What Are ETFs and How Do They Work?

An ETF, or exchange traded fund, is a type of investment fund that pools money from different investors in order to buy a range of assets such as stocks and bonds. Similar to index funds, most (not all) ETFs tend to be passively managed.  

ETFs are sponsored or created by financial institutions. These financial instutions buy assets that the ETF will own. ETFs are not typically run by professional fund managers like mutual funds are. Instead, ETFs are passively managed.

This simply means that the ETF is designed to track the performace of an underlying market index. A market index measures the performance of a specific sector of the financial markets. For example, the S&P 500 index tracks the performance of the 500 most important companies in the US.

So, an S&P 500 ETF would simply own the stocks of the 500 most important companies in the US. The idea here is to track an underlying market index in hopes of replicating the performance of that index. For example, the S&P 500 typically averages a 10% return over time.

An ETF simply buys the stocks that the S&P 500 tracks in order to try to replicate this 10% return. It is important to note that a market index is not an investment itself. It is simply a measuring stick for how a particular group of assets is doing. An ETF looks at this measuring stick and buys the assets that the measuring stick tracks.

Once an ETF is created, shares of the fund are offered to investors. When you buy a share of the ETF, you do not directly own all of the assets that the ETF owns. You simply own a portion of the ETF itself as a shareholder. The ETF owns all of the underlying assets.  

ETFs are fairly similar to other types of investment funds such as index funds and mutual funds, but they do have one major difference. Unlike other types of investment funds, ETFs can be bought and sold throughout the day just like a stock.

For example, lets say that you bought a share of an ETF at 9:30 in the morning. If you wanted to, you could sell that share the same day at 4:00 in the afternoon. Other investment funds only allow you to buy or sell a share of the fund at the end of the trading day.

1) The share price of the ETF increases

If the share price of an ETF increases, you can cash in for a profit. ETFs are more flexibile than index funds and mutual funds in terms of when you can cash in. An ETF trades throughout the day just like a stock. This means you can sell your ETF shares at any point during the day when the market is open. Index funds and mutual funds only allow you to buy or sell them at the end of the trading day.

2) Income from dividends or bonds

If your ETF invests in stocks that pay dividends, you will receive a pro rated portion of these dividends as a shareholder of the ETF. A dividend is simply a portion of a company's profit that is passed onto you as a shareholder. ETFs are required to distribute the dividends they earn to the shareholders (you as the investor) at least once per year.

These dividends are a way to make money, but you can also choose to reinvest any dividends you earn back into the ETF in order to aqcuire more shares. Secondly, you could invest in a Bond ETF. Any interest earned from bonds that the fund holds will be distributed to you as a shareholder.  

3) Capital gain distrubtions

It is quite rare, but it is possible for an ETF to payout a capital gain distribution. A capital gain is when a capital asset is sold for a profit. For example, lets say an ETF bought a stock for $50 and sold the stock later on for $100. The $50 profit would be referred to as a capital gain.

Any capital gains are distrubted among shareholders on a pro rata basis. With that being said, ETFs focus on a passive instead of active investing strategy. This simply means that most ETFs are not focused on profiting through capital gain distributions. Instead, most ETFs focus on holding onto the same assets of a particular market index for a long time.  

ETFs are typically more cost effective than actively managed mutual funds. However, there are some fees that you should look out for. First, you may have to pay a commission when you buy or sell an ETF. This fee is not charged by the ETF directly, but is charged by an online broker when you buy a share of an ETF.

Not all brokers charge a commission when you buy or sell shares of an ETF, but expect to pay up to $25 to the broker if a commission is charged. Secondly, ETFs charge what is called an expense ratio. An expense ratio is a fee that an ETF charges to cover the admininstrative and operating costs that the fund incurs.

Expense ratios can range depending upon the ETF, but they typically do not exceed 1%. For example, lets say you had $1,000 invested in an ETF that charged a 0.5% expense ratio. You would be charged $5 to cover the expense ratio.

ETFs can incur taxes in three different areas. These rules are applicable if you buy ETFs through a taxable brokerage account. You can avoid some of the taxes associated with index funds by buying them through tax advantaged accounts (see item 5).  

