversified stock portfolios through a single ticker that behaves like a simple stock in many ways.
What is an ETF?
What is an ETF?
Technically speaking, an ETF is a specialized investment company that manages a single portfolio of investments in stocks, bonds, real estate, or other assets. This company is then registered on the stock market, much like any other business. You can buy or sell shares of an ETF at any time during a normal market day, and the share price reacts in real time to shifting buyer demand and supply-side sells.
Most ETFs are passively managed, set up to simply mirror the composition and performance of a specific market index. Others are actively managed by professional fund advisors, attempting to beat the market through human expertise. In most cases, you’re better off with the predictable, long-term performance of a passive index-tracking ETF, which also comes with lower management fees.
What’s so special about ETFs?
What’s so special about ETFs?
At first glance, an ETF looks a lot like a mutual fund. You use a single ticker to trade ownership in a curated list of stocks (or other assets) and reap the rewards of instant diversification. In some cases, the investment firm behind the scenes offers a mutual fund version and an ETF alternative tracking the same market index. The results of owning either one are effectively the same in the long run.
However, there are some significant differences:
- Mutual funds change hands only once per day after the market closes, while ETFs are available whenever the stock market is open.
- The tax-reporting paperwork for a mutual fund is quite different, and you may end up paying taxes on individual stock transactions made by the fund. With an ETF, the day-to-day stock trading is handled by the fund manager, and your only tax liability is based on buying and selling the actual ETF.
- Passive index trackers are far more popular in the ETF world than among mutual funds. According to Charles Schwab, there are about 500 index-tracking mutual funds on the market today but 2,000 ETFs in the same category. Therefore, it’s easier to find an ETF that matches your investing style and sector focus.
How to use ETFs
How to use ETFs
An ETF is a cost-effective way to inject a diversified group of stocks into your portfolio without complicating the trading and tax reporting experience. Many investors take advantage of these flexible funds by mirroring the stock market as a whole through funds tracking the S&P 500 (SNPINDEX:^GSPC) or Russell 3000 indices.
Popular funds tracking the S&P 500 include the Vanguard 500 Index Fund ETF (VOO -0.41%) and the SPDR S&P 500 ETF Trust (SPY -0.39%). Warren Buffett’s Berkshire Hathaway (BRK.A -0.3%) (BRK.B -0.26%) has large holdings in both. For the ultra-broad Russell 3000 index, you could use the iShares Russell 3000 ETF (IWV -0.49%) or the Vanguard Russell 3000 ETF (VTHR -0.59%). These funds offer immediate exposure to hundreds or even thousands of stocks across every conceivable industry, with robust liquidity and minimal management fees.
If an index-tracking ETF is the only investment you’ll ever make, that’s a perfectly reasonable strategy that puts your financial management efforts far ahead of most people’s. It can also be a stepping stone on the way to picking market-beating individual stocks someday, supported by the robust, long-term gains of a simple index-based platform.
