An ETF is a collection of stocks or bonds in a single fund that trades on major stock exchanges. Learn how ETFs work to decide if they're right for you.
What is an ETF?
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.
ETF shares are created when big financial firms, called authorized participants, buy a basket of the underlying stocks and exchange it for a large block of ETF shares (called a creation unit) with the fund company. To redeem shares, they do the reverse—giving ETF shares back in exchange for the underlying stocks. This process helps keep the ETF's market price close to its actual value.
Did you know? 84% of Vanguard ETFs® outperformed their peer group over 10 years.1
ETF vs. 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.
Here's a simple breakdown:
| Feature | ETFs (exchange-traded funds) | Mutual funds |
|---|---|---|
| Trading | Trade like stocks throughout the day on exchanges | Traded once per day after market close |
| Pricing | Market price fluctuates in real time | Priced based on net asset value (NAV) daily |
| Minimum investment | Invest as little as the cost of one share, or $1 through dollar-based investing | Often require minimum initial investments (e.g., $1000+) |
| Fees | Typically lower expense ratios; may have trading commissions | Higher expense ratios; some have sales loads |
| Tax efficiency | Generally more tax-efficient due to structure | Less tax-efficient; more capital gains distributions |
ETF vs. stock
ETFs help with diversification by pooling hundreds or thousands of securities, which helps reduce the impact of any single underperforming asset. In contrast, holding individual stocks concentrates risk, making your portfolio more vulnerable to company-specific events that can negatively affect the stock's value.
Individual stocks represent ownership in a single company and are often used in active investing, where investors try to outperform the market by picking winners. While ETFs can be actively managed , most follow a passive strategy, tracking broad indexes to provide diversified, low-cost exposure with less reliance on timing or stock-picking. While active investors may trade stocks frequently, ETFs are typically favored by those seeking consistent, long-term market returns.
Types of ETFs
There are many different types of ETFs available to investors, including:
- Index and actively managed ETFs. Index ETFs track a specific market index, such as the S&P 500, offering low-cost, passive exposure to a broad market segment. Their actively managed counterparts employ portfolio managers who aim to outperform the market by selectively buying and selling holdings.
- Stock and bond ETFs. Stock ETFs invest in equities across various market capitalizations and styles, helping provide diversified exposure to the stock market. Bond ETFs hold fixed income securities such as government, corporate, or municipal bonds, with a goal of offering income generation and portfolio stability. Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.
- Sector ETFs. Sector ETFs focus on specific industries—such as technology, health care, or energy—allowing investors to target sectors they choose. Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility.
- Commodity ETFs. Commodity ETFs provide exposure to physical goods like gold, oil, or agricultural products. They can serve as a hedge against inflation and can be held either directly or through futures contracts.
- International and global ETFs. International ETFs invest in markets outside the U.S., offering geographic diversification. Global ETFs include both domestic and foreign markets, providing comprehensive worldwide exposure. Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.
- Specialty ETFs (leveraged and inverse funds). Leveraged ETFs aim to amplify daily returns—such as 2x or 3x the index performance—and are designed for short-term trading. Inverse ETFs aim to profit from market declines by delivering the opposite return of their benchmark and are often used as a hedging tool.
Advantages of ETFs
ETFs offer investors many benefits, including:
- Diversification. Similar to index mutual funds, an ETF could contain hundreds—sometimes thousands—of stocks or bonds, helping to spread out your risk exposure compared to owning just a handful of individual stocks or bonds.
- 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 for fraction shares and dollar-cost investing. A mutual fund may require $1,000, $3,000, or more to get started.2
- 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.
- 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.3
- 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.
Why are ETFs more tax-efficient?
In general, ETFs are more tax-efficient because they can manage shareholder activity without selling holdings within the fund. While mutual fund managers need to rebalance the fund based on shareholder activity, ETF managers only need to create or redeem creation units. This means investors may have less exposure to capital gains.
It's important to note that emerging markets ETFs, leveraged/inverse ETFs, and commodity ETFs can be tax-inefficient due to volatile cash flows and/or restrictions around performing in-kind deliveries of securities. Volatile cash flows may introduce a need for more portfolio rebalancing to better track the indexes, resulting in potential tax consequences.
Learn more about the differences between ETFs and mutual funds.
Disadvantages of ETFs
Investors should be aware of the potential downsides to investing in ETFs, including:
- Trading costs. While ETFs often have low fees, they can come with trading costs that can add up over time. Every time you buy or sell, you pay the bid-ask spread—the difference between the buying and selling price—and some brokers may still charge commissions, especially for frequent traders. These small costs can eat into returns, particularly if you trade often.
- Tracking error. 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.
How to invest in ETFs
You can follow these steps to invest in ETFs:
- Open a brokerage account.
- Fund the account.
- Research and choose ETFs based on your investing goals.
- Place your trade using ticker symbols.
Open a brokerage account
Ready to start investing in ETFs?
Do ETFs pay dividends or capital gains? If so, can I reinvest them?
Just like mutual funds, ETFs pay out dividends monthly or quarterly. Capital gains distributions are less common in ETFs than in mutual funds, but they can still occur. You may have to pay taxes on these capital gains 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, and most investors can typically do this online. 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, and funds from other companies
Frequently asked questions about ETFs
Yes, ETFs are generally suitable for beginner investors because they help provide enhanced diversification, low expense ratios, and are easy to buy and sell like stocks. Their passive management and broad market exposure make them a simple, relatively low-risk way to start investing.
Yes, you can lose money with ETFs. While they're diversified and generally lower risk than individual stocks, their value fluctuates with the market, and factors like poor performance, fees, or selling at a low share price can result in losses. Investing always carries risk—ETFs are no exception.
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 and 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.
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.
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.
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.
An ETF expense ratio 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.
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.