What is an ETF?

If you’re looking to invest your money without having to pick individual stocks, an exchange-traded fund (ETF) might be worth a closer look. An ETF bundles a mix of securities into a single investment product you can buy and sell just like a stock. It’s a simple way to spread your money across many investments at once.

ETFs have become one of the most popular options for everyday investors. They’re flexible, typically low-cost and straightforward enough for beginners while still being useful for experienced investors. Whether you’re just starting to invest or looking to diversify what you already have, it’s worth understanding how ETFs work.

What is an ETF (exchange-traded fund)?

An exchange-traded fund is a collection of securities—stocks, bonds, commodities or a mix of all 3—packaged together and sold as a single investment. When you buy one share of an ETF, you’re getting a small piece of everything inside it.

ETFs were designed to solve a real problem for everyday investors. Building a diversified portfolio used to mean buying dozens of individual securities, which took time, money and a fair amount of expertise. ETFs changed that. Instead of researching and buying each investment separately, you can get broad exposure to an entire market, sector or asset class in a single trade. That means your money isn’t tied to the performance of any one company. If one holding within an ETF has a bad day, the others can help balance it out.

How do ETFs work?

When you buy an ETF, you’re buying shares through a brokerage account, the same way you’d buy a stock. Those shares trade on a stock exchange throughout the day (as their name implies), so the price moves up and down based on supply and demand just like any other publicly traded investment.

A few key terms can help you understand what’s happening in this process:

• Market price: The price you pay when you buy or sell an ETF share. It moves throughout the day based on supply and demand.
• Liquidity: A measure of how easy it is to buy or sell an ETF. ETFs with high daily trading volume tend to be easier to trade efficiently than lower-volume funds.
• Bid-ask spread: The small difference between what a buyer will pay and what a seller will accept. It’s usually minimal for popular ETFs, but it’s a real cost worth factoring in.
• Net asset value (NAV): The total value of everything the ETF holds, divided by the number of shares outstanding. Think of it as what the ETF is worth on paper. Most of the time, market price and NAV stay very close together.

Types of ETFs

Not all ETFs are built the same. There are several types, each designed for a different investment objective or investment strategy. Here’s a quick look at the main categories and when you might consider each one:

• Broad market index ETFs track a wide index like the S&P 500 or the total U.S. stock market. These are a good starting point for core, long-term diversification.
• Sector and thematic ETFs focus on a specific industry or trend, like technology, healthcare or clean energy. These give you targeted exposure if you have a strong conviction about a particular area.
• Bond ETFs hold a collection of bonds and are often used for income generation or to balance out the risk of stock holdings.
• Commodity ETFs invest in raw materials like gold, oil or agricultural products without needing to hold the physical asset.
• Cryptocurrency ETFs offer exposure to digital assets like Bitcoin or Ethereum without requiring you to directly own or store them. They tend to carry higher volatility and fees than traditional ETFs.
• Factor and smart beta ETFs use specific criteria—like low volatility or dividend growth—to select holdings, rather than simply tracking an index.
• Actively managed ETFs don’t track an index. Instead, they’re managed by a team making active investment decisions. They typically come with higher costs.

What does it cost to invest in an ETF?

Most ETFs charge an expense ratio—an annual fee expressed as a percentage of your investment. For example, an expense ratio of 0.10% means you’d pay $1 a year for every $1,000 invested. Index ETFs tend to have very low expense ratios, while actively managed ETFs generally cost more.

When buying or selling ETF shares, keep the bid-ask spread in mind. And if your brokerage charges trading commissions, those add up, too. That said, many major brokerages have moved to commission-free ETF trading in recent years.

ETFs vs. mutual funds vs. individual stocks

ETFs aren’t the only way to invest, and they’re not always the best choice for every situation. Here’s how they compare to other common options.

	ETFs	Mutual funds	Individual stocks
Trading	Buy and sell anytime during market hours	Priced once per day, after markets close	Buy and sell anytime during market hours
Diversification	Built in—one share holds many securities	Built in—one share holds many securities	Not built in—you own shares of one company
Minimum investment	Price of one share (or less with fractional shares)	Often higher minimums, varies by fund	Price of one share (or less with fractional shares)
Costs	Expense ratio plus bid-ask spread	Expense ratio, sometimes sales charges	No ongoing fees, but no built-in diversification
Tax efficiency	Generally tax-efficient	Can generate more taxable distributions	Depends on how long you hold

Each option has its place. ETFs are a strong fit if you want diversification and low costs. Mutual funds can be a good choice if you prefer a set-it-and-forget-it approach with automatic investing. Individual stocks make sense if you want to own a specific company and are comfortable with the added risk that comes with less diversification.

