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What's an ETF?

11 minute read
  •  
December 17, 2024

An ETF (exchange-traded fund) is an investment that's built like a mutual fund—investing in potentially hundreds, sometimes thousands, of individual securities—but trades on an exchange throughout the day like a stock.

How do ETFs work?

ETFs are investment funds that are traded on exchanges, much like stocks. They're made up of a basket of securities, such as stocks, bonds, or commodities, and are designed to track the performance of a specific market index or sector. ETFs offer investors a convenient and cost-effective way to diversify their portfolios, providing exposure to a wide range of assets with a single investment. Because ETFs trade on an exchange, they can be bought and sold throughout the trading day, unlike mutual funds, which trade once per day after the market closes, regardless of when you place your order.

How is an ETF different from a mutual fund?

ETFs and mutual funds are both popular investments that allow individuals to invest in a diversified portfolio of stocks, bonds, and other assets. However, there are some key differences in ETFs versus mutual funds:

  • ETFs are traded on an exchange throughout the day; mutual funds are traded at the end of the day based on the fund's net asset value (NAV).
  • Vanguard ETFs® can be purchased for as little as $1, whereas mutual funds usually require a minimum initial investment of at least $1,000.
  • ETFs typically have lower fees than mutual funds since most are passively managed and have lower operating costs.
  • ETFs are generally considered more tax-efficient than mutual funds; ETFs often have lower turnover rates, resulting in fewer capital gains distributions.

ETF benefits

Why invest in ETFs? Below are some reasons to consider adding this popular investment to your portfolio.

Diversify your holdings

Similar to index mutual funds, an ETF could contain hundreds—sometimes thousands—of stocks or bonds, spreading out your risk exposure compared to owning just a handful of individual stocks or bonds.

Enjoy lower investment minimums

An ETF's minimum is the price of a single share, which could be as little as $50, depending on the ETF (Vanguard ETFs can be bought and sold for as little as $1). A mutual fund may require $1,000, $3,000, or more to get started.1

Have more transparent pricing

ETFs provide real-time pricing, so you can see their prices change throughout the trading day. Mutual funds aren't priced until the trading day is over, so you don't know your price until after you've placed your trade.

Enjoy lower costs

ETFs are a great low-cost investment option. Unlike mutual funds, ETFs provide real-time pricing and various order types that give you more control over your price. They can also be bought and sold online commission-free in your Vanguard Brokerage Account.2

Experience more trading flexibility

Another benefit of ETFs is their tradability. While mutual funds can only be bought or sold at the end of the trading day, ETFs trade throughout the day, just like stocks. This allows investors to adjust their holdings quickly and easily in response to market changes or new investment opportunities.

Buy ETFs

Are ETFs tax-efficient?

Similar to conventional index mutual funds, most ETFs try to track an index, such as the S&P 500. An index ETF only buys and sells stocks when its benchmark index does (aside from rebalancing or tax-loss harvesting). Big investment moves—like when a company is removed from the index completely—happen very rarely.

In addition, ETF managers can use capital losses to offset capital gains within the fund, further reducing (or possibly eliminating) the taxable capital gains that get passed on to fund shareholders at the end of each year.

Disadvantages of ETFs

Wondering when an ETF may not be the best fit? If you're looking to automate specific transactions, an ETF may not be the best choice, since you can't automate investments or withdrawals. Additionally, ETFs may not perfectly track the performance of the underlying index or sector due to factors such as fees, trading costs, and changes in the fund's composition. This can result in a difference between the fund's performance and the performance of the index it's tracking.

What are the different types of ETFs?

While Vanguard has dozens of different ETFs, there are 3 main types/options:

  • Core ETFs. You can build a fully diversified portfolio with our 4 total-market ETFs that cover nearly all aspects of the U.S. and international stock and bond markets.
  • ESG ETFs. Find an ETF that aligns with your personal preferences and considers environmental, social, and governance issues.
  • Short-term ETFs. Use these ETFs to save for a short-term goal, like a down payment on a home.

Do ETFs pay dividends or capital gains? If so, can I reinvest them?

Just like mutual funds, ETFs can distribute capital gains (usually once per year in December) and dividends (monthly or quarterly, depending on the ETF). Even though capital gains for index ETFs are rare, you may face capital gains taxes even if you haven't sold any shares.

If you own your ETFs in a Vanguard Brokerage Account, you may be able to reinvest capital gains and dividends.

Learn more about our brokerage reinvestment program

Can I convert my conventional Vanguard mutual fund shares to Vanguard ETF Shares?

Yes. Most funds that offer ETF Shares will allow you to convert mutual fund shares to ETF Shares of the same fund. (Four of our bond ETFs—Total Bond Market, Short-Term Bond, Intermediate-Term Bond, and Long-Term Bond—don't allow for conversions.)

Conversions are allowed from Admiral™ Shares and are tax-free if you own your mutual fund and ETF Shares through Vanguard.

Keep in mind that you can't convert ETF Shares back to conventional shares. If you decide in the future to sell your Vanguard ETF Shares and repurchase conventional shares, that transaction could be taxable.

How to convert Vanguard mutual fund shares to ETF shares

If you have a brokerage account at Vanguard, there's no charge to convert conventional shares to ETF shares. If you own your Vanguard mutual fund shares through another broker, keep in mind that some brokers may not be able to convert fractional shares, which could result in a modest taxable gain for you. Other brokers may also charge a fee for a conversion. Contact your broker for more information.

Can I buy ETFs from other companies through Vanguard?

All Vanguard clients have access to ETFs and mutual funds from other companies, as well as individual stocks, bonds, and CDs (certificates of deposit). And you'll pay $0 commission to trade ETFs and stocks online.

