There’s a lot of hype around exchange-traded funds (ETFs) as a new, improved way to invest. In fact, they aren’t all that different from regular mutual funds. Like mutual funds, they pool together investors’ money to buy a diversified portfolio of stocks or bonds. The only difference is that instead of buying an ETF directly from a fund company, you buy a share of it through a brokerage, just like you would a stock.
Most ETFs are index funds, meaning that instead of having managers specially choose which investments to hold, they passively mimic some list of investments. For example, State Street’s SPDR S&P 500 (SPY), tracks the well-known index of blue-chip American companies. Vanguard Small-Cap (VB) follows an index of small companies, while iShares MSCI EAFE (EFA) holds a representative slice of foreign stocks.
Like index mutual funds, ETFs have very low costs—in fact, their annual expenses are usually a bit lower than a mutual fund tracking the same index. You may, however, lose some of that price advantage to trading costs. Since you have to buy ETFs via a broker instead of direct from the fund company, you could pay a commission each time you buy or sell ETF shares. (Many brokerages now offer free trades on some ETFs, however.) In the end, the choice between an ETF and a similar index mutual fund is mostly a matter of convenience. If you don’t already have a brokerage account, buying a regular mutual fund is simpler. If you do use a broker, an ETF gives you a way to instantly buy an index with a click of the mouse.
There’s one more important difference between ETFs and index mutual funds: There are many, many more ETFs, tracking an increasingly wide and wild variety of indexes. You can buy ETFs following just bank stocks, or stocks in the alternative energy sector, or stocks in Vietnam. Unlike broad, diversified index ETFs, hyper-focused funds like these can’t be your core investments. They are more akin to trading in individual stocks.
There are also ETFs that use alternative rules for constructing indexes. While traditional indexes weight stock holdings based on their market value, a host of new ETFs follow indexes that are tilted to favor factors the index designer thinks will give investors a chance to earn higher returns. For example, there are ETFs tilted to stocks with high dividends, and others that hold a bit more in companies with higher revenues. Although they are technically index funds, such ETFs blur the line between passive and active management. If you buy one, you may or may not do well, but you definitely can’t depend on getting the market’s average return.