ETF Basics: What to Know Before Investing
Key Takeaways
ETFs appear to be becoming a go-to investment vehicle in today's dynamic financial landscape.
Four key features are attracting investors: trading flexibility, transparency, low costs and tax efficiency.
ETFs may be suitable for all kinds of investors aiming to build flexible and diverse portfolios.
More than 123 million U.S. investors own mutual funds, according to the Investment Company Institute.1 But exchange-traded funds (ETFs) are rapidly gaining ground.
The amount of investor assets in ETFs has grown from less than $500 billion in 2005 to almost $13.5 trillion as of the end of 2025.²
Although many investors have a vague idea of what ETFs are and how they work, the market has changed significantly since the first ETF launched in 1993. By delving into what these dynamic financial tools have to offer today, you can empower yourself to make savvy decisions that enhance your portfolio.
What Are ETFs and What Makes Them Unique?
An ETF is an investment vehicle that holds a basket of securities—such as stocks, bonds or commodities—and trades on an exchange like an individual stock.
The vehicle’s unique creation and redemption process provides access to depth of liquidity to dynamically respond to investor supply and demand.
Learn More: Understanding ETFs’ Levels of Liquidity
Why Are ETFs So Popular?
ETFs’ growing popularity with investors comes from four attractive features: trading flexibility, transparency, low costs and tax efficiency.
ETFs trade throughout the day.
ETFs can be bought and sold relatively quickly through a brokerage firm at market prices that may change throughout the trading day.
Each ETF will have a bid and an ask price. The bid price is the published highest price per share a buyer is willing to pay for an ETF. The ask price is the lowest published price a seller is willing to accept for an ETF.
Most ETFs are transparent.
Most ETFs must disclose their full holdings daily, according to Securities and Exchange Commission regulations. This means investors have up-to-date information on what they currently own.
ETFs typically have low costs.
The ETF vehicle has low processing and management costs, resulting in lower expense ratios than mutual funds. However, investors need to be aware of other costs associated with trading ETFs.
While most ETFs now have no trading commissions, a broker may charge a fee to execute the transaction, and the investor pays the bid-ask spread to the market maker for facilitating the trade. These costs vary by brokerage firm and ETF.
ETFs are more tax efficient than mutual funds.
Compared with actively managed mutual funds, many ETFs have lower turnover—and therefore, fewer taxable events. Additionally, the ETF structure generally makes it more tax efficient. When mutual fund investors redeem shares, the fund may have to sell securities to meet the redemptions. Those sales may trigger capital gains for the fund and all its shareholders.
When ETF investors sell shares, the sale is facilitated by a market maker in the secondary market, with no capital gains impact on other ETF investors.
Learn More: Understanding ETF Tax Efficiency
What Types of ETFs Are Available?
The first U.S.-listed ETF was a passively managed fund that tracked the S&P 500® Index. Now there are more than 4,000 funds, as asset managers have responded to investor demand by offering many different asset classes and investment styles.
Key types of ETFs:
Indexed/Passive ETFs: Seek to mirror the holdings and performance of a recognized, measurable benchmark, e.g., the broad market S&P 500 and the Bloomberg U.S. Aggregate Bond indices.
Strategic beta or alternatively weighted ETFs: Seek enhanced returns or reduced risk while tracking a market-capitalization weighted index by selecting and weighting securities based on criteria other than market cap.
Active ETFs: Seek excess return over a benchmark through a wide variety of approaches. Some active ETFs are index-like with tight parameters to the index. Others follow a specific methodology. Some are strategically managed according to market conditions. And still others follow the same bottom-up, fundamental approach as many mutual funds.
How Do ETFs Compare to Mutual Funds?
Like mutual funds, ETFs are baskets or pools of individual securities, such as stocks or bonds. And like mutual funds, ETFs are structured as open-end investment companies. Moreover, both ETFs and mutual funds post net asset values of their underlying securities at the end of each trading day.
However, there are key differences between the two vehicles.
*Most retail broker-dealers have reduced ETF commissions to zero. Please consult your broker-dealer on specific fees.
Learn More: ETFs vs. Mutual Funds
Who Uses ETFs and Why?
ETFs are a great option for many investors. They can be combined with mutual funds and stocks to build diverse and flexible portfolios.
Who may benefit from ETFs:
Buy-and-hold investors: Buying and selling ETFs generally trigger transaction costs outside the funds, so individuals who do not trade frequently may like the overall lower cost of an ETF compared to other investment vehicles.
Lump-sum investors: ETFs might be advantageous to investors aiming to invest a large, single amount rather than those making smaller, regular investments that incur transaction costs each time.
Investors seeking flexibility: Investors interested in applying a variety of trading strategies may find ETFs appealing. Unlike mutual funds, ETFs let investors sell short, buy on margin, purchase options, place stop and limit orders and more.
Investors interested in market niches: Some ETFs focus on narrow slices of the market, which can be attractive to investors seeking specific market exposures.
What Questions Should You Ask Before Investing in an ETF?
As more ETFs become available, it can be challenging to distinguish between approaches. Getting answers to these questions can help:
What is the fund’s objective?
How does the fund seek to achieve its objective?
Can the fund be purchased at a fair price?
Can the fund be sold easily?
Does the fund offer the exposure you need, or are there underlying concentrations that could create unintended risk?
Does the fund align with your goals?
How to Use ETFs to Diversify a Portfolio?
Understanding how ETFs are structured, trade and maintain liquidity provides important context when evaluating investment options. The next step is applying that knowledge in alignment with your goals.
Depending on their underlying holdings and approach, ETFs can offer broad market exposure or targeted exposure to specific sectors, asset classes or investment strategies. Evaluating costs, diversification, trading characteristics and portfolio role will help you determine how a particular ETF fits your existing asset allocation, risk tolerance and long-term goals.
When integrated thoughtfully into portfolios, ETFs can help you pursue opportunities across market environments while potentially managing risks—and tax bills.
Explore More Insights
Source: Investment Company Institute. 2025 Investment Company Fact Book.
Source: Morningstar Direct as of 12/31/2025.
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Exchange Traded Funds (ETFs) are bought and sold through exchange trading at market price (not NAV), and are not individually redeemed from the fund. Shares may trade at a premium or discount to their NAV in the secondary market. Brokerage commissions will reduce returns.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
Diversification does not assure a profit nor does it protect against loss of principal.