1. Taxes on income earned from stock dividends and bonds

If you invest in an ETF that earns income from stock dividends or bonds, your portion of the income earned is subject to taxes. The income that you earn from bonds is taxed at your ordinary income rate. The income that you earn from dividends will be taxed at your ordinary income rate if it is a nonqualified dividend.

The income you earn from dividends will be taxed at long term capital gains rates (more on that below) if it is a qualified dividend. You will typically be sent an IRS Form 1099-DIV that will show how much income you earned. You are required to report this income when you file your taxes.

2. Taxes on capital gains distributions

If an ETF incurs a capital gain by selling investments within the fund for a profit, your portion of these profits (distributions) are subject to capital gains tax. You will typically be sent an IRS Form 1099-DIV that will show how much you earned through capital gains distributions.

Although it is rare, any capital gains distributions you receive from holding shares of an ETF are taxed at long term capital gains rates (more on that below).
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3. Taxes when you sell shares of your ETF

Thirdly, you can incur capital gains tax when you sell shares of your ETF for a profit. The price of ETF shares typically increase when the underlying assets the fund owns increase in value. For example, lets say you bought a share of an ETF for $40 and sold it later on for $60. Your profit of $20 would be subject to a capital gains tax.

You would incur a short term capital gains tax if you held your shares for less than a year before selling, or a long term capital gains tax if you held your shares for more than a year before selling (more on that below).

4. What are capital gains and their tax rates?
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For clarity, a capital gains tax is simply a tax on the profit you make when you sell an asset. If you sell an asset at a loss, you have a capital loss and do not owe any taxes. You can incur either a short or long term capital gains tax.

A short term capital gains tax occurs when you hold an asset for less than a year before selling it. Short term capital gains tax rates are the same as your ordinary income. A long term capital gains tax occurs when you hold the asset for more than a year before selling it.

Long term capital gains rates are more favorable as you will pay 0%, 15% or 20% depending upon your tax filing status and income. You can use the chart below to get an idea of what long term capital gains rates could look like for you. Simply find your tax filing status and corresponding income range to see what rate you could incur.

(Accurate for 2024).

5. Strategies to reduce ETF taxes

a) Hold ETFs in tax advantaged accounts

The easiest way to reduce the taxes associated with ETFs is to buy them through tax advantaged accounts. The most popular of these accounts for the typical investor would be IRAs (individual retirement accounts), and employer sponsored 401(k)s.

These account types offer either tax deferred or tax free benefits. A Traditional IRA and 401k offer a tax deferred benefit. Essentially, you don't pay taxes on the dollars you invest today, but wait or defer the taxes until you pull the money out in retirement.

So, if you bought ETFs through a tax deferred account, you would not owe any taxes on any of the income, capital gains, or increases in share price until you pulled the money out in retirement, at which point you would incur taxes at your ordinary income rate.

On the other hand, a Roth IRA and 401k offer tax free benefits. You contribute to these accounts with dollars that have already been taxed, but then the investments within your account grow tax free and when you pull the money out in retirement you don't owe any taxes.

So, if you bought ETFs through one of these accounts, you would pay taxes on the dollars you contributed to the account, but you would not owe any taxes on any income, capital gains, or increases in share prices when you pull the money out of the account in retirement.

Learn more about these accounts

b) Wait for more than a year before selling shares
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In order to get a more favorable capital gains tax rate, you can wait until you have held shares of your ETF for a minimum of 1 year. This will get you into the lower tax rates of 0%, 15% and 20% as opposed to being taxed at your ordinary income tax rate. Again, this applies if you hold your ETFs in a brokerage account.

c) Understand what your ETF invests in
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If your ETF is highly invested in assets that produce income such as dividend stocks and bonds, you might want to avoid that fund if your goal is to reduce taxes. This is not really a problem if you buy ETFs through a tax advantaged account.  

d) Seek out tax experts

Most importantly, you need to seek out tax experts. Taxes associated with ETFs can get confusing. It is important that you understand the tax implications of your investments, as well as how to be tax efficient. You can speak with a CPA or financial advisor for more clarity.

1) Diversification - ETFs allow you to get exposure to lots of different stocks all at once, which lowers your risk. You do not directly own all of the assets that the ETF owns, but you own a share of the ETF itself. Since the ETF owns a predetermined set of assets, you get exposure to all of these assets. Investing in an ETF  is much easier than trying to build an investing portfolio comprised of individual stocks.

