What is the difference between an ETF and a mutual fund?

ETFs trade on stock exchanges throughout the day at market prices, while mutual funds are priced once daily after markets close. ETFs generally have lower expense ratios, greater tax efficiency due to the in-kind creation/redemption process, and no minimum investment requirements beyond the share price. Mutual funds may offer fractional shares more easily and allow automatic investment plans, but their higher costs and tax inefficiency make ETFs the preferred choice for most investors.

Are ETFs good for beginners?

ETFs are an excellent choice for beginners. A single broad-market ETF like one tracking the S&P 500 gives you instant diversification across hundreds of companies. They are easy to buy through any brokerage account, have low costs, and require no minimum investment beyond the share price. Many investors build entire portfolios with just 3-5 ETFs covering domestic stocks, international stocks, and bonds.

How do ETF expense ratios affect returns?

The expense ratio is an annual fee expressed as a percentage of assets. A 0.03% expense ratio means you pay $3 per year for every $10,000 invested, while a 0.75% ratio costs $75 per year on the same amount. Over 30 years with a $100,000 investment growing at 8% annually, the difference between a 0.03% and 0.75% expense ratio amounts to roughly $50,000 in lost returns due to compounding.

Yes, ETFs can lose money. An ETF tracks an underlying index or basket of assets, and if those assets decline in value, the ETF price will fall accordingly. During the 2008 financial crisis, broad stock market ETFs lost over 50% of their value. However, unlike individual stocks, a diversified ETF cannot go to zero because it holds many securities. Long-term investors who held through past downturns have always recovered and eventually profited.

How many ETFs should I own?

Most individual investors need 3-10 ETFs for a well-diversified portfolio. A simple 3-fund portfolio covering U.S. stocks, international stocks, and bonds provides excellent diversification. Adding more ETFs for specific sectors, factors, or asset classes can fine-tune your exposure, but beyond 10-12 funds, the marginal diversification benefit is minimal and portfolio complexity increases.

What Is an ETF? A Complete Guide to Exchange-Traded Funds

Exchange-traded funds have transformed investing over the past three decades, growing from a single product launched in 1993 to a global market exceeding $13 trillion in assets. For individual investors, ETFs offer a simple, low-cost way to build a diversified portfolio that would have been impractical just a generation ago.

This guide explains what ETFs are, how they work under the hood, how they compare to mutual funds and index funds, and how to evaluate them for your portfolio.

What Is an ETF?

An exchange-traded fund is an investment vehicle that holds a basket of securities — stocks, bonds, commodities, or a combination — and trades on a stock exchange just like an individual stock. When you buy a share of an ETF, you are buying a small slice of the entire basket.

Most ETFs are designed to track an index. For example, an S&P 500 ETF holds all 500 companies in the S&P 500 index in the same proportions, giving you instant exposure to the broad U.S. stock market with a single purchase. This passive approach eliminates the need to research and select individual companies.

How ETFs Work: The Creation and Redemption Process

The mechanism that makes ETFs unique is the creation and redemption process, which involves three participants: the ETF issuer (such as Vanguard or BlackRock), authorized participants (large financial institutions), and regular investors like you.

Creation

When demand for an ETF rises and its price starts trading above the value of its underlying holdings (known as a premium), authorized participants step in. They buy the underlying securities on the open market, deliver them to the ETF issuer, and receive new ETF shares in return. They can then sell these shares on the exchange, profiting from the premium while pushing the ETF price back toward its fair value.

Redemption

When the ETF trades at a discount (below the value of its holdings), authorized participants do the opposite. They buy cheap ETF shares on the exchange, return them to the issuer, and receive the underlying securities in return. This process brings the ETF price back in line.

This arbitrage mechanism is what keeps ETF prices closely aligned with their underlying holdings throughout the trading day. It also provides a major tax advantage: because redemptions happen “in kind” (exchanging securities rather than selling them), the ETF rarely realizes capital gains, making it more tax-efficient than a mutual fund.

ETF vs. Mutual Fund vs. Index Fund

These three terms are related but distinct. Understanding the differences helps you choose the right vehicle for your situation.

ETF vs. Mutual Fund

Trading — ETFs trade throughout the day at market prices. Mutual funds are priced once per day after markets close (4 PM ET).
Costs — ETFs typically have lower expense ratios. The average U.S. equity ETF charges about 0.15%, while the average equity mutual fund charges 0.42%.
Tax efficiency — The in-kind creation/redemption process makes ETFs significantly more tax-efficient. Mutual funds must distribute capital gains to shareholders annually, even if you did not sell.
Minimum investments — ETFs have no minimum beyond the share price (often $30-$500). Many mutual funds require $1,000-$3,000 minimums.
Flexibility — ETFs can be traded intraday, shorted, or optioned. Mutual funds cannot.

ETF vs. Index Fund

An index fund is not a separate category from ETFs and mutual funds. Rather, it describes the strategy: passively tracking an index. An index fund can be structured as an ETF or as a mutual fund. When people say “index fund,” they often mean an index mutual fund, but many of the most popular index funds today are ETFs.

The key takeaway: ETFs and mutual funds are vehicle types. Index investing is a strategy. You can pursue index investing through either vehicle, but ETFs usually offer lower costs and better tax efficiency.

Types of ETFs

The ETF universe has expanded far beyond simple index tracking. Here are the main categories you will encounter.

Broad Market Equity ETFs

These track major stock indexes like the S&P 500, total U.S. stock market, or total international stock market. They are the building blocks of most portfolios and offer maximum diversification within equities at the lowest cost.

Bond ETFs

Bond ETFs provide exposure to fixed income without the complexity of buying individual bonds. Categories include U.S. Treasury, investment-grade corporate, high-yield, municipal, international, and inflation-protected (TIPS). They are essential for the fixed income portion of your asset allocation.

