What is an ETF?
An ETF (Exchange-Traded Fund) is a basket of securities that trades on an exchange like a stock. The SPDR S&P 500 ETF (SPY) was the first US-listed ETF in 1993 and now holds over $500 billion in assets. ETFs combine the diversification of mutual funds with the trading flexibility of stocks - you can buy and sell them throughout the trading day at market prices.
ETF vs. Mutual Fund
ETFs generally have lower expense ratios than equivalent mutual funds and are more tax-efficient due to their unique creation/redemption mechanism. However, mutual funds allow automatic investment of exact dollar amounts, while ETFs trade in whole shares at market prices. For long-term investors using automatic contributions, mutual funds may be more convenient despite slightly higher costs.
Key Considerations
Not all ETFs are created equal. Broad market index ETFs are excellent core holdings, but leveraged ETFs, inverse ETFs, and narrowly themed ETFs carry significantly higher risks. Check the bid-ask spread before buying - thinly traded ETFs can have wide spreads that increase your effective cost. For most investors, a few broad-market ETFs provide all the diversification needed.