# What is an ETF: how exchange-traded funds work

> An ETF is a fund that trades like a stock. Learn how ETFs work, what they cost, the main types, and the risks, with SEC sources.

Written by [Tactfolio research team](https://tactfolio.com/about/editorial-policy.md), published 2026-10-16, updated 2026-10-16.

An ETF, or exchange-traded fund, is a fund that holds many investments and trades on a stock exchange like a single stock. One share gives you a small piece of everything the fund owns. Most ETFs track an index, such as the S&P 500, and charge a small yearly fee.

## Key points

- An ETF pools money from many investors and buys stocks, bonds or other assets with it.
- You buy and sell ETF shares through a brokerage account, at market prices, any time the market is open.
- Most ETFs follow an index. Some are run by managers who pick what to hold.
- You pay a yearly fee called the **expense ratio**. The fund takes it from its assets, so you never get a bill.
- ETFs are not insured. Their price can fall, and you can lose money.

## What is an ETF in simple terms?

An ETF is a basket of investments that you can buy as one share. If the basket holds 500 stocks, one share gives you a tiny slice of all 500.

The SEC's investor site, [Investor.gov](https://www.investor.gov/introduction-investing/investing-basics/investment-products/mutual-funds-and-exchange-traded-2), says ETFs pool money from many investors. The fund then invests that money in stocks, bonds, short-term debt or other assets. Each share is a part ownership of the whole pile and the income it earns.

"Exchange-traded" means the shares trade on a stock exchange. That is the big difference from a regular mutual fund, which you buy from the fund itself.

## How do ETFs work?

You buy ETF shares from other investors on an exchange, through your broker. The price moves all day, like a stock price.

Behind the scenes, big firms called **authorized participants** keep the share price close to the value of what the fund holds. They do it in two ways:

- **Creation.** When demand is high, an authorized participant hands the fund a basket of the stocks it holds. The fund gives back a big block of new ETF shares. The SEC's example is 50,000 shares.
- **Redemption.** When demand is low, it works in reverse. The firm hands back a block of ETF shares and gets the stocks back.

If the ETF's price drifts above or below the value of its holdings, these firms can trade the gap for a profit. Their trades push the price back in line ([SEC investor bulletin](https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins-24)).

That value is called the **net asset value**, or NAV. It is what all the fund's holdings are worth, minus what it owes, divided by the number of shares. When an ETF trades above its NAV, that is a premium. Below it is a discount.

## What does an ETF cost?

You pay for an ETF in three ways: the yearly fee, the spread and any commission.

- **Expense ratio.** This is the fund's yearly cost as a share of its assets. A 0.10% expense ratio is $10 a year on $10,000. The fund takes it out of its assets, so you never see a bill. Our guide to the [ETF expense ratio](https://tactfolio.com/learn/etf-expense-ratio.md) shows how it adds up over 30 years.
- **Bid-ask spread.** The bid is the most a buyer will pay right now. The ask is the least a seller will take. The gap is a hidden cost each time you trade.
- **Commissions.** Some brokers charge a fee per trade, and some do not. Check your broker's fee list.

The SEC gives a spread example. If an ETF trades at $59.50 bid and $60 ask, buying 200 shares and selling right away loses $100 ([Investor.gov](https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins-24)).

## Types of ETFs

Some ETFs are broad and plain. Others are narrow or complex.

| Type | What it holds | Example idea |
| --- | --- | --- |
| Index ETF | Every stock in an index, or a sample | A fund that tracks the S&P 500 |
| Bond ETF | Government or company bonds | A fund of 7 to 10 year Treasury bonds |
| Sector ETF | Stocks in one industry | Health care or technology |
| Commodity ETF | Gold, oil or futures on them | A gold fund |
| Leveraged ETF | Uses borrowing or contracts to multiply daily moves | 2x or 3x the S&P 500 for one day |
| Inverse ETF | Aims for the opposite of a daily move | Rises when an index falls that day |

One well-known index is the [S&P 500](https://tactfolio.com/learn/sp500-index.md), a list of about 500 large US companies. Funds that follow it are covered in [S&P 500 index funds](https://tactfolio.com/learn/sp500-index-funds.md). Commodity funds work differently from stock funds, as our [commodities guide](https://tactfolio.com/learn/commodities-explained.md) explains.

[Leveraged ETFs](https://tactfolio.com/learn/leveraged-etfs.md) and inverse ETFs reset every day. Held for longer, their returns can differ a lot from the multiple in their name. The SEC and FINRA both warn buy-and-hold investors about them.

## Why do people buy ETFs?

Investor.gov lists four main reasons people buy ETFs:

- **Diversification.** One fund can hold hundreds of companies. If one company fails, it is a small part of the whole.
- **Low minimums.** You can often buy one share, and some brokers sell parts of a share.
- **Trading all day.** You can sell at the market price whenever the market is open.
- **Tax efficiency.** Many ETFs swap stocks with authorized participants instead of selling them. So they tend to pay out fewer taxable capital gains than mutual funds.

