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ETFs, or exchange-traded funds, combine the convenience of investing in stocks with the diversification and reduced risk offered by mutual funds.

The first U.S. ETF was launched in 1993, and over the last quarter-century these funds have become hugely popular with investors. America's ETFs held a combined $3.99 trillion in July 2019, according to the industry group the Investment Company Institute.

Learn more about ETFs — to determine whether they're a good choice for your portfolio.

What exactly is an ETF?

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An ETF is a bundle of stocks, bonds or other investments pulled together with money pooled from a large number of investors.

When you invest in an ETF, you own a little piece of each asset that's part of the bundle. It's a way of getting some exposure to high-flying investments you might not be able to afford otherwise.

For example, an ETF that's invested in all of the stocks making up the S&P 500 index offers you the chance to put some of your money into pricey blue-chip stocks like Amazon. ("Alexa, make me some money.")

One reason ETFs are so appealing is that they're easy to buy, sell and follow. Investing in an ETF is very similar to investing in an individual stock.

How do ETFs work?

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Like stocks, ETFs trade on stock exchanges under ticker symbols.

Just as Amazon uses the symbol "AMZN," the oldest and most heavily traded U.S. ETF — known formally as the "SPDR S&P 500 ETF Trust" (yeah, it's a mouthful) — trades under the symbol "SPY."

The value of one share of an ETF is derived from the values of the assets making up the fund. Those can include:

  • Stocks
  • Bonds
  • Commodities, such as gold or oil

The typical ETF is based on a financial market index and contains all of the individual stocks or other investments that make up the index. When State Street Global Advisors created SPY in 1993, the granddaddy ETF was designed so it would mimic the S&P 500.

As with stocks, you profit from an ETF when you sell your shares at a higher price than you paid.

How to invest in ETFs

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ETFs are highly liquid and diverse, they have low barriers to entry — but they're not guaranteed successes. Your investment practices can make a huge difference in how things will turn out for you.

You need to do your research. Before sinking money into an ETF, it's wise to become as informed as possible. In most cases, the best way is to review the disclosure materials that ETFs are legally required to provide.

The two most important disclosures are the summary and the prospectus, which is a more comprehensive document that lays out all of the important details.

A prospectus will contain a ton of information. You might need some strong coffee to get through one, but it's an essential step for learning about the risks, investment strategies and costs of a specific fund, especially a newer one without much of a track record.

You must decide how you want to invest. Traditional brokerages sell ETFs, but they do so at a price. ETF investors may have to pay high commissions on their trades, or steep fees to maintain their brokerage accounts.

Brokerage apps and robo-advisors — also known as automated investment services — minimize the costs by using artificial intelligence tools to choose investments, make recommendations and help customers build strong portfolios.

Automated investing services such as Wealthsimple also have human advisers standing by, for whenever investors need to talk with one.

As a MoneyWise reader, get $10,000 managed for free for one year when you open your first Wealthsimple account. Sign up now to take advantage of this special offer.

How ETFs are different from mutual funds

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ETFs have a lot in common with mutual funds, which also allow shareholders to own bits of many assets that have been bundled together. But here are a few examples of how the two are very different investment beasts.

  • Trading frequency: Mutual fund shares may be purchased or sold only at the end of each trading day, and at a fixed price. An ETF can be bought and sold with as much freedom as you trade stocks — and, same as stocks, ETF prices fluctuate throughout the day.
  • Management: A mutual fund has managers who actively decide on the assets that go into the fund's portfolio. An ETF is a passive investment with a portfolio usually buillt to match a market index, like the Dow Jones Industrial Average.
  • Size: America's mutual funds held a massive $19.9 trillion in August 2019, the Investment Company Institute says. The respectable $3.99 trillion invested in ETFs seems teensy by comparison.
  • Costs: Mutual funds can be more expensive, because the managers need to be paid and because investors often face the potential for higher capital gains taxes than with ETFs.
  • Requirements: Mutual funds usually have investment minimums, meaning you may need a few thousand dollars to get started. ETFs typically don't have these requirements — you can buy just one share, maybe for as little as $50.

Are ETFs right for you? Here are a few pointers to remember.

The advantages of ETFs

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  • ETFs may be a good choice if you're new to investing and want to dip your toe in the water. Their low cost makes it easy to get started, and the simplicity of buying and selling ETFs the way stocks are traded allows you to experiment without feeling tied down.
  • Because ETFs are diversified, they spread your risk around and minimize the impact if one stock, bond or other asset in the bundle goes crashing.
  • With no investment minimums, ETFs are accessible to a broad cross-section of investors.

The disadvantages of ETFs

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  • ETFs are low-cost, but not no-cost. Often there are commissions to be paid, and management fees. The expenses are rising as ETF companies find they have to spend more on marketing to stand out in what has become a very competitive business.
  • ETF diversification isn't perfect. An ETF usually matches the makeup of a market index — but you could miss out on great investments that aren't part of the index. Plus, if you've got a stock ETF and one of the stocks is a dud, you can't dump it.
  • The ability to buy and sell ETFs throughout the day isn't necessarily a good thing. If your ETF is having a rough couple of hours, you might be tempted to move your money around — which isn't smart if you're investing for a long-term goal, like a comfortable retirement.