Invest in stocks, bonds, CDs & funds from other companies

ETF trading & pricing FAQs

What types of ETF trades can I place?

You can place any type of trade that you would with stocks, including:

  • Limit orders, which ensure you get a price in the range you set—the maximum you're willing to pay or the minimum you're willing to accept.
  • Market orders, which are likely to execute immediately at the best available price but offer less control over the price you pay or receive.
  • Stop orders, which combine multiple steps: First, you set a trigger price. When the price of the ETF moves past your trigger price, a market order is immediately created.
  • Stop-limit orders, which also combine multiple steps: Like a stop order, you first set a trigger price. But when the price of the ETF moves past your trigger price, a limit order is immediately created.

Understand order types & how they work

You can also buy on margin or sell short, but you'll need to be preapproved for these types of transactions based on your level of experience and asset level.

Can I exchange an ETF I already own for a new one?

The process of selling shares of one ETF and purchasing shares of another has 2 steps—similar to the process for buying and selling stocks. First, you'll need to sell shares of the ETF you already own; the proceeds of the sale will be available in your settlement fund within your account. Once the security is sold, you can purchase shares of another security immediately.

How is the market price of an ETF determined?

The market price of an ETF is determined by the prices of the stocks and bonds held by the ETF, as well as market supply and demand.

The market price can change throughout the trading day and may be above or below the total value of the stocks and bonds the ETF invests in. Though the difference is usually small, it could be significant when the market is particularly volatile.

Why is the market price sometimes different from the net asset value (NAV) of an ETF?

The market price of an ETF is driven in part by supply and demand. Depending on these market forces, the market price may be above or below the NAV of the fund, which is known as a premium or discount.

For historical information on the daily closing market price and NAV for a specific Vanguard ETF, look for the Price tab on the ETF's profile page.

Browse Vanguard's complete ETF lineup

What's an expense ratio in an ETF?

An expense ratio in an ETF is the annual fee that an investor pays to the fund's management company for managing the fund. It's expressed as a percentage of the fund's total assets and is deducted from the fund's assets before any returns are distributed to investors. This fee covers the costs of managing, operating, and administering the fund and is typically used to cover expenses such as portfolio management, legal and accounting fees, marketing and distribution expenses, and other administrative costs. The expense ratio is an important factor to consider when choosing an ETF, as it directly impacts the overall returns and performance of the fund.

How to choose an ETF?

When choosing an ETF for your portfolio, there are a few key factors to consider. First, look at the fund's objective and make sure it aligns with your investment goals and risk tolerance. Next, research the fund's holdings and make sure they're diversified and in line with the market sector or industry you want exposure to. It's also important to consider the fund's expense ratio and bid-ask spread as these can impact your returns. Finally, compare the performance of the ETF to its benchmark index and other similar funds to ensure it has a track record of meeting its objectives.

Buy on margin

To buy a security using money borrowed from a broker. If the price of the security rises before you sell it, you keep all the gains after repaying the loan (and interest). However, if the price of the security drops substantially, you could lose more than your initial investment.

Sell Short

To sell shares of a security that the seller doesn't own — in other words, to complete a sale by delivering shares borrowed by or for the seller. Such sales are made in anticipation of a decline in the price of the security, which enables the seller to cover the sale with a future purchase at a lower price and therefore a profit.

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1Vanguard Target Retirement Funds and Vanguard STAR® Fund have a $1,000 minimum. Most other Vanguard funds have a $3,000 minimum. Some Vanguard funds have higher minimums to protect the funds from short-term trading activity. Fund-specific details are provided in each fund profile.

2Commission-free trading of Vanguard ETFs applies to trades placed online; most clients will pay a commission to buy or sell Vanguard ETFs by phone. Commission-free trading of non-Vanguard ETFs applies only to trades placed online; most clients will pay a commission to buy or sell non-Vanguard ETFs by phone. Vanguard Brokerage reserves the right to change the non-Vanguard ETFs included in these offers at any time. All ETFs are subject to management fees and expenses; refer to each ETF's prospectus for more information. Account service fees may also apply. All ETF sales are subject to a securities transaction fee. See the Vanguard Brokerage Services commission and fee schedules for full details. 

All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss.

For more information about Vanguard funds, visit vanguard.com to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.

You must buy and sell Vanguard ETF Shares through Vanguard Brokerage Services (we offer them commission-free online) or through another broker (who may charge commissions). See the Vanguard Brokerage Services Commission and Fee Schedules for limits. Vanguard ETF Shares are not redeemable directly with the issuing Fund other than in very large aggregations worth millions of dollars. ETFs are subject to market volatility. When buying or selling an ETF, you will pay or receive the current market price, which may be more or less than net asset value.

ESG funds are subject to ESG investment risk, which is the chance that the stocks or bonds screened by the index provider or advisor, as applicable, for ESG criteria generally will underperform the market as a whole or, in the aggregate, will trail returns of other funds screened for ESG criteria. The index provider or advisor's assessment of a company, based on the company's level of involvement in a particular industry or their own ESG criteria, may differ from that of other funds or an investor's assessment of such company. As a result, the companies deemed eligible by the index provider or advisor may not reflect the beliefs and values of any particular investor and may not exhibit positive or favorable ESG characteristics. The evaluation of companies for ESG screening or integration is dependent on the timely and accurate reporting of ESG data by the companies. Successful application of the screens will depend on the index provider or advisor's proper identification and analysis of ESG data. The advisor may not be successful in assessing and identifying companies that have or will have a positive impact or support a given position. In some circumstances, companies could ultimately have a negative or no impact or support of a given position.