The Basics of Exchange-Traded Funds (ETFs)
When it comes to investing your money, a wide range of options are at your disposal including stocks, bonds, mutual funds, certificates of deposit (CDs), annuities, and retirement plans such as 401(k) and 403(b) plans. While these are just some examples of the most common investment options, one alternative that’s become more popular over the last 30+ years is an exchange-traded fund (ETF).
Key Takeaways
- What an ETF is: A diversified basket of securities—stocks, bonds, currencies, or commodities—that typically tracks a market index, sector, or theme and trades on an exchange like a stock.
- Explosive growth: ETF ownership has climbed to 19.8 million U.S. households, with total net assets up from $2.1 trillion in 2015 to $13.4 trillion through 2025 across 4,495 funds.
- Many flavors: Common types include equity, bond, commodity, sector, international, thematic, currency, dividend, and market-cap index ETFs—each offering targeted exposure through a single investment.
- Cost and flexibility edge: Most ETFs are passively managed (avg. 0.53% expense ratio vs. 1.42% for equity mutual funds), trade intraday, offer daily holdings transparency, and have no investment minimums.
- Mind the risks and taxes: Watch for broker commissions and the chance a fund closes; ETF gains are still taxed via capital gains, dividends, and occasional capital gain distributions.
What is an exchange-traded fund (ETF)?
An exchange-traded fund (ETF) is an investment fund holding a diversified basket of securities such as stocks, bonds, currencies, or commodities. ETFs are typically designed to follow a specific investment strategy, market sector, or theme (e.g., the popular SPY ETF tracks the S&P 500 Index, providing exposure to 500 of the largest U.S. companies via a single investment).
How exchange-traded funds work: index fund comparison
A “market index” measures the price performance of a group of assets (e.g., stocks or bonds) within a specific market, industry, or sector—constructed by aggregating the values of their components and tracking overall performance over time. The Nasdaq Composite is a well-known example, primarily tracking the performance of technology companies such as Apple, Amazon, Meta, and Netflix. The Dow Jones, another popular index, consists of 30 large, publicly traded companies spanning a broad range of industries with holdings including Home Depot, McDonald’s, Walt Disney, and Microsoft. There are literally thousands of indexes to choose from in the United States alone.
This is where ETFs come in; if you like the performance of a particular market index but don’t want to spend money buying individual stocks or invest the time needed to research and manage each one, an ETF allows you to conveniently and cost-effectively replicate index performance—with many in fact specifically designed to track these market indexes, making it easy for investors to gain broad exposure through a single investment.
ETFs have grown in popularity
Since the first American ETF launched back in 1993, these relatively new investment vehicles have gained traction in the United States—their continued expansion suggesting strong investor interest, this upward trend expected to persist in the foreseeable future. Investors are specifically drawn to ETFs for their cost-effectiveness, built-in diversification, and the flexibility to buy or sell shares throughout the trading day: factors fueling the ongoing influx of capital into these funds.
Different ETF types
Some of the most common ETFs among several types include:
Stock/equity ETFs
Stock ETFs track a specific stock index or sector. Examples include S&P 500 ETFs, technology sector ETFs, and international stock ETFs.
Bond (fixed income) ETFs
Bond ETFs invest in bonds or other fixed-income securities, “fixed-income” meaning investments that pay regular interest. These ETFs can focus on government, corporate, municipal, or international bonds.
Commodity ETFs
Commodity ETFs track the price of commodities such as gold, oil, or agricultural products. Some hold the physical commodity, while others use futures contracts (agreements to buy or sell a commodity at a set price on a future date).
Sector and industry ETFs
Industry ETFs focus on specific sectors such as healthcare, energy, financials, or real estate.
International and global ETFs
Global ETFs invest in markets outside the investor’s home country and can target specific countries, regions, or developed/emerging markets.
Thematic ETFs
Thematic ETFs are based on a specific theme or trend such as clean energy, artificial intelligence, or cybersecurity.
Currency ETFs
Currency ETFs track the performance of a specific currency or basket of currencies.
Dividend ETFs
Dividend ETFs hold stocks of companies with a consistent history of paying dividends to shareholders.
Market-cap index ETFs
Market-cap index ETFs track a market index by holding stocks weighted by their market capitalization.
Active vs. passive management: key differences
You might assume ETFs share similarities with mutual funds and index funds. You’re right! The key difference, however, is with respect to how they’re managed. Consider two popular funds: the Fidelity Contrafund (actively managed) and the Vanguard 500 Index Fund (passively managed). While Contrafund managers actively manage their portfolio to beat the market, the Vanguard fund simply seeks to replicate S&P 500 performance. This illustrates the core distinction between active and passive management.
