What Is a Stock ETF? And How Does It Work?

The 1990s was a fun decade, and there’s no denying that many fads from those days are starting to become popular once again. Your old Beanie Babies and Pokémon cards could be worth a small fortune on eBay and fanny packs are (somehow) back in vogue.  

And now an investment born during the era that brought us “The Macarena” is starting to grab the attention of investors around the world: the stock exchange-traded fund (or stock ETF, for short).

In a nutshell, a stock ETF looks a lot like a mutual fund that is traded like a single stock. Since the first one was created and offered in the 1990s, ETFs have steadily grown in popularity among folks looking for a lower-cost alternative to mutual funds. Now there are more than 2,500 ETFs accounting for more than $6.5 trillion in assets under management—and that’s just in the United States.¹

But are stock ETFs all they’re cracked up to be? Let’s take a closer look at stock ETFs, how they work, and whether or not they have a place in your investing portfolio.

What Is a Stock ETF?

A stock ETF—also known as an equity ETF—is a type of investment that pools money from investors together into a basket of single stocks designed to be bought and sold on a stock market exchange.

How Does a Stock ETF Work?

ETFs and mutual funds are kind of like most boy bands from the 1990s—they have a lot in common.

Like mutual funds, stock ETFs make it easy to diversify your investments. That’s because most ETFs own stocks from dozens or even hundreds of different companies inside them. When you buy shares of a stock ETF, that automatically gives you tiny pieces of ownership in a bunch of companies, which makes ETFs less risky than simply buying shares of single stocks.

Most stock ETFs are put together to mirror the performance of a stock market index, like the S&P 500 or the Dow Jones Industrial Average. That means the typical ETF won’t have a team of financial experts picking and choosing stocks behind the scenes. Instead, the ETF will just have stocks that are in the index it’s based on. This type of “passive management” usually helps keep their fees low. 

How Do I Buy Stock ETFs?

ETFs are bought and sold like single stocks on a stock exchange throughout the day. Investors can watch the price of a stock ETF rise and fall on a stock price chart and then decide when they want to buy (or sell) their shares. That ability to easily trade ETFs again and again usually attracts investors who want to “time the market” and buy shares when they are low and then sell them high.

But here’s something that you need to keep in mind: Because the price of an ETF is constantly changing, you can’t set up automatic payments to buy shares of a stock ETF like you could with a mutual fund.

Instead, you’ll need to manually buy shares through a broker at the price that it’s going for at the time of your purchase. What’s worse, you’ll likely have to pay a commission or transaction fee each and every time you buy or sell a stock ETF . . . and those fees can really add up over time.

Types of Stock ETFs

In a way, stock ETFs are similar to the stuffed donuts you’ll find at your favorite donut shop—they come in a variety of different types and flavors (although admittedly less delicious). What kind of stocks are inside an ETF all depends on what that specific ETF is trying to accomplish, and investors have plenty of options to choose from.

Market chaos, inflation, your future—work with a pro to navigate this stuff.

Here's a quick rundown of the main types of stock ETFs you might come across.  

Index Stock ETFs

Like we mentioned earlier, most stock ETFs are index funds designed to mimic the performance of the stock market or a specific part of the stock market. So if a stock ETF is based off the S&P 500 Index, then your returns will be more or less the same as the S&P 500 itself.

Market-Cap Stock ETFs

Market-cap is short for market capitalization, which is basically the total value of a company’s stock—the larger the market cap, the larger the company. Market-cap ETFs choose stocks based on the size of each company's market cap. For example, one ETF might focus on holding stocks from companies with a market cap of more than $10 billion (those are known as “large cap” or “growth and income” companies).

Sector Stock ETFs

There are also stock ETFs that focus on a particular sector of the economy. Sector ETFs are not as diversified as other ETFs and mutual funds because they only have stocks from companies from a particular industry or that offer similar products or services. You can find sector stock ETFs that are focused on health care, technology or energy, just to name a few.

International Stock ETFs

Like the name suggests, international ETFs contain stocks from companies that are based outside of the United States to give investors some diversity in their portfolios. Pretty straightforward!

