You may have come across the term ETF before. It stands for Exchange Traded Fund, and like stocks and bonds, it's something you can invest in. In this lesson you'll learn what an ETF is, and what the advantages and disadvantages are.

What is an ETF?

Simply put, an ETF is a basket filled with a range of different stocks or bonds. When you invest in an ETF, you're not investing in a single company or bond, you're investing in many at once. Investing in ETFs is a form of passive investing.

To understand what an ETF actually is, the name tells you a lot. "Exchange Traded Fund" has two parts: 

ETFs track an index

An ETF holds multiple stocks or bonds, but how do you know what they're collectively worth? That's where the index comes in. An index typically combines the weighted average value of a specific group of stocks or bonds. For example, the 25% most sustainable listed companies in the US.

An ETF holds the same stocks or bonds as the index it tracks, in the same proportions. So the value of an ETF moves in lockstep with its index.

It's worth noting that alongside ETFs, there are also index funds. These are also funds that track an index, and the two are often confused. They're very similar, but not identical:

ETFs can be bought and sold throughout the trading day. Index funds can only be traded at the end of the trading day, at the price set at that point, making them slightly less flexible than ETFs.

Investing in ETFs: pros

You've already seen a few of the advantages above:

1. You invest in many different stocks or bonds at once, spreading your risk. If one investment in the ETF underperforms, others can make up for it.

2. ETFs are highly tradable: they're easy to trade on the market. On any day the exchange is open, you can buy or sell them without difficulty, making them considerably more flexible than, say, property investments. Stocks and bonds are also traded on exchanges, so they share this advantage.

3. Investing in ETFs also takes less time than picking individual stocks or bonds. Rather than researching each investment yourself, you simply choose a ready-made basket.

4. Finally, ETFs are relatively low cost. Because ETF investing is passive, you face fewer transaction costs. You'll still pay other costs, such as spread, fund fees, and the service costs of your investment platform, but these tend to be lower overall.

Investing in ETFs: cons

Every advantage has a trade-off, and ETFs are no exception. The main drawbacks are linked to the fact that ETFs track an index:

1. You're largely at the mercy of the index. When it rises, your investment rises too, but when it falls, so does your portfolio.

2. You have less say over exactly what you're invested in. You can choose which ETF to buy, but you have no influence over the individual stocks or bonds inside it.

3. Your return is always slightly lower than the index’s return because of the ETF’s fees.

Key takeaways

• Investing in ETFs is a form of passive investing.
• An ETF is a ready-made basket of stocks or bonds.
• ETFs spread your risk across multiple investments, though not all ETFs are equally diversified.
• ETFs track an index and their value moves in line with it.
• ETFs are liquid and easy to trade on the market.