What is an ETF (Exchange Traded Fund) | Beginners Guide

There comes a time in the life of every successful entrepreneur when their company matures. It pays you a healthy salary and possibly dividends. Instead of reinvesting every spare dollar in your company, you start to grow your wealth in different ways.

This means investing in other asset classes like bonds, stocks, minerals, real estate etc. A great way to create a strong portfolio is through ETF investing. They come with major advantages and limited downsides.

In this guide, you’ll learn what an ETF is, its pros and cons, and how to best utilize them.

Note: these are our personal opinions derived through research and personal experience. The information here is for educational purposes only and should in no way be construed as financial advice. ETFs are risky instruments and you risk losing money so you should contact your financial advisor before making an investment decision.

What is an Exchange traded fund (ETF)?

An exchange traded fund is a type of security that represents a fund which is a collection of securities (like stocks or bonds) that can be traded on open exchanges. The name actually says it all.

The draw of an ETF is that you’re able to trade multiple assets without having to buy each one individually. It can be considered the same as an index fund but it’s much cheaper to buy an ETF because you only have to purchase a single share.

With an index fund, there are certain amounts of capital you need to invest upfront. With an ETF, since it’s a security, you only have to buy a single unit.

Another difference is that the price of an ETF fluctuates through the trading day while an Index fund has its price fixed once a day and isn’t openly traded on exchanges.

ETFs work through a simple process. The fund owner uses their money or raises money to buy the assets the ETF derives its value from. These can be stocks, bonds, etc. The owner then turns around and sells shares in that fund to investors like you and me.

While you don’t own the underlying assets, you own a piece of the fund and also get dividend payouts. Each ETF has a fee that’s paid for management known as an expense ratio. This fee varies depending on the management style of the fund which is broadly divided into active or passive management.

Different ETFs track different areas such as the total stock market, technology stocks, real estate stocks, currencies, etc. We’ll go into more detail on that later in this guide.

For example, VTI is an ETF created by Vanguard that tracks the total stock market. Over the last 10 years, the annualized return was 13.48% while the total stock market annualized return was 13.49%.

Pros of ETFs

  • Can easily buy a representative portion of stocks from various industries and diversify your portfolio
  • Relatively low management fees with some going as low as 0.04%
  • If you’re interested in certain industries, you can get ETFs that are concentrated there
  • Inexpensive to get started because you only need to purchase a single unit of stock
  • Taxation is more favorable because you only pay when you sell and earn a profit

Cons of ETFs

  • Some ETFs have low daily volumes which means it can be difficult to sell them when you’d like to cash out
  • With industry-specific ETFs, you lack true diversity because if an industry-wide slump occurs, you’d be adversely affected
  • Exchange traded funds that can’t gather enough assets are at risk of closing and forcing you to sell of your stock early and potentially at a loss

Types of ETFs

There’s no cut and dry classification of ETFs. Some places categorize them based on how they’re managed (active or passive) or the kind of securities they invest in.

The latter classification makes more sense because it gives you a better understanding of the risk profile associated with the ETF.

Stock ETFs

These are the most popular ETFs and account for the majority of investment dollars. It’s comprised of stocks from different companies in multiple sectors. It mitigates risk by market cap weighting the fund and striving for growth consistent with the index it’s based on.

Bond ETFs

There are multiple types of bonds that can serve as an investment vehicle for preserving. These ETFs purchase large amounts of bonds from national governments, local governments, and even companies.

The interesting part about bond ETFs is that they don’t have a maturity date like bonds you’d purchase on your own. That way, you can benefit from the regular cash payments and reduce the risk associated with stocks.

Commodity ETFs

Commodities are raw materials that can be sold. These include but aren’t limited to things like gold, oil, grain, coffee, rice, etc. Due to the nature of the commodities market, there’s a lot of diversity in these ETFs.

Some purchase the commodity themselves, others purchase shares in companies that deal with the commodities, and others focus on futures contracts. It’s important to understand the makeup of the ETF before purchasing.

Currency ETFs

If you’re interested in forex markets but don’t want to take on the risk of trading on your own, currency ETFs may be the best choice for you. They track the relative growth of a currency or group of currencies.

They tend to have more active management styles which are reflected in their expenses ratios. The average fees are 0.54% across the major ETFs.

Industry or Sector ETFs

These types of ETFs can be considered a sub-segment of stock ETFs and are a great idea if you want exposure to an entire market sector without buying individual company stocks. You’ll benefit from the overall growth of that sector but you’re also susceptible to the contractions as well.

The good news is that each business sector – 11 total in the United States – follows a general boom and bust pattern. If you’re able to identify historic trends, you’ll be able to move your money out of one sector when it’s seeing a downturn and into a different sector that’s seeing an upturn.

This is an advanced strategy and isn’t suitable for a neophyte. Instead, invest in sector ETFs you believe will grow over time.

Inverse ETFs

These ETFs can be volatile because they go up in value when other stocks decline in value. It attempts to short stocks of other companies in the hopes of turning a profit. This is another advanced strategy and is considered riskier than standard stocks and bonds.

How to use ETFs to build wealth

ETFs are useful because they allow you to get a cross-section of the entire stock market or industry sector. You’ll be able to mimic those returns to a few fractions of a percentile.

They’re weighted by market cap which means companies with larger valuations represent more of the assets in the portfolio. If you’re dealing with bonds or commodities, the ETF manager will have a different philosophy behind how they choose the asset allocation.

The benefit of this approach is that you’re shielded from major price fluctuations you’d see in individual stocks. This is a double-edged sword because fluctuations can be negative or positive. In either case, you’ll be shielded from it to an extent.

The best way to use an ETF is as a long term investment vehicle. Look at the historical returns of the ETF you want to invest in.

Pay attention to how closely it mimics returns of the index it tracks. This is called the tracking error and varies depending on the type of ETF you’re investing in. For example, commodity ETFs have larger tracking errors while stock ETFs have smaller tracking errors.

You should also pay attention to the expense ratio – a term that describes the fees associated with the fund. The higher the fees, the more it’ll eat into your returns. The last thing to consider is the investment philosophy and the securities that make up the ETF.

  • What index do they track
  • How do they decide how much of one asset to buy (like shares in a single company)
  • What’s the maximum percentage a single asset can be represented in the fund
  • What are the top assets in the fund and their percentages

As mentioned before, you should have a long investment horizon when using ETFs. They likely won’t give you 100% returns in a year. They can give you returns that mimic the stock market or certain industries.

These returns can add up over time. Even if you don’t have a lump sum to invest at once, you can use dollar-cost averaging. That’s the process of investing a fixed amount of money every month (or whatever interval you choose).

Over time, you’ll be earning returns while still growing your initial investment.


ETFs are relatively new but they’re making a huge impact on the way people invest. Instead of having to read charts, time the market, and other ‘advanced’ strategies. You can bet on the entire market and watch as your nest egg grow.

This guide has given you the basics of ETF investing but you should still do your own research and only make an investment when you’re ready.