What Is an ETF?
An ETF packs a whole basket of stocks into one fund, which then trades on an exchange just like a stock.
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Text version · Indexes & ETFs, lesson 3: “What Is an ETF?”
An ETF packs a whole basket of stocks into one fund, which then trades on an exchange just like a stock.
A box holding the whole basket of stocks
An ETF holds a basket of constituents and usually tracks an index. It trades on an exchange anytime, just like a stock: place 1 order and you get a small slice of the whole basket.
Built-in diversification
If one company runs into trouble, it only affects its small share of the basket. Bet on a single stock and you carry all of its ups and downs alone.
Diversified doesn't mean it can't fall
Diversification removes single-company risk, but it can't escape systematic risk, when the whole market falls together. In a bear market, an ETF tracking the broad market falls with it.
Key takeaways
- An ETF (exchange-traded fund) holds a basket of assets and usually tracks an index.
- Buying 1 ETF share means indirectly owning a small piece of every constituent, automatically spreading out single-company risk.
- ETFs trade like stocks throughout the trading day, with prices that move with the market.
- Diversification reduces single-company risk; when the whole market falls, the ETF falls too.
Try it yourself
You can do these exercises in this lesson's interactive simulation:
- Click "Buy 1 ETF unit": what do the cyan slivers at the bottom of each stock in the box represent? About how much is each one worth?
- Switch to "Buy all 50 yourself" and place the orders one by one: how many orders, how much money at least, and how much in fees?
- Click "One company crashes 50%": how much do you lose all in on Ming's Coffee? And holding 1 ETF unit?
- Switch to "Buy all 50 yourself" and place the orders one by one, then make Ming's Coffee crash: how much does your homemade portfolio fall? Why aren't the stocks equally weighted even though you bought 1 share of each?
Quiz and explanations
- 1. Buying one share of an S&P 500 ETF is like…
- Answer: Indirectly owning a small piece of about 500 companies.Behind the ETF is a basket of constituent stocks.
- 2. What's the main advantage of an ETF over a single stock?
- Answer: It spreads out risk automatically.If one company runs into trouble, the effect on the whole is small.
- 3. An equal-weighted ETF holds 20 stocks. One of them crashes 50% and the rest don't move. Roughly how much does the ETF fall?
- Answer: 2.5%.Each stock is 1/20 = 5%, and 5% × 50% = 2.5%.
Terms in this lesson
- constituent (Constituent): A stock included in an index's calculation.
- ETF (Exchange-Traded Fund): A fund listed and traded on an exchange that usually holds a basket of assets to track an index.
- systematic risk (Systematic Risk): Risk the whole market shares and diversification can't remove, such as recessions or interest rate changes.