The ABCs of ETFs

ETF: The investment fund that trades like a stock.

Understanding ETFs

Let's say you want to invest in big tech stocks—maybe Apple (AAPL), Amazon (AMZN), Alphabet (GOOGL), Facebook (META) and Microsoft (MSFT). The bad news is, buying just one share of each of those companies will set you back roughly $3,000. 

Fortunately, there's another way. You can buy shares in an exchange-traded fund (ETF), which is a basket of stocks that itself trades on stock exchanges. That means it trades just like individual company stocks, but you don't have to shell out a month's pay to get in the game. 

Because ETFs trade like stocks, you need to buy shares in them from a broker. It's not too scary: just pull up a broker's website and look for your chosen fund's ticker symbol. Just like with a stock, you'll be buying a number of shares, not a dollar amount.

It takes all kinds (of ETFs)

ETFs come in different shapes and sizes, and are organized through different strategies. Many ETFs track indices or sectors, and they even have a ticker symbol, just like a stock. 

Got a preference for bank stocks? You could invest in an ETF like the Vanguard Financials (VFH). 

Want to avoid banks? Load up on the Invesco QQQ ETF, which tracks the Nasdaq-100, a market index comprising 100 of the largest non-­financial companies on Nasdaq.

Many ETFs base their holdings on a market index or a specific market sector.  

Some ETFs, often labeled ESG (for environmental, social and governance) funds, follow self-imposed ethical guidelines. For example, they might only buy stock in companies committed to ethical business practices or environmental sustainability.

Benefits of ETFs

Avoid excess fees 

Most ETFs are passively managed, which means they track indices—as opposed to paying an expert (also known as a portfolio manager) to pick the stocks. As a result, they have a lower expense ratio than actively managed mutual funds—meaning you pay less money to the managers of the fund itself. 

Lower taxes 

Because of IRS rules and other complex factors related to the way ETFs are structured, the profit you make from an ETF is not subject to capital gains tax until you sell your shares: another benefit of ETFs. By contrast, daily gains in a mutual fund are taxable. 

If your investments are all in tax-deferred retirement accounts such as IRAs or 401(k)s, capital gains tax won't be an issue. But you will need to pay income tax on those withdrawals in retirement, just like with mutual fund earnings.

Are ETFs a good long-term investment?

They certainly can be! ETFs are traded on exchanges all day long just like individual stocks. Why does this matter? Because it lets investors take advantage of market swings. 

Of course, if you're saving for retirement or another long-term goal, it's generally not a great idea to try to time the market. But professional money managers at pension funds, university endowments and other enormous pools of assets can rely on ETFs as they make—and act on—strategic investment decisions all day long. 

Given these advantages, it's no surprise that ETFs have become a huge force in global markets. In the U.S. alone, total assets in ETFs more than doubled in the five years through 2017. 

So as you're pondering how to invest for goals like retirement, consider adding some ETFs to your portfolio. Choose your investments wisely, and you'll be able to set them and forget them, assured that your ETFs will be working for you the whole time.