What is an ETF and how does it work?

What is an ETF?

An ETF (short for ‘exchange-traded fund’) is an investment product that bundles together a group of assets, such as stocks, bonds or commodities. Think of it as a basket – instead of buying one apple (a single stock), you buy the whole fruit basket (the ETF).

ETFs trade on stock exchanges just like individual company shares. That means you can buy and sell them during stock market hours, often at low cost. Unlike mutual funds, which are priced once per day, ETFs update in real time, making them more flexible for everyday investors.

The goal of most ETFs is to track the performance of an index or sector. For example, the SPDR S&P 500 ETF mirrors the S&P 500 index, giving investors exposure to 500 leading US companies in one trade. Others may focus on technology, energy or even international markets, giving investors tailored options to match their investment goals.

How do ETFs compare to individual stocks?

ETFs and individual stocks share similarities – both trade on exchanges and both can grow your wealth over time if you sell your holdings at a profit. But they differ in key ways that affect risk, returns and costs.

When you buy a single stock, your results depend entirely on that company’s performance. If the business thrives, the payoff can be substantial. But if the company stumbles, you’d bear the full loss if you end up selling your shares for less than what you paid. This concentrated risk makes individual stocks exciting but unpredictable.

ETFs, by contrast, spread your money across multiple holdings. Instead of tying your outcome to one business, you gain exposure to dozens or even hundreds. This diversification could help smooth out volatility. A single underperformer can have a lesser impact when paired with stronger companies in the fund.

Another major difference is potential upside. Individual stocks can experience significant growth if the underlying company performs well, but they can also decline sharply if the business struggles. ETFs, on the other hand, are built to track the performance of an index or sector. This generally means more stable outcomes, with less potential for extreme gains or losses.

Costs also separate the two. Buying stocks usually involves only trading fees. ETFs come with a small annual expense ratio, which pays for managing the fund. These fees are typically low but still reduce returns over decades.

Here’s a quick comparison of ETFs vs individual stocks:

Benefits and risks of investing in ETFs

Like any investment, ETFs come with both strengths and weaknesses. Understanding these can help you decide whether they fit your financial goals and risk tolerance.

Strengths of ETFs

1. Diversification

An ETF gives you access to a basket of assets in a single purchase. Instead of tying your results to one company, you gain exposure to many stocks, bonds or commodities at once. This spreads risk and can help smooth out the ups and downs of market volatility.

2. Cost-efficiency

Most ETFs charge relatively low annual fees, known as expense ratios. These are typically lower than the fees for actively managed mutual funds. Lower costs mean you keep more of your returns over the long term, which is especially important for beginner investors building their portfolios.

3. Flexibility

Because ETFs trade on stock exchanges, they can be bought and sold throughout the trading day, just like individual stocks. This makes them more flexible than mutual funds, which are priced only once per day. Many platforms also allow fractional ETF investing, making them accessible with smaller amounts of money.

Weaknesses of ETFs

1. Market-limited outcomes

While ETFs provide broad exposure, they generally track the performance of an index or sector. This means they are unlikely to outperform the overall market. In contrast, a single company’s stock might deliver much higher returns if that business performs exceptionally well.

2. Tracking error

Although most ETFs aim to mirror an index closely, performance can sometimes differ slightly. This gap, known as tracking error, can impact results – especially over longer periods.

3. Ongoing fees

Even though ETF expense ratios are low, they still reduce returns over time. For long-term investors, these small costs compound, making it important to compare fees across different ETFs before investing.

How to invest in ETFs with 0% commission

Types of ETFs investors should know

ETFs come in many forms and each type is structured to provide exposure to different parts of the market. Knowing the categories can help you understand what role an ETF might play in a portfolio, without implying which one you should choose.

1. Index ETFs
2. Sector ETFs
3. Bond ETFs
4. Commodity ETFs
5. Thematic ETFs
6. International ETFs

Please note: The ETFs listed below are provided strictly as educational illustrations to explain the different categories. They shouldn’t be considered as investment advice or recommendations to buy, sell or hold any security. Past performance doesn’t guarantee future results. Investors should conduct their own research or consult a qualified financial professional before making any investment decisions.

1. Index ETFs

These funds are designed to track the performance of a specific market benchmark. For example, the SPDR S&P 500 ETF (SPY) follows the S&P 500 index, while the Vanguard Total Stock Market ETF (VTI) reflects the broader US market. They provide a straightforward way to align returns with the performance of a chosen index.

