How do ETFs work? The basics, pros & cons

Exchange-traded funds (ETFs) may sound like intimidating investment instruments, but at their core, they're diversified portfolios, like mutual funds, that are easily traded, like stocks. But how do ETFs work exactly, and could they be a good addition to your taxable, tax-deferred or tax-free accounts? Read on to learn more about these increasingly popular securities.

Like mutual funds, ETFs enable investors to purchase an interest in a diversified portfolio of securities. These might include stocks, bonds or other assets. But unlike a mutual fund that is not exchange-traded and only trades once at the end of the day, ETFs are more like conventional stocks in which investors buy and sell shares at fluctuating market prices on exchanges throughout the trading day.

Many ETFs track the performance of a market index.^* For example, an ETF that tracks the S&P 500 Index would invest in most or all of the large-cap U.S. equities. There are ETFs that track all kinds of indexes, so it's likely you can find one that gives you exposure to assets that fit your objectives. There are corporate bond ETFs, for example, as well as those that track indexes of emerging markets, the technology sector and mid-sized companies.

Since ETFs invest in most or all of the securities in an index, the ETF returns typically mirror the returns of the index it's tracking rather than outperform it. But a growing number of ETFs attempt to achieve a better rate of return than particular indexes. These are called "actively managed ETFs" because they're run by an advisor who buys and sells securities to accomplish a specific investment objective.

Like mutual funds, ETFs offer an easy way to access a basket of diverse securities. Spreading your investments among different kinds of assets can help mitigate some of the risks of investing. While you could technically purchase many individual stocks or bonds to achieve diversification, that strategy can be both arduous and expensive.

Generally speaking, ETFs have the ability to meet redemptions in-kind, rather than by selling the portfolio securities. This arrangement minimizes capital gains distributions. As a result, the SEC notes, "taxes on ETF investments have been historically lower than those for mutual fund investments."

You can buy and sell shares in ETFs through a brokerage account much like you'd buy stocks, and many brokerages offer commission-free trades. In addition, plenty of ETFs aren't very expensive.

Another bonus: ETFs that passively track an index generally have low expense ratios because they're less costly to operate. That translates into lower fees for you.

You can see the market price of an ETF throughout the day; some ETFs will even publicly disclose their holdings daily. That disclosure can be useful if you want to monitor exactly what you're investing in, especially if you're trying to avoid certain sectors or companies that don't align with your values.

A loving young Asian mother and adorable little daughter holding a fallen red maple leaf together, enjoying the beautiful Autumn scenics in nature park

A loving young Asian mother and adorable little daughter holding a fallen red maple leaf together, enjoying the beautiful Autumn scenics in nature park

ETF vs. mutual fund: How to choose?

Mutual funds and ETFs are two types of fund categories that give you access to a basket of stocks, bonds and other assets. They share some characteristics, and you even may consider investing in both.

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As with stocks, bonds and other securities, ETFs can decline in value and you could lose your investment. And there are a couple of other additional cons to consider:

If you buy or sell shares through a brokerage that doesn't offer free trading commissions, the fees can add up and dent your investment returns. Further, reinvesting a dividend payment or capital gains distribution can be complicated, incurring more brokerage fees.

An ETF can be priced above or below its net asset value (the value of its underlying holdings) in the marketplace. That's because other factors can affect the market price, including investors' demand for the fund. However, the ETF market is structured to minimize the risk of these premiums or discounts to net asset value developing.

As you explore how ETFs work, you'll still want to take the time to research a particular ETF before investing in it. An ETF's prospectus—a legal document with details about an investment—can tell you important information like its potential risks, fees, investment strategy and financial performance history. Some ETFs, like leveraged ETFs, operate very differently than a standard ETF. You'll want to understand the features of these specialized assets before diving in.

Whether you're considering investing in an ETF, stocks or mutual funds—or a mix of all three—connecting with a financial advisor can walk you through these options and help you build an investment portfolio that will best suit your risk tolerance and financial goals.