What is an ETF? The Complete Guide for Beginners to ETFs

ETFs (Exchange Traded Funds) are gaining popularity among investors, especially those looking for a simple and cost-effective way to broadly invest in the stock market. But what exactly are ETFs, how do they work, and why are they so popular? In this beginner’s guide, you’ll learn everything you need to know about ETFs to successfully start investing in this asset class.

What is an ETF? A Simple Explanation for Beginners

An ETF (Exchange Traded Fund) is a publicly traded fund that tracks the performance of a specific index, industry, or sector. Unlike traditional mutual funds, ETFs can be bought and sold on the stock exchange just like stocks. They offer an easy way to invest in a wide variety of assets without needing to pick individual stocks or bonds.

How ETFs Work: An Overview

ETFs operate by tracking an index such as the S&P 500, the MSCI World, or the DAX. Any movement up or down that an index, like the S&P 500, makes, the ETF also makes. The ETF contains all or a representative selection of the stocks in this index, allowing you to invest in a broad range of companies with a single purchase.

For example, an ETF that tracks the S&P 500 holds shares in the 500 largest publicly traded US companies. Instead of buying each of these stocks individually, you can invest in the entire index by purchasing a single ETF share.

Generally, ETFs are passively managed funds, meaning they are not actively managed by a fund manager but simply mirror the index. This significantly reduces the effort required, making the cost of ETFs typically lower than that of actively managed funds.

Differences Between ETFs and Traditional Funds

The main differences between ETFs and traditional mutual funds lie in how they are traded and managed:

Exchange-Traded Fund (ETF): ETFs are traded on the stock exchange, similar to stocks. This means you can buy and sell them during the stock exchange’s trading hours. ETFs also have a lower cost structure because they are passively managed.

Traditional Mutual Funds: These funds are actively managed by a fund manager who aims to outperform the market by selecting specific stocks and avoiding others. This active management often leads to higher costs, and you can only buy or sell shares once daily, usually at the day’s closing price.

ETFs offer a cost-effective way to invest broadly in different markets without bearing the high cost structure of traditional funds.

Key Benefits of ETFs for Investors

ETFs have several advantages that make them an attractive choice for investors, particularly beginners looking for a simple and cost-efficient way to enter the market.

Low Costs and Broad Diversification

One of the biggest advantages of ETFs is their low cost. Since they are passively managed and only track the underlying index, fees are much lower than for actively managed funds. When choosing your ETF, you should pay attention to the Total Expense Ratio (TER). For ETFs, this is often less than 0.1% to 0.5% per year, whereas traditional funds often charge over 1%. Feel free to use our ETF Finder to compare ETFs not only in terms of volume and total cost but also sustainability.

Another advantage is the broad diversification ETFs offer. Since an ETF contains hundreds or even thousands of stocks or bonds, it reduces the risk associated with investing in individual stocks. This diversification helps cushion against the fluctuations of individual companies and makes your portfolio more stable.

ETFs as a Passive Investment for Long-Term Growth

ETFs are ideal for passive investors who don’t have the time or inclination to constantly monitor the market and trade actively. By tracking an entire index, ETFs allow you to invest for the long term and benefit from general market development without having to trade frequently.

Since most ETFs generate an average annual return of 5-7% over the long term, they are excellent for long-term wealth building. By regularly investing in ETFs, you can benefit from the compound interest effect over the years.

Types of ETFs Available

There are several types of ETFs focusing on different asset classes and markets. Depending on your investment strategy, you can choose from various ETFs.

Stock ETFs, Bond ETFs, Commodity ETFs, and More

Here are the most common types of ETFs available to investors:

Stock ETFs: These ETFs invest in a broad selection of stocks, often grouped by market capitalization, sector, or region. Examples include the iShares MSCI World ETF, which invests in international stocks, or the S&P 500 ETF, which invests in the 500 largest US companies.

Bond ETFs: These ETFs invest in bonds, offering a fixed return. They are suitable for investors looking for stable returns and lower risk. Examples include the iShares Core Global Aggregate Bond ETF, which invests in a wide range of bonds.

Commodity ETFs: Commodity ETFs allow you to invest in physical commodities like gold, silver, or oil without having to buy them directly, such as the SPDR Gold Shares ETF.

Real Estate ETFs: These ETFs invest in publicly traded real estate companies or REITs (Real Estate Investment Trusts) that focus on owning and managing real estate. An example is the iShares US Real Estate ETF.

Sustainable ETFs: Are They Real, and How Do They Work?

Yes, there are sustainable ETFs that support companies and projects following ESG criteria (Environmental, Social, Governance). These ETFs only invest in companies that use sustainable practices, act in an environmentally friendly way, take social responsibility, and are ethically managed.

Sustainable ETFs like the iShares MSCI World ESG Screened UCITS ETF allow investors to invest in globally operating companies that meet strict ESG standards. These ETFs are becoming increasingly popular as more investors seek to achieve financial returns while supporting positive environmental and social impacts.

However, it’s essential to verify how sustainable the ETF truly is. Our Impact Check offers a great tool for filtering by themes that matter to you and finding ETFs that are sustainable in those areas.

Sustainable ETFs are an excellent choice for investors who want to combine returns with ethical values in their investment strategy.

Conclusion

ETFs are an excellent option for beginners looking for a simple, low-cost, and diversified way to invest in the market. They offer numerous benefits, such as low costs, broad diversification, and the ability to invest passively, making them a popular choice for long-term wealth building. With a variety of ETF types, including stock, bond, commodity, and sustainable ETFs, there is an option for every type of investor. If you’re seeking a stable and flexible investment strategy, ETFs are the perfect entry point into the world of investing.