2. Sector ETFs

Sector funds group companies within a particular industry, such as technology (XLK), healthcare (XLV), or energy (XLE). They allow investors to observe how a single sector performs compared to the overall market.

3. Bond ETFs

Bond ETFs hold collections of fixed-income securities, such as government or corporate bonds. Examples include the iShares 20+ Year Treasury Bond ETF (TLT) and the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD). These funds reflect movements in bond markets, which often behave differently from equities.

4. Commodity ETFs

These provide exposure to raw materials or resources. The SPDR Gold Shares (GLD) gives access to gold price movements, while the United States Oil Fund (USO) is linked to oil futures. They are often studied in the context of diversification or inflation protection.

5. International ETFs

These funds offer exposure to non-domestic markets. The iShares MSCI EAFE ETF (EFA) reflects developed markets outside the US and Canada, while the iShares MSCI Emerging Markets ETF (EEM) includes companies from countries with developing economies.

How to buy ETFs in 4 steps

1. Open an account

To start, you’ll need an account with a broker or an investing app that offers ETF trading, such as Crypto.com Stocks. Account setup usually requires providing personal details, verifying your identity and funding the account. Once approved, you’ll be able to place trades directly from the platform.

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2. Research and choose

Next, identify which ETF aligns with your financial goals and risk tolerance. Some investors look at index-based funds, while others explore sector, bond, or thematic ETFs. It’s important to review details such as the fund’s holdings, expense ratio and historical performance before making a choice.

3. Place an order

When you’re ready to buy, you can place a trade. A market order executes at the current available price, while a limit order lets you set the maximum price you’re willing to pay. Orders are processed during market hours and your ETF shares will appear in your account once filled.

4. Monitor and manage

After buying, keep track of your ETF’s performance over time. Some investors rebalance their portfolios periodically to maintain their target mix of assets. Monitoring helps ensure your investments continue to match your objectives as markets and personal circumstances change.

ETFs vs stocks vs mutual funds: Key differences

When comparing investment options, it helps to understand how stocks, ETFs and mutual funds differ in structure, risk, and cost.

As you’ve now learned, ETFs hold multiple assets, so they provide exposure to many holdings in one purchase. This typically spreads risk more effectively than owning a single stock.

Stocks represent ownership in a single company. If the business performs well, stockholders may benefit through price appreciation (when selling shares) or dividends. However, if the company struggles, the value can decline sharply. This makes stocks higher risk but also higher potential reward.

How to invest in stocks in the US

Mutual funds also pool money to invest in a basket of securities, but they’re managed differently. They are priced only once per day after markets close and often carry higher management fees, especially if actively managed.

In short, ETFs blend features of both – they offer diversification similar to mutual funds while maintaining the trading flexibility of stocks. Each option has strengths and limitations, and the right choice depends on your goals, risk tolerance and preferred time horizon.

Ready to get started?

1. Sign up to Crypto.com and create your Crypto.com Stocks account.
2. Discover ETFs that match your goals with ease.
3. Start investing in ETFs from 0% commission.

FAQs about exchange-traded funds (ETFs)

Are ETFs stocks?

No, ETFs are investment funds that hold a collection of assets, such as stocks, bonds or commodities. They trade on stock exchanges in a similar way to individual company shares.

What’s the difference between ETFs and mutual funds?

ETFs can be bought and sold throughout the trading day and they generally have lower expense ratios. Mutual funds are priced once daily after markets close and often carry higher ongoing fees.

Are ETFs tax efficient?

ETFs are generally structured in a way that can provide certain tax efficiencies compared to mutual funds, though outcomes vary by investor. This structure can sometimes reduce taxable distributions compared to traditional mutual funds.

Do ETFs pay dividends?

Yes, some ETFs distribute dividends if the underlying securities generate dividend or interest income. Payments are usually passed along to investors on a monthly, quarterly, or annual basis.

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All investments involve risk, and not all risks are suitable for every investor. The value of securities may fluctuate and as a result, clients may lose more than their original investment. The past performance of a security, or financial product does not guarantee future results or returns. Keep in mind that while diversification may help spread risk, it does not assure a profit or protect against loss in a down market. There is always the potential of losing money when you invest in securities or other financial products. Investors should consider their investment objectives and risks carefully before investing.