What are exchange-traded funds?

An exchange traded fund or ETF is type of investment that is traded on the market actively like stocks. ETFs have benefits similar to stocks and index funds. Because an ETF trades actively throughout the day like stocks, its price changes constantly, as investors buy and sell shares of the ETF. Like index mutual funds, the expense ratio of an ETF is typically low. In fact, ETFs generally have lower expense ratios than passively managed mutual funds. There are many different types of ETFs, including, actively managed ETFs, bond ETFs, market ETFs, among others. Check out the video below.

Video: Exchange-traded-funds

Why investors buy ETFs.

Investors invest in exchange-traded funds for various reasons. They invest to create wealth, achieve financial stability and independence, plan for retirement, vacation, or education. Because they are usually passively managed, meaning fund managers are not actively researching, picking and selling securities, ETFs incur less cost to investors, compared to actively-managed mutual funds. A single ETF can include most or all the stocks or securities of a particular index.  A very popular ETF is the Vanguard S&P 500 ETF (VOO).

How to purchase ETFs.

You can buy ETFs from a broker (Fidelity, E-trade, TD Ameritrade, etc.) or from the fund itself. Investors buy ETFs at the fund's net asset value (NAV). The NAV is nothing more than the amount of money you need to buy one share of the ETFs. Here are the steps you need to take to buy ETFs: 1) open a brokerage account; 2) fund your account; 3) decide how many shares of the ETF you want to buy; 4) choose your order type. Although ETFs are less risky investments compared to stocks, you should always read the fund's prospectus. This is a document that outlines the fund's investment strategy, fees, risks, among other things. Here's a nice little guide on how to evaluate and select index funds for your portfolio.

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Benefits and risks of ETFs.

As an investor, owning ETFs comes with risks and benefits. If the ETF's price goes down, you will lose money and vice versa. There is no certainty that companies whose stocks the ETF holds will prosper or do well. To a large extent, an ETF's NAV is dependent upon the basket of securities (stocks, bonds, cash, etc) it holds. Many factors affect an ETF's share price (NAV), including but not limited to quarterly earning reports of individual companies, regulatory, political, economic or other events.  

How investors make money from ETFs

Investors make money in two major ways. First, they earn money through capital gains. A capital gain is essentially the increase in price of a fund to a price higher than the initial purchase price. Second, investors make money through dividends. Dividends are basically free money you get for simply owning the fund or being a fund holder. Dividends are usually paid to shareholders quarterly. Not all companies pay dividends. Exchange-traded funds are meant to be kept for the long-term. Here's a nice overview of how investors earn money from mutual funds. Check out this comparison between stocks, ETFs and index funds.