2) Trades like a stock - ETFs trade throughout the day just like a stock does - when the market is open. This gives you more flexibility and liquidity than index funds and mutual funds which can only be bought or sold at the end of the trading day. If you are a long term investor this won't matter as much if you simply plan on a buy and hold strategy.

3) Low fees - Compared to actively managed mutual funds, ETFs are an affordable investment option. Most ETFs keep their expense ratios (fees) below 1% per year. However, there are many ETFs that offer expense ratios lower than that. For example, the Spider S&P 500 Index ETF (SPY) charges only a 0.09% ETF per year.

4) Low minimum investment - Mutual funds (and some index funds) often require you to have large minimum investments in order to buy shares. This can sometimes costs you thousands of dollars for a single share. ETFs often have much lower minimum investment requirements which can make them a better option if you have a small investing budget.

1) Potential commissions - There are some brokers that will charge you a commission every time you buy or sell shares of an ETF. This could range up to $25 per trade which can eat into your profits every time you make a trade. If you plan on buying and holding ETFs this is not as big of a deal.

2) Typically won't beat average returns - Since ETFs typically invest in a predetermined mix of assets based upon a market index, the fund typically won't beat the returns that that underlying index provides. In other words, you are typically stuck with the average returns of the underlying index that the ETF is tracking. Mutual funds are a better bet if you want an investment with the potential to beat average returns.  

There is not necessarily a "best" investment. A better question to ask yourself is if ETFs are a good investment for you? The answer to that will vary greatly. Most investors who opt to use ETFs want a low cost investment option that is easy to invest in.  

ETFs are fairly similar to index funds in terms of investing style. ETFs typically buy assets in an underlying market index. This simply means that ETFs have more of a set it and forget it investing style as opposed to trying to get above average returns - which is what mutual funds aim to do.

ETFs also trade throughout the day just like a stock would. This makes ETFs more flexible and liquid than other types of investment funds. As previously mentioned, this is not that important if you plan on holding onto ETFs for long periods of time.

If you are an investor that has a small investing budget and lack the financial expertise to choose your own investments, ETFs can be a good option. You get an investment vehicle that is easy to invest in, as well as exposure to lots of assets all at once for relatively low costs

Buying ETFs is quite simple and can be done through an online broker. The first step is to open an investing account through your chosen broker. (You can check out our list of the best online brokers if you need help finding one).

Once you have chosen a broker, simply go through an online application for an investing account. An investing account simply holds your ETFs. At a bare minimum, you will need a brokerage account, but it might be better to buy ETFs through IRAs to avoid some of the tax problems. (Check out our list of the best investing accounts for more information.)

After your account is approved, transfer funds from your bank account to your investing account. From there, you can research ETFs that you want to invest in. Most brokers offer free tools to help you compare the best ETFs.

Once you find an ETF that you want to invest in, you need to execute a trade. This might sound complicated, but it is not.  You simply need to search for the ticker symbol of the fund you want to invest in, select a dollar amount to invest, and execute the trade.

A ticker symbol is simply just a series of letters and numbers that represent a particular investment. For example, the Spider S&P 500 Index ETF ticker symbol is SPY. If you wanted to buy this fund, you could search for the ticker symbol and execute a trade.

ETFs are pooled investment funds that you can trade throughout the day just like a stock. ETFs are similar to index funds in that they typically have a passive management style. ETFs are an easy way to gain exposure to lots of assets in a particular market sector.

As a shareholder you can earn a pro rated portion of dividends or interest that the fund earns from the investments that it holds. In some cases you may also be entitled to capital gains the ETF earns, but this is a rare occurence due to the structure of ETFS.

ETFs have pros and cons. They offer strong diversification, low fees and low minimum investment requirements. On the flipside, you can incur potential broker commissions every time that you buy and sell ETFs depending upon the broker you use, and ETFs will typically only provide the average return of the market index that they track.

At the end of the day, ETFs may or may not be a good investment for you. It depends upon your individual circumstances and what you are trying to accomplish. You can speak with a licensed financial advisor for more advice, or open an investing account at an online broker to start researching potential ETFs to invest in.