Active management: trying to outperform a benchmark
Actively managed investments (e.g., many mutual funds) see a dedicated team striving to outperform a specific benchmark such as the S&P 500. You can think of it like a chef constantly tweaking a recipe: tasting and making changes to create the best possible dish. These professionals use research, analysis, and frequent trading to pursue higher returns than the market average. The goal of active management? To deliver returns surpassing the market, even after accounting for management fees. Achieving this often requires constant research and asset trading, making actively managed funds more expensive to operate with investors typically paying higher fees. Despite the higher costs and professional expertise, there’s no guarantee active managers will consistently beat the market—meaning investors should carefully consider both possible rewards and risks given potential underperformance.
Passive management: trying to match a benchmark
In contrast, passive investment management seeks to match the returns of a chosen benchmark (such as the S&P 500) rather than outperform it. These types of funds require minimal human oversight and less frequent trading, making them largely automated as part of a simplified approach that costs less than active fund management. Their simplicity and affordability make passive funds a good match for beginners or investors who favor a straightforward, low-maintenance way to participate in the market.
How do ETFs differ from mutual funds?
| ETFs | Mutual funds | |
|---|---|---|
| Fees | Mostly passive, so lower—averaging about 0.53% | Active funds cost more—averaging about 1.42% for U.S. equity funds |
| Trading | All day on an exchange, at real-time prices | Once per day, priced after markets close |
| Tax efficiency | Generally more efficient—you rarely owe tax on gains you didn't trigger | Can pass along capital gains from other investors' sales |
| Minimum investment | None—buy as little as a single share | Often $1,000+ (ranges from $1 to $5,000) |
While ETFs are often compared to mutual funds since both aim to pool investors’ money to build diversified portfolios, these two investment vehicles operate differently with respect to…
Fund management
Most ETFs are passively managed and thus tend to have lower management fees than actively managed mutual funds. ETF.com, for example, reports the average U.S. equity mutual fund charges 1.42% in annual administrative expenses while the average ETF charges just 0.53%.
Trading flexibility
ETFs trade on stock exchanges throughout the day—just like individual stocks—with prices that fluctuate in real time based on supply and demand. In contrast, mutual fund shares are only bought or sold through the fund company and priced once per day after markets close. This difference gives ETF investors more flexibility and control over their trading decisions.
Tax efficiency
ETFs are generally more tax-efficient than mutual funds as you're less likely to owe capital-gains tax on gains you didn't trigger yourself. You will, however, pay capital gains taxes when you sell ETF or index fund shares for more than you paid. If you buy index fund shares for $1,000 and later sell them for $1,200, for example, you’d have a $200 capital gain and owe taxes on that amount. Mutual fund sales can lead to even more taxes, as shown here in this scenario…
Another investor wants to cash out and sell mutual fund shares.
The fund manager may need to sell some fund investments in order to raise the cash needed to pay the investor.
The fund realizes a capital gain if the investments are sold for more than they were purchased for.
The profit is divided among all current shareholders (not just the investor who sold), meaning you could end up owing taxes on your share of those gains even if you didn't sell any of your own shares.
When investors sell ETF shares, on the other hand, it usually doesn’t trigger taxes for other investors.
Minimum investment requirements
ETFs don’t require a minimum investment while many mutual funds do, ranging anywhere from $1 to $5,000 with many popular funds requiring at least $1,000.
ETF investment benefits
Low fees and ease of trading are two primary factors fueling ETF growth. A few additional benefits include…
Transparency
ETFs offer more transparency regarding their holdings compared to mutual funds, which typically report portfolios only once a month or quarter. This distinction matters. Why? Because mutual fund managers might deviate from their stated investment objectives to potentially introduce additional risk. Most ETFs, in contrast, publish their complete portfolio holdings daily on public platforms—giving investors the confidence to know exactly what they own.
Lower investment minimums
You can purchase ETFs for the cost of a single share, with prices varying by fund, whereas mutual funds typically require a minimum investment amount often starting at $1,000+ and sometimes increasing significantly from there.
- Low fees—mostly passive, so cheaper to own
- Tax efficiency—you rarely owe tax on gains you didn't trigger
- Transparency—most publish full holdings daily
- Low minimums—buy for the price of a single share
- Intraday trading—buy or sell anytime markets are open
- Built-in diversification in a single investment
- A fund can close—if it doesn't attract enough assets, you may be forced to sell sooner than planned, with tax consequences
- Trading costs—online brokers may charge commissions, which can add up if you buy small amounts often
- Market risk—as with any investment, you can lose principal
ETF investment risks
As with most investment options, you’ll also need to consider some risks when investing in an ETF. Common ones include…
The possibility of an ETF folding
If an ETF is closed and liquidated, it typically means the fund didn’t attract enough assets to cover administrative costs. Although your investment is returned, you may be required to sell holdings sooner than planned—potentially triggering unexpected tax consequences.
