What are ETFs and how do they work?

So, you want to know what ETFs are? You’ve heard people on TV discussing the stock market's recent performance — or, influencers talking about their investment portfolios on TikTok. They throw around the words: stocks, bonds, and ETFs. So what in the world is an ETF? The short answer: It’s an acronym for exchange-traded fund. And while an ETF might sound super complex, it's actually pretty easy to understand — even if you're young and new to investing.

Exchange-traded funds (ETFs) explained

An ETF combines certain features of mutual funds and stocks. Like a mutual fund, an ETF invests in a basket of assets, such as stocks and bonds. When you purchase an ETF, you won't own individual stocks in each asset the ETF owns. Instead, you'll own a small percentage of the ETF itself. The ETF's value goes up and down 📈 depending on how the assets held by the ETF perform. 

You can buy a share in an ETF just like you would a stock. There are ETFs available for various trading strategies. For instance, if you want your investment earnings to mirror the performance of the S&P 500, you could buy a share in an ETF modeled after the index. Or, if you think social media and streaming services 📺 are where it’s at, you could buy an ETF that owns shares in tech organizations. 

ETFs allow you to build an investment portfolio for less money than buying individual shares in stocks or bonds. Even if you only have a few dollars, you can buy a single share in an ETF and start learning the basics of investing.  

Types of ETFs

There are two main categories of ETFs: equity and non-equity. Here's how they’re different.

Equity exchange-traded funds

Equity ETFs focus on buying stocks in different companies. Each ETF follows a different theme. One ETF might buy single stocks in companies that operate in specific market sectors, such as retail. 👜 

Some ETFs may hold shares in just a few single companies, while larger ETFs can invest in thousands of companies. 

If you're interested in investing in an equity ETF, you can review its prospectus to learn about which stocks it invests in. If the ETF has been trading for a while, you can also check its historical performance. 📉 

Non-equity exchange-traded funds

A non-equity ETF holds investments in assets like corporate bonds, foreign currencies, or commodities such as precious metals. A non-equity ETF's value goes up or down depending on the assets it holds. So, an ETF that invests in gold 🪙 would likely rise in value if gold prices go up.

Non-equity ETFs can help investors reduce risk by investing in various asset classes. Some assets tend to perform better at certain times in a market cycle. You can diversify your market cycle risk by holding multiple types of ETFs, such as bond ETFs or real estate ETFs. 

How do ETFs work?

Unlike mutual funds, an ETF trades on stock exchanges, like the New York Stock Exchange (NYSE) or Nasdaq. You can buy them through virtually any investment platform that trades stocks or bonds. You don't need to go through a mutual fund brokerage or other special provider to buy a share in an ETF. 

ETFs trade all day long. So, if you're eating lunch 🥙 with friends and someone talks about how well their shares in an ETF are doing, you can pull out your smartphone and buy your own share in just a few minutes. You could gift your friend a share, too, in thanks for their recommendation.

ETFs make it easier for investors who don't have as much capital as institutional investors to access similar investment opportunities. Instead of buying individual shares in high-priced stocks, your ETF provides you with fractional ownership in various equities or other assets.

Why do people invest in ETFs?

ETFs provide several benefits, which make them attractive to investors.

One of the primary advantages of ETFs is diversification. The more diversification you have in your investments, the less risk you carry. To put that in perspective, imagine you own one share of $100 stock in your favorite clothing store. Unfortunately, the store reports poor earnings for the year, causing the stock price to decline by 50%. Your investment is now worth half of what it was, or $50.

Now, assume you have five different stocks in several companies, each worth $100. Over three months, two stocks increased in value by 20%, one grew by 30%, and two declined by 15%. While you lost $30 on the two investments that decreased by 15%, your other shares offset your losses, leaving you with a final gain of $40. Not bad! 👍

The same principle applies to ETFs. Since they invest in multiple stocks or other assets, there's less overall risk if the value of some assets declines.

Other benefits include lower expense ratios, tax advantages, and dividend reinvestment. A lower expense ratio means you pay less for the manager's work overseeing the ETF. If you receive dividends from your ETF shares, you can keep them or use them to buy new shares.

Build a future for your family with an ETF investment strategy

While ETFs may sound a little fancy, they're not too difficult to understand once you dig into the details. Even better — they're a fantastic way to learn the ins and outs of investing when you’re young without getting into the nitty gritty of portfolio diversification and asset allocation. In fact, you can start investing in ETFs for as little as $1. While your $1 investment may not turn you into an overnight millionaire, you can use it to learn how trading works and build wealth over time. To learn more, check out Greenlight's® investing app!