The pros and cons of ETFs

Like any investment, ETFs have real advantages (and a few drawbacks) worth knowing about before you dive in. Here’s a look at both sides.

Pros

Cons

Diversification: One ETF can hold hundreds of securities, which spreads your risk across many companies or asset classes at once. You don’t have to build that diversification yourself. Low costs: Most ETFs (especially index funds) carry very low expense ratios. That means more of your money stays invested and working for you over time. Flexibility: ETFs trade throughout the day like stocks, so you can buy or sell whenever the market is open. You’re not locked in to end-of-day pricing like you are with mutual funds.

Trading costs: Every time you buy or sell an ETF, you’re subject to the bid-ask spread. If you trade frequently, those small costs can chip away at your returns over time. Tracking error: Index ETFs are designed to match the performance of a benchmark, but they don’t always do it perfectly. Small differences (called tracking errors) can mean your returns don’t exactly match the index. Premium and discount risk: In less liquid ETFs, the market price can drift above or below the NAV. If you buy at a premium or sell at a discount, you may get less than you bargained for.

How to start investing in ETFs

Getting started with ETFs is more straightforward than you might think. Here’s a step-by-step look at how to go from curious to invested.

1. Choose the right account

The investment account you use matters. A tax-advantaged account like an IRA or 401(k) is a good fit if you’re investing for retirement. A standard brokerage account works well for other goals, like building general wealth or saving for something specific. The right choice depends on your timeline and what you’re investing for.

2. Define your goal and time horizon

Before you pick an ETF, get clear on what you’re investing for and how long you plan to stay invested. Are you saving for retirement 30 years from now, or building a cushion over the next 5 years? Your goal and time horizon should drive every decision that follows.

3. Choose your ETFs

Once you know your goal, look for ETFs that match it. For most beginners, a low-cost broad market index ETF is a solid starting point. As you get more comfortable, you can explore bond ETFs for balance or sector ETFs for more targeted exposure. When comparing options, pay attention to the expense ratio, the fund’s size and how long it’s been around.

4. Place your trade

You can buy or sell ETFs just like stocks, making them a flexible investment option. When you’re ready to trade ETFs, log in to your brokerage account, search for the ETF by its ticker symbol and place your order. Choose a market order to execute at the current price or a limit order to set the maximum price you’re willing to pay.

5. Set up contributions and a review plan

Investing once is a start, but investing consistently is what builds wealth over time. If your brokerage allows it, set up automatic contributions on a regular schedule—monthly or quarterly works well for most people. Then, plan to review your portfolio once or twice a year to make sure it still aligns with your goals.

How taxes impact ETF returns

ETFs are generally considered tax-efficient investments, but that doesn’t mean they’re tax-free. 

When you sell an ETF for more than you paid, you’ll owe capital gains tax on the profit. Hold it for more than a year and you’ll qualify for the lower long-term capital gains rate. Sell sooner and your gains are taxed as ordinary income, which is typically higher. This is one reason why a long-term, buy-and-hold approach may work well with ETFs.

Many ETFs also pay out dividend income from the securities they hold. Those distributions may be taxable in the year you receive them, even if you reinvest them automatically.

FAQs about ETFs

Here are some of the most common questions people ask about ETFs.

Are ETFs a good option for beginner investors?

They can be. The built-in diversification means you’re not betting everything on a single company, and low costs can make them accessible on almost any budget. A simple broad market index ETF is one of the most straightforward ways to get started. But, like any investment, it’s worth understanding what you’re buying before you commit.

How do ETFs differ from index funds?

Most index funds are mutual funds, which are priced once per day and may have higher minimums. ETFs that track an index work similarly on the inside, but they trade throughout the day like stocks and tend to be slightly more tax-efficient in many cases.

How long should I hold an ETF?

It depends on your goal. Long-term ETFs like broad market index funds tend to work best when you stay invested through market ups and downs. Let your timeline drive the decision, not short-term market movements.

Learn more about investing with Navy Federal Credit Union

ETFs are a great foundation for a long-term investing strategy, and they’re just one of the tools available for building wealth. Whether you want to dig deeper into investment strategies, learn how to invest for retirement or just get more comfortable with the basics, Navy Federal has resources to help you take the next step.

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