What is an ETF?

An ETF is basically a fund that trades like a stock. They come in thousands of different combinations based on everything from asset classes to geographies. Think of them as Lego blocks for investing that are simple to assemble into a portfolio.

Traders can use ETFs to jump in and our of complex bets, and long-term investors can use them to easily diversify their savings. The biggest ETFs are linked to the S&P 500 Index of large US companies, meaning you only have to buy one fund to get exposure to a huge swath of corporate America. Index mutual funds do pretty much the same thing but they can’t be traded throughout the day, and they may also have higher minimum investments.

Why investors are pouring money into ETFs

The main reason ETFs are popular is that they are cheap. The funds have tax advantages in the US, and they typically charge customers less than a mutual fund would. “The heart of the matter for the guy on the street is that you ultimately get to keep more of your money,” said Eric Balchunas, senior ETF analyst at Bloomberg. “We call it the ‘great cost migration.’ That’s the mother of all trends.”

Most ETFs, like their index-fund cousins, are linked to an index. That means the funds’ holdings are supposed to mirror the composition of stocks or bonds contained in an index. So-called passive investing has caught on in part because human money managers (running actively managed funds) have tended to underperform the indexes they are gauged against.

That said, a growing number of ETFs are actively traded, which is perhaps a sign that investors are looking to spice up, or take a different flavor of risk, with a portion of their savings. Actively managed ETFs may also have tax advantages for investors as compared to a traditional mutual fund.

Are ETFs worth investing into?

How much a fund costs matters immensely because that expense eats away an investor’s returns. As Vanguard, whose founder pioneered the index fund, points out: a $100,000 investment that gains 6% a year for 25 years would be worth $430,000 if there were no fees or charges. Raise that expense to 2% of assets, however, and you only end up with $260,000.

Brokerages like Robinhood are also part of the story. Trading apps are easy to use and sign up for, and most don’t charge commissions (you can read more about how retail brokerages typically make money here, here, and here). Just as these services made it simple for a new generation to buy and sell stocks, they’ve also made it simple to get into ETFs: You can access Vanguard’s S&P 500 ETF, or a BlackRock ETF that invests in corporate bonds, from one brokerage account.

Whats the difference between an ETF and a mutual fund?

Balchunas, author of The Institutional ETF Toolbox, likens the ETF boom to the shift from tapes and records to MP3s, which made music recordings far cheaper and more flexible. He says the standardization of ETFs—each ticker is just a few letters—is also an under-appreciated factor, as it makes buying and selling them more convenient. Those factors have made ETFs the preferred format these days, which is one of the reasons why many mutual funds—which can only be bought and sold at the end of the day, and often cost more than ETFs—are converting into ETFs. Bloomberg expects 10% of mutual funds to make the switch in the coming decade, amounting to around $1 trillion of assets.

“ETFs just fit like perfect puzzle pieces in this digital culture,” Balchunas said.

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