But some ETFs are much less diverse than others. A fund that tracks a single stock has none of the spread-out benefit.

## Common mistakes

- Thinking all ETFs are safe because they are funds. A sector or leveraged ETF can swing far more than the market.
- Ignoring the expense ratio. A difference of 1% a year adds up over decades.
- Using market orders in thin funds. A wide spread can cost more than the fee.
- Holding a leveraged ETF for months without knowing it resets daily.
- Buying several funds that own the same stocks, and thinking you are spread out.

## More on investing basics

These guides build on what an ETF is. Start with the one closest to your question.

**Comparing your choices**

- [ETF vs index fund](https://tactfolio.com/learn/etf-vs-index-fund.md): how an index ETF and an index mutual fund differ in trading, minimums and taxes.
- [ETF vs mutual fund](https://tactfolio.com/learn/etf-vs-mutual-fund.md): the wider comparison, active funds included.
- [ETF vs stocks](https://tactfolio.com/learn/etf-vs-stocks.md): owning a basket vs owning one company.

**Costs and accounts**

- [IRA vs 401(k)](https://tactfolio.com/learn/ira-vs-401k.md): the two main US retirement accounts that often hold ETFs.

**Habits that help**

- [Dollar-cost averaging](https://tactfolio.com/learn/dollar-cost-averaging.md): investing the same amount on a schedule.
- [Portfolio rebalancing](https://tactfolio.com/learn/portfolio-rebalancing.md): bringing your mix back to target.

## Try it on Tactfolio

Every Tactfolio strategy holds US-listed stocks and ETFs. The [60/40 portfolio](https://tactfolio.com/strategies/60-40-portfolio.md) is a plain example. It holds an S&P 500 ETF and a Treasury bond ETF and resets to 60/40 each month. You can see its hypothetical backtest, including the years it lost money. Then you can build your own mix of ETFs in the [strategy builder](https://tactfolio.com/builder) and test it on decades of real prices.

## Common questions

### Is an ETF a stock?

No. An ETF is a fund that trades like a stock. When you buy a share, you own a slice of a basket of investments, not one company.

### How do ETFs make money for you?

An ETF can pay you in three ways. Its share price can rise. It can pass on dividends or interest from what it holds. It can also pay out capital gains, though ETFs tend to do this less than mutual funds.

### Can you lose money in an ETF?

Yes. ETFs are not insured by the FDIC or any government agency, says Investor.gov. If the stocks or bonds inside the fund fall, the ETF falls too.

### What is a good expense ratio for an ETF?

Broad index ETFs often charge less than 0.10% a year. For example, iShares lists 0.03% for its core S&P 500 ETF, as of October 16, 2026. Funds that are narrow, active or leveraged usually charge more.

### Do ETFs pay dividends?

Many do. A stock ETF passes on most of the dividends its companies pay, minus the fund's costs. Bond ETFs pass on interest. Some funds pay every month, others every quarter.

## Put it into practice

- [Every ETF, with fees and returns](https://tactfolio.com/etf.md): What each ETF holds, what it costs, how it did year by year, its worst drop, and which Tactfolio strategies hold it.
- [ETF screener](https://tactfolio.com/screener.md): A free ETF screener for 162 US-listed funds. Filter by type, issuer and fee, sort by returns or worst drop, and compare funds side by side.
- [ETF pairs compared](https://tactfolio.com/etf-comparisons.md): Popular ETF pairs such as VOO vs VTI and QQQ vs QQQM, compared on fees, holdings, returns and drawdowns over the same dates.
- [VOO vs VTI](https://tactfolio.com/etf-comparisons/voo-vs-vti.md): VOO vs VTI: what each ETF holds, what it costs, and how both did over the same dates, with yearly returns and worst drops.
- [Backtest a portfolio](https://tactfolio.com/trading-tools/backtest-portfolio.md): Backtest a portfolio of US stocks and ETFs. Enter tickers and shares, pick when to rebalance, and get the results with a link to share.

## Sources

- [Exchange-Traded Funds (ETFs)](https://www.investor.gov/introduction-investing/investing-basics/investment-products/mutual-funds-and-exchange-traded-2), Investor.gov (SEC), accessed 2026-10-16
- [Updated Investor Bulletin: Exchange-Traded Funds (ETFs)](https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins-24), Investor.gov (SEC), accessed 2026-10-16
- [Exchange-Traded Funds and Products](https://www.finra.org/investors/investing/investment-products/exchange-traded-funds-and-products), FINRA, accessed 2026-10-16
- [Updated Investor Bulletin: Leveraged and Inverse ETFs](https://www.investor.gov/publications-research-studies/info-sheets/Leveraged-Inverse-ETFs), Investor.gov (SEC), accessed 2026-10-16
- [iShares Core S&P 500 ETF](https://www.ishares.com/us/products/239726/ishares-core-sp-500-etf), BlackRock iShares, accessed 2026-10-16