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ETF Series, Part 1: What Are ETFs?

Learn about the basics of ETFs: what they are and how they came about.

You’ve likely heard of ETFs. After all, they’re becoming quite popular. In this series, we’ll discuss why ETFs have become so attractive to investors, and the mechanics of how ETFs are created and what happens when you buy one. But, before we get to that, we should first answer a very basic question: What are ETFs?

“ETF” stands for “Exchange-Traded Fund.” And that’s exactly what they are: they are funds that trade on exchanges. Why is it notable that they trade on an exchange? What does it mean that they are “funds”? Let’s explore those things and more.

One common way of explaining ETFs is to compare them to another kind of fund: mutual funds. To be sure, there are many similarities. For instance, an ETF (as its name indicates) is also a fund. Consequently, like a traditional mutual fund, each ETF holds an asset or group of assets such as:

  • U.S. stocks
  • International stocks
  • Commodities
  • Bonds
  • Or, one of a variety of asset classes.

Some of the most popular ETFs such as SPY and QQQ are index ETFs in that they hold the same stocks or use proxies as the index they follow. So, for instance, the SPY follows the S&P 500 (by far the most popular ETF), and so it contains every stock that is in the index itself. Likewise, QQQ follows the Nasdaq-100—an index composed of the 100 largest, most actively traded U.S. companies listed on the Nasdaq stock exchange—and thus has every stock in that index. So, an ETF is remarkable in that it can allow you to buy an entire index with one transaction.

Of course, ETFs go far beyond indices. As mentioned above, there’s a wide breadth of ETF types, and they can include a range of different asset classes – just like mutual funds.

But there are many important differences between mutual funds and ETFs. We’ll discuss in greater detail why some of these differences are so important in article 3 of this series. But the major differences between mutual funds and ETFs are that, while ETFs may “look like” mutual funds, they actually “behave” quite a bit more like stocks.

This is where the importance of “exchange-traded” comes in. ETFs are bought and sold (traded) on exchanges, intraday like a stock. Mutual funds are not. This means that they are “like stocks” in that most can be bought on margin, short-sold, and you can use trading tools on ETFs that you cannot use with mutual funds.

Generally speaking, ETFs also offer more transparency than mutual funds, and can also be less expensive since their operating expenses tend to be lower.

Now that you have a basic understanding of what ETFs are and their potential benefits, let’s move on to the next section and take a look at the very interesting history of ETFs.

ETFs Part 2: The Evolution of ETFs
9 Frequently Asked Questions About Short Selling

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