Dividend Stock ETFs

Some companies offer to pay out dividends to investors as a thank you for investing in their company’s stock. Dividend ETFs are focused on owning stocks from companies that have a track record of rewarding stockholders with dividends.

The Pros and Cons of a Stock ETF

We’ve talked about all the features that come with a stock ETF, so let’s go through a quick breakdown of the pros and cons of a stock ETF.

Pros

• Easy Diversification: Like their close cousin the mutual fund, stock ETFs are usually invested in more than a hundred different company stocks, which can help you diversify your investment portfolio with the click of a button.

• Low Fees: Most ETFs keep their fees low by simply copying and pasting stocks from an index to include in their fund.

• Tax Benefits: With ETFs held in taxable brokerage accounts, ETFs typically pass on fewer capital gains to investors because their funds have lower turnover (that just means ETFs usually don’t change the investments inside them very often since they usually track an index).

Cons

• Passive Management: Since most ETFs track an index, it’s hard to find ETFs that will try to outperform the stock market. Mutual funds, on the other hand, generally have a team of financial experts that will try to pick stocks that will help the fund beat the stock market.
      
• Hefty Transaction Costs: While ETFs might have lower fees than mutual funds, you will probably get hit with commission and transaction costs every time you buy and sell shares of an ETF.
   
• Not Ideal for Long-Term Investing: While you can hold onto stock ETFs for the long term, they’re designed to be traded like stocks . . . that means the temptation is always there to try and time the market in order to score some short-term gains. Not to mention the fact that you can’t set up automatic payments to buy shares of ETFs.

Stock ETFs vs. Mutual Funds: Which One Should I Invest In?

When it comes to investing, nothing beats having a buy-and-hold investment strategy. That means keeping a long-term view of investing and hanging on to your investments over time . . . no matter what’s happening with the stock market!

That’s why we recommend good growth stock mutual funds over stock ETFs for retirement investing. Here are some of the main reasons why.

1. Mutual funds are perfect for long-term investing.

Mutual funds instantly diversify your investment portfolio and let you set up automatic payments to buy more shares every month. That makes it extremely easy to develop the habit of investing consistently over time, which is one of the keys to building wealth!

2. Mutual funds offer more investment choices.

Remember earlier when we said there are about 2,500 ETFs in the U.S.? Well, there are more than three times as many mutual funds (about 7,636, to be exact) to choose from.² And mutual funds offer investors something that most ETFs don’t: access to more funds with a wide range of strategies and styles designed to beat the stock market.

3. The right mutual funds can help you beat stock market returns.

While most ETFs are happy to settle for returns that match the overall stock market, the majority of mutual funds are backed by a team of financial experts whose sole job is to research and pick stocks that will hopefully outperform the stock market over the long haul.

Does It Ever Make Sense to Invest in Stock ETFs?

While we always recommend investing in mutual funds inside your retirement accounts, stock ETFs can still be part of your wealth-building strategy under the right circumstances.

If you’ve maxed out your 401(k) and Roth IRA and still want to keep investing, ETFs are especially good to include in a taxable brokerage account. That’s because ETFs that track an index like the S&P 500 have a low turnover ratio—which just means you’ll pay less in capital gains taxes on your investments as you go.

As long as you hold on to your ETFs for long-term growth, just like you would with a mutual fund, they could serve as a nice complement to the investments you have inside your other retirement accounts.

Work With a Financial Advisor 

How do you find mutual funds that are consistently outperforming the stock market? A financial advisor can help you do just that.

Here’s the deal: You shouldn’t have to figure out ETFs, mutual funds and investing all by yourself. And we make it easy for you to find a financial advisor you can trust through our SmartVestor program.

We’ll connect you with up to five financial advisors who are ready to serve you and help you get started with investing. And the best part? It’s free to get started!

Find your SmartVestor Pro today!  

This article provides general guidelines about investing topics. Your situation may be unique. To discuss a plan for your situation, connect with a SmartVestor Pro. Ramsey Solutions is a paid, non-client promoter of participating Pros.