If you're curious about how ETFs operate, you're in the right place. Exchange-Traded Funds, commonly known as ETFs, have been available for roughly three decades and have become a staple in the investment world. Yet, many individuals still wonder, how do ETFs actually function?

ETFs have transformed the traditional Mutual Fund into a modern digital asset. But what are they really, and how can you begin investing in them? Let's break it down.

Understanding How ETFs Operate

ETFs enable investors to allocate funds into a collection of stocks, commodities, or currencies (including cryptocurrencies), allowing them to profit from a specific sector of diversified assets. Investors favor ETFs because they can invest in a category of stocks instead of just one, which helps to mitigate risk. If one company in your chosen ETF underperforms, it's likely that others will do well.

Are ETFs Similar to Mutual Funds?

While they might seem alike, ETFs differ from mutual funds in that the latter can only be purchased or sold at the end of the trading day at that day's price. In contrast, ETFs can be traded throughout the day on major exchanges via nearly all online brokerage platforms. Additionally, ETFs often have lower fees compared to mutual funds.

As Matt Collins, Head of ETFs at PGIM Investments, explains, “The great thing about ETFs is that if someone decides they want to invest in a sector like robotics or the S&P 500, they can do it in seconds. They can easily buy this pooled investment vehicle through their brokerage account, making it accessible and transparent.”

Is Intraday Trading of ETFs Beneficial?

This feature can be advantageous during times of market volatility, Collins notes. Having the option to make trades in response to significant market shifts can provide peace of mind for some investors.

However, it can also be a downside. “Not everyone can resist the urge to trade,” Collins cautions. “The founder of Vanguard emphasizes that some investors may be better off without the temptation to trade frequently. Mutual funds can be beneficial as they offer less temptation, particularly in retirement accounts. There's a place for both, but sometimes having the ability to trade isn't the best choice for your financial health.”

Who Should Consider ETFs?

Are ETFs Regulated by the SEC?

Yes. “Launching an ETF involves a rigorous process,” Collins states. “Initially, a trust is established, which must receive SEC approval. This trust outlines its investment parameters. The trust then files to market a product under its umbrella, with the SEC overseeing the types of investments eligible for public trading. The final step involves approval from stock exchanges like the NYSE or NASDAQ. Thus, both the SEC and the exchanges ensure that the ETF is ready for trading.”

Are ETFs Actively Managed?

When it comes to management, ETFs are typically more passively managed compared to mutual funds, but this is changing. “Active ETFs are expanding at a quicker pace than passive ones,” Collins notes, “largely because there were only a handful of active ETFs five years ago. Over the next decade or two, I expect to see more balance in this area, but the good news is that the costs associated with active management are decreasing.”

What’s the Key Advantage of an ETF?

In a single word: diversification, according to Collins. “Few ETFs lack extensive diversification, even those focusing on a narrow sector. The main advantage is that they reduce risk and limit the temptation to trade impulsively.”

Are All ETFs and Their Managers Equal?

Not at all. “There are established leaders in the field, such as PGIM, BlackRock, and JP Morgan,” Collins points out. “Then you have Vanguard and SPDR products. Lastly, there are many new startups—some excellent, some not so much. Currently, ETFs are offered by a wide range of managers, both new and seasoned.”

How Easy is it to Trade ETFs?

Collins assures that it’s simple. “Anyone familiar with basic technology can easily find the value of an ETF.”

If you don’t yet have a brokerage account, consider platforms like E*Trade, which offers ETFs among various investment options. By clicking the link, you'll access thousands of funds, complete with performance history, ratings, current prices, expense ratios, and more. After researching, select the fund you want, enter your investment amount, hit the “buy” button, and wait for purchase confirmation—usually within moments, though setting up an account for the first time may take up to 24 hours.

If you have questions, don't hesitate to reach out. Every brokerage, online or in-person, has representatives available to assist you through the process.