Sector and Industry ETFs

These focus on specific sectors such as technology, healthcare, energy, or financials. They allow you to overweight or underweight particular industries based on your outlook, though sector concentration increases risk.

Factor ETFs

Factor ETFs target specific return drivers like value, momentum, quality, size, or low volatility. They offer a middle ground between pure passive indexing and active management, aiming to capture systematic premiums identified by academic research.

Dividend ETFs

Dividend ETFs focus on companies with high or growing dividend yields. They are popular with income-seeking investors and those who prefer the psychological comfort of receiving regular cash payments.

Commodity ETFs

These provide exposure to physical commodities like gold, silver, oil, or agricultural products. Some hold the physical commodity, while others use futures contracts. Commodity ETFs can serve as inflation hedges and diversifiers.

International and Emerging Market ETFs

International ETFs cover developed markets outside the U.S. (Europe, Japan, Australia), while emerging market ETFs target developing economies (China, India, Brazil, Taiwan). Together, they provide geographic diversification beyond domestic equities.

Key Metrics for Evaluating ETFs

Not all ETFs are created equal. Even two funds tracking the same index can differ in meaningful ways. Here are the metrics that matter most when choosing between ETFs.

Expense Ratio

The expense ratio is the annual fee the fund charges, expressed as a percentage of assets. For broad-market index ETFs, look for expense ratios below 0.10%. For specialized or factor ETFs, ratios between 0.15% and 0.50% are typical. Every basis point matters over long holding periods due to compounding.

Assets Under Management (AUM)

Larger ETFs generally offer tighter bid-ask spreads (lower trading costs) and are less likely to close. For core holdings, prefer ETFs with at least $1 billion in assets. Smaller niche ETFs are acceptable for satellite positions but carry liquidity risk.

Tracking Error

Tracking error measures how closely the ETF follows its target index. A well-managed ETF will have a tracking error near zero, with any deviation mainly explained by the expense ratio. High tracking error suggests poor fund management or structural issues.

Bid-Ask Spread

The bid-ask spread is the difference between the highest price a buyer will pay and the lowest price a seller will accept. For heavily traded ETFs, spreads are just a penny or two. For thinly traded or exotic ETFs, spreads can be significant, adding hidden costs to every trade.

Tax Efficiency

Check the ETF's history of capital gains distributions. A well-managed ETF should distribute minimal (ideally zero) capital gains. This is especially important in taxable accounts.

How to Choose the Right ETF

Selecting ETFs involves matching your investment goals with the right combination of funds. Here is a practical process.

Define your asset allocation — Determine how much of your portfolio should be in each asset class. Your asset allocation comes first; ETF selection follows.
Identify the index or exposure — For each asset class bucket, decide what index or strategy you want to track. For U.S. stocks, this might be the S&P 500 or the total market.
Compare expense ratios — Among ETFs tracking the same index, the one with the lowest expense ratio will almost always produce the best returns over time.
Check liquidity — Verify that AUM and daily trading volume are sufficient for your needs. For buy-and-hold investors, liquidity matters less than for active traders, but it still affects execution quality.
Evaluate the issuer — Major issuers like Vanguard, BlackRock (iShares), State Street (SPDR), and Schwab have long track records, massive scale, and competitive pricing.

Building a Portfolio with ETFs

ETFs make it possible to construct a globally diversified portfolio with just a handful of funds. Here are two example approaches.

The Three-Fund Portfolio

Popularized by John Bogle, this approach uses just three ETFs:

A total U.S. stock market ETF (60%)
A total international stock market ETF (25%)
A total U.S. bond market ETF (15%)

This portfolio provides exposure to thousands of securities worldwide at a blended expense ratio below 0.05%. It is simple to maintain, easy to rebalance, and difficult to improve upon for most investors.

The Multi-Asset ETF Portfolio

Investors who want more granular control can expand to 8-12 ETFs covering specific sub-asset classes: U.S. large cap, U.S. small cap, international developed, emerging markets, investment-grade bonds, Treasury bonds, TIPS, REITs, and commodities. On MavenEdge Finance, you can explore our curated universe of 77+ ETFs across all major asset classes and compare them by expense ratio, performance, and risk metrics.

Common ETF Investing Mistakes

ETFs are simple, but investors still make avoidable errors.

Trading too frequently — Because ETFs are easy to trade, some investors overtrade, racking up commissions and taxes. Buy-and-hold is the best approach for most.
Chasing niche themes — Thematic ETFs (AI, cannabis, space) are often launched after a sector has already risen, trapping investors at the peak. Stick to broad-market funds for your core allocation.
Ignoring overlap — Holding a total market ETF alongside a large-cap ETF means you are double-counting the same stocks. Check holdings overlap before adding new funds.
Trading at market open or close — The first and last 30 minutes of the trading day often have wider spreads and more volatility. Place orders during the middle of the day when possible.
Overlooking foreign withholding taxes — International ETFs may have tax implications that do not show up in the expense ratio, particularly for non-U.S. dividend income.

The Future of ETFs

The ETF industry continues to evolve rapidly. Active ETFs — which employ a portfolio manager rather than tracking an index — are the fastest-growing segment, offering the tax and cost advantages of the ETF structure with active security selection. Single-stock ETFs, direct indexing, and cryptocurrency ETFs are expanding the boundaries of what the structure can deliver.

For individual investors, the core message remains the same: low-cost, broad-market ETFs are the most reliable tools for building long-term wealth. They democratize access to sophisticated diversification strategies that were once available only to institutional investors.

An ETF does not make you a better or worse investor. It is simply the most efficient vehicle for expressing your investment views. Choose your allocation wisely, keep costs low, and let compounding do the work.