How to use ETFs to diversify your portfolio, trade more frequently, and invest safer

• An exchange-traded fund (ETF) is a basket of securities that's traded on a stock exchange.
• There are two types of ETFs: Index-based ETFs and actively managed ETFs.
• Most ETFs are index-based ETFs, which are passively managed and track an index like the S&P 500.

First created in the 1990s, exchange-traded funds (ETFs) have become a popular and important investment product. You may be able to use ETFs as a low-cost and convenient way to diversify your portfolio. However, you'll also want to understand the costs and risks that come with investing in ETFs.

What is an exchange-traded fund (ETF)?

An exchange-traded fund (ETF) is a basket of securities that's sold on stock market exchanges through brokerage firms. That means an ETF could hold thousands of underlying stocks. When you purchase a share of the ETF, you become a partial owner of the fund. Your investment could increase or decrease in value as the price of the underlying stocks changes.

And ETFs are traded during the day, much like stocks. "Exchange-traded refers to the fund being able to be bought and sold during the trading day," says Curtis Bailey, a CFA charterholder and financial advisor at Quiet Wealth Management. "A fund is an ownership structure that allows an investor to own a portion of an underlying basket of securities."

How do ETFs work?

An ETF is created when an ETF manager files a plan with the Securities and Exchange Commission (SEC), later forming an agreement with an authorized participant (typically large broker-dealers) who will create ETF shares. The authorized participant will essentially borrow shares of stocks and bundle them into a trust to form what's called ETF creation units, which are then bought and sold by investors just like regular stock. You can even purchase ETFs on margin and place limit orders.

Like stocks, you may have to pay a transaction fee to your brokerage for each trade. Additionally, ETFs have a fixed fee like mutual funds - an expense ratio. "The largest ETFs often have really low fees," says Bailey. "[But] some ETFs have higher expense ratios than actively managed mutual funds."

However, it's important to note that tracking errors could lead to a discrepancy between the ETF's price and value of the underlying assets in some cases.

There could also be a difference between the price that people are willing to buy and sell shares of the ETF. The bid-ask spread - which is the difference between offer/sell (ask) price and the purchase/buy (bid) price of a security - may be more common for thinly traded ETFs. "This spread may represent an additional hidden cost as an investor pays more to buy the shares and receives less to sell the shares," says Bailey.

Quick tip: A tracking error is the difference between the return of an investment portfolio and the return fluctuations of a chosen benchmark.

ETFs vs. mutual funds vs. index funds

An index fund is a general term for a fund that tracks an index. Both ETFs and mutual funds could be index funds.

Mutual funds also hold a basket of securities. However, unlike ETFs, mutual funds may have higher initial minimum investment requirements and they're only traded once per day after the markets close. There are other important differences for investors to consider as well.

"The fund structure dictates what it can hold and how it can invest," says Bailey. "It's important to understand the fund's underlying investments, strategy, and costs."

Different types of ETFs

Broadly speaking, there are two types of ETFs: Index-based ETFs and actively managed ETFs. Index-basedETFs are passively managed and track a stock market index - a grouping of individual stocks that share a common feature. For example, the Standard & Poor's (S&P) 500 is an index of the 500 largest public companies in the US. Most ETFs are passively managed.

The different types of index-based ETFs often refer to the type of index the ETF tracks:

• Equity ETFs often track a specific index of stocks. The index may be based on the companies' size, region, industry, or other commonalities.
• Bond or fixed-income ETFs track a portfolio of bonds, such as corporate and government debt.
• International ETFs track companies from a specific country or region.
• Sector or industry ETFs track companies within a sector, such as energy or real estate.
• Socially responsible ETFs may track an index of socially conscious companies.
• Commodity ETFs track the price of raw materials, such as gold or oil.
• Currency ETFs track one or more currencies, such as the Euro or a cryptocurrency.

Then there are actively managed ETFs, which aren't based on an index. Instead, they often have a benchmark index and a fund manager or team tries to outperform the benchmark. Generally, you'll pay higher fees for an actively managed ETF.

Quick tip: The cost and risk associated with ETFs can vary depending on the type of ETF and management style.

Examples of real ETFs

With the different types of ETFs in mind, here are a few examples of real ETFs:

• SPDR S&P 500 ETF Trust (SPY) is one of the first and most popular equity ETFs. It tracks the S&P 500.
• Invesco QQQ Trust (QQQ) is another popular equity ETF. It tracks the Nasdaq-100 Index, which is made up of the largest non-financial companies on the Nasdaq stock exchange.
• Vanguard Total International Stock Index Fund ETF Shares (VXUS) is an international equity ETF that tracks the FTSE Global All Cap ex US Index, an index of every public company outside the US.
• iShares Global Clean Energy ETF (ICLN) is a sector and socially responsible ETF that tracks the S&P Global Clean Energy Index.
• ARK Innovation ETF (ARKK) is a large, actively managed ETF that primarily invests in companies that create and use innovative technology.

Pros and cons of investing in ETFs

ETFs can be an important part of your portfolios in that it can diversify your investing portfolio. But consider the pros and cons of ETFs in general and of the specific ETF you're considering investing in.

The financial takeaway

You can buy and sell ETFs like stocks, and they can provide a low-cost option for quickly investing in a large basket of securities.

"Every investor should consider ETFs," says Bailey. "They are typically more tax-efficient and lower cost than mutual funds and offer diversification that would be hard to mimic through individual positions."

However, there are also complex and high-risk ETFs available. Before making an investment decision, consider how the particular ETF could impact your portfolio and how it compares to other types of funds.