Trading costs
Mutual fund companies often don’t charge a broker’s commission for buying and selling shares, though some may have transaction fees. In contrast, ETFs are exchange-traded and may incur online broker commission fees. Consider these costs carefully—especially if you regularly purchase small quantities of ETFs—to ensure such fees don’t outweigh the benefits of lower management fees and tax efficiency.
How ETFs are taxed
ETFs are taxed in three primary ways: dividends, capital gains, and annual capital gain distributions.
Capital gains tax
You’ll owe capital gains tax when you sell ETF shares for a profit and incur short-term capital gains tax (taxed at your ordinary income rate) for any shares held for less than a year. Sell shares held for more than a year, and you’ll pay long-term capital gains tax typically ranging from 0% to 20% depending on your income. If you buy ETF shares for $2,000 and sell them for $3,000 after holding them for over a year, for example, your taxable gain would be $1,000 (meaning you’d owe $150 in taxes on the sale at a long-term capital gains tax rate of 15%).
Dividends
Dividends received from ETFs are often taxed as ordinary income or qualified dividends, typically taxed at lower long-term capital gains rates with the tax treatment ultimately depending on the ETF and your individual tax situation.
Annual capital gain distributions
Some ETFs may generate capital gains distributions: shareholder payments from profits earned by selling underlying securities. The tax treatment of distributions can vary based on the type of ETF (e.g., stock, bond, commodity, or international).
Where to find ETF performance data
ETF performance data is available on a variety of reputable financial websites and platforms. Here are some of the most reliable sources (note Vision Retirement has no affiliation with third-party sites)…
ETF provider websites
Most ETF issuers (e.g., iShares and SPDR) provide up-to-date performance data on their official websites for each fund.
Financial news sites
Websites like Yahoo Finance, Google Finance, Bloomberg, and Morningstar offer complete ETF performance data including historical returns, interactive charts, and side-by-side fund comparisons.
Brokerage platforms
If you have an account with an online broker like Betterment, you can look up ETFs and examine detailed performance data directly through their platform interfaces.
Market data aggregators
Services such as Seeking Alpha and ETF.com have tools to evaluate and compare ETF performance including information on fees, holdings, and risk metrics.
In sum: exchange-traded fund investments
ETFs are often a viable option for many people—including young or new investors—as only a small amount of capital is required to jump in. As with most investment options, however, they do have some risks. As selecting the right ETF for your needs might feel overwhelming (with almost 5,000 ETFs currently available to choose from in the U.S.), it’s important to work with a qualified financial advisor who can help guide you and determine if (and how) specific options fit into your overall retirement plan.
Still have questions about ETFs, how they fit into your investment strategy, or how to begin investing in them? Schedule a FREE discovery call with one of our financial advisors to get them answered.
Reviewed for accuracy
Benjamin Stark, CFP®
Financial Advisor and Director of Client Experience at Vision Retirement, with 10+ years as a financial advisor.
Read full bio →FAQs
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An ETF expense ratio is the annual fee an exchange-traded fund (ETF) charges shareholders to cover operating costs, expressed as a percentage of the fund’s average assets under management (AUM). If an ETF has an expense ratio of 0.20%, for example, you’ll pay $2 per year for every $1,000 you have invested in the fund. Because the ratio is automatically deducted from fund returns, you won’t pay it directly—the returns you see are already net of these expenses.
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Exchange-traded funds are traded on stock exchanges in a manner similar to individual stocks.
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Yes, an exchange-traded fund can pay dividends; many hold stocks or other assets that themselves pay dividends or interest. When companies or securities in an ETF’s portfolio pay dividends, the ETF collects those payments and typically distributes them to ETF shareholders (often on a quarterly, semiannual, or annual basis).
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Yes, an exchange-traded fund can split just like individual stocks. An ETF split occurs when the fund boosts the number of outstanding shares by issuing more shares to current shareholders—the price per share decreasing proportionally to keep the total value of each investor’s holdings the same. In a 2-for-1 split, for example, each shareholder receives an additional share for every share they own (the price per share cut in half). Splits usually set out to make the ETF’s share price more attractive or accessible to investors.
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First, open an investment account with a brokerage firm or your financial advisor. You can then select ETFs on your own or consult a financial advisor for guidance.
Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.
There is no assurance that the techniques and strategies discussed herein are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal.
ETFs trade like stocks, are subject to investment risk, fluctuate in market value, and may trade at prices above or below the ETF's net asset value (NAV). Upon redemption, the value of fund shares may be worth more or less than their original cost. ETFs carry additional risks such as not being diversified, possible trading halts, and index tracking errors. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor
