What are ETFs?
An ETF (exchange-traded fund) is a single investment that holds a basket of many assets — often stocks or bonds — and trades on an exchange like an individual stock. Buying one share gives you a small stake in every holding in the fund, which is a simple way to diversify. Diversification does not ensure a profit or protect against loss in a declining market, and like any investment, ETFs carry market risk, including the possible loss of principal.
Buy one share of an ETF holding 100 companies and you own a small slice of all 100. The weighting is rarely equal, though — many ETFs concentrate a large share of their assets in their biggest holdings, so a fund that looks broad can still lean heavily on one sector or a handful of companies. Check the holdings before you assume a fund is diversified.
ETFs have drawn trillions of dollars for that convenience. But there are a few things worth understanding before you buy one.
How do ETFs work?
Many ETFs track an index — a list of companies representing a slice of the market, such as the S&P 500 or the Nasdaq-100. Rather than buying each company individually, you buy one fund that holds them, and your investment follows the value of the companies inside it. Indexes exist for nearly every sector, region, and theme, so if you can name a segment of the market, there is likely an ETF tracking it.
ETFs are also versatile. Whatever segment you want exposure to — a broad index, a single sector, bonds, commodities, real estate, currencies, or a narrower theme — there is usually a fund for it. Similar funds tracking the same index can charge different expense ratios, so cost is one straightforward way to tell them apart.
Some categories carry meaningfully more risk than a broad index fund. Leveraged and inverse ETFs, for instance, are built for short holding periods and can lose value quickly, including in markets that eventually move the way you expected. Dividend-focused ETFs are a gentler example — worth understanding how dividends work before you rely on the income. Read a fund’s prospectus and objective before buying, whatever the category.
How big is the ETF market?
The first U.S. ETF launched in 1993, giving investors a way to hold a diversified basket without buying each stock separately. The category has grown enormously since: U.S.-listed ETFs held $15.7 trillion in assets as of June 30, 2026, across more than 4,000 funds, according to FactSet.
Mutual funds offered a similar pooled structure long before ETFs existed. The two still differ in how they trade, what they require as a minimum, and how they are taxed and priced — the differences that follow.
Important factors to consider within an ETF
As you’re researching various ETFs to purchase, there are several factors to consider. While all investors ought to do their own due diligence, here’s how to understand what each ETF contains and the costs associated with each one:
Expense ratio
The expense ratio is the annual cost of owning a fund, charged as a percentage of your investment and used to cover the fund’s operating costs. A lower expense ratio means less of your return goes to fees.
The range is wide. A broad S&P 500 index ETF can charge as little as 0.02% — about $2 a year on a $10,000 investment. Narrow, actively managed, or fund-of-funds ETFs can cost many times that. One thing worth checking: a fund’s total expense ratio can be much higher than its management fee, because funds that hold other funds pass along those underlying costs too. Compare the total, not just the management fee.
Higher fees do not guarantee higher returns, and they compound against you over time.
ETF holdings
Every ETF publishes what it holds. The quickest way to check is to search the fund’s ticker plus “holdings,” or open the holdings page on the issuer’s site. It is worth doing before you buy — two funds tracking the same theme can hold very different things.
Net asset value (NAV)
The Net Asset Value or NAV represents the value of each share’s portion of the fund’s underlying assets and cash at the conclusion of each trading day, less any liabilities. This figure is used to compare the performance of different funds and report proper numbers for accounting purposes.
Dividend yield
If an ETF pays dividends, its dividend yield reflects the income investors may receive relative to what they hold. Dividends are not guaranteed and can change or stop. Payments may be monthly, quarterly, or annual, and the amount varies, so check the fund issuer’s distributions page for its actual payment history rather than assuming a steady figure. Past distributions do not predict future payouts.
How are ETFs taxed compared with mutual funds?
Both pool many investors’ money into one basket, but they move assets differently, and that can affect what you owe in a taxable account.
ETF shares are generally created and redeemed “in-kind” — exchanged for baskets of the underlying securities rather than sold for cash — using large blocks called creation units. Because the fund is not selling holdings to raise cash, it triggers fewer taxable events. A mutual fund meeting redemptions often has to sell holdings, and any resulting capital gains are distributed to everyone still in the fund.
The size of that advantage varies. The Securities and Exchange Commission notes in an investor bulletin that “very generally, the federal income tax consequences of investing in ETFs and mutual funds are comparable.”
How do ETF and mutual fund fees compare?
Most ETFs are passively managed — they follow an index rather than trying to beat it, which takes less work and costs less to run. Actively managed ETFs exist and typically charge more.
Mutual funds are more often actively managed and can carry higher costs, sometimes including a load fee on top of the expense ratio.
ETF vs. index fund: what’s the difference?
The short answer: “ETF” describes how a fund is traded, while “index fund” describes what a fund is trying to do. The two overlap — many ETFs are index funds, and many index funds are available as ETFs — so the real question is usually about structure, not strategy.
- An index fund is any fund designed to track a market index (like the S&P 500) rather than to beat it. It can be structured either as an ETF or as a mutual fund.
- An ETF is a fund that trades on an exchange throughout the day like a stock. An ETF may track an index (an “index ETF”) or be actively managed.
Where ETFs and index funds can differ in practice:
| Dimension | Index fund (mutual-fund form) | ETF |
| How you buy/sell | Priced once per day, after market close (at NAV) | Trades throughout the day at market price |
| Minimums | May require a minimum initial investment | Often one share, or a fractional share where offered |
| Taxes | Fund-level trades can pass capital-gains distributions through to holders | In-kind creation/redemption tends to limit capital-gains distributions, which can make ETFs relatively tax-efficient in a taxable account |
| Cost | Low for index trackers; no bid-ask spread, but some funds carry sales loads | Low for index trackers; no loads, but you pay the bid-ask spread on each trade |
That tax difference is real but usually small — for most funds it is a modest advantage rather than a decisive one.
Neither is universally “better” — the right fit depends on how you want to buy, your account type, and the specific fund’s costs and holdings. Both still carry market risk, including the possible loss of principal, and tracking an index does not eliminate the risk of loss when that index falls.
Comparing the two? It helps to read up on what an index fund is and how active and passive strategies differ.
Passive vs. active ETFs
ETFs were built mainly for passive investing, but actively managed ETFs are now widely available. The difference:
- An active ETF is managed by portfolio managers who actively make investment decisions, with the goal of outperforming a specific benchmark or index. The managers use their expertise and research to select a portfolio of securities they believe will generate higher returns than a passive ETF. Actively managed ETFs aim to outperform, but there is no guarantee they will, and they typically carry higher fees that can reduce net returns.
- Passive ETFs aim to replicate the performance of a specific market index, such as the S&P 500 or the FTSE 100. Instead of relying on active management decisions, passive ETFs follow an rules-based approach set by an asset manager, holding the same securities in similar proportions as the underlying index. Since passive ETFs do not require constant portfolio adjustments, they typically have lower operating expense ratios, which include management fees, compared to active ETFs.
The M1 bottom line
An ETF can be low-effort way to own a diversified basket in a single trade, which is why long-term investors use them so heavily. On M1 you can hold ETFs in a custom target allocation, in a taxable brokerage account or a retirement account, and automate contributions as part of building wealth over time.
Whatever you choose, make sure it fits the strategy you are actually running.
Frequently asked questions about ETFs
An ETF (exchange-traded fund) is a single security that holds many underlying assets, such as stocks or bonds, and trades on an exchange like a stock. Buying one share gives you exposure to everything the fund holds, which is a common way to diversify.
“Index fund” describes a fund’s goal (tracking an index rather than beating it); “ETF” describes how a fund trades (on an exchange, throughout the day). Many index funds are available as ETFs. Index funds can also be structured as mutual funds, which price once daily and may have minimums.
Both pool many investors’ money into a basket of assets, but ETFs trade on an exchange throughout the day, while mutual funds are priced once daily after the close. ETFs are often passively managed with lower expense ratios and can be relatively tax-efficient, while mutual funds are more often actively managed and may carry higher fees. Mutual funds, in turn, can suit automatic dollar-based investing and carry no bid-ask spread; which fits better depends on the specific fund and how you invest.
It depends on the fund and on what you need it for. ETFs are not risk-free: an ETF falls when its holdings fall, some are narrow or use leverage, and fees vary widely between funds tracking the same thing. What an ETF does give you is a way to hold many assets at once without picking them individually.
Investing involves risk, including the possible loss of principal. This content is educational and is not personalized investment, tax, or legal advice. M1 does not provide tax advice; consult a qualified professional about your situation. Tax figures and rules referenced are set by the IRS and change periodically — verify current figures at IRS.gov. Brokerage products and IRAs are offered by M1 Finance LLC, member FINRA/SIPC.
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