How Exchange-Traded Funds Can Help You Build a Diversified Investment Portfolio
By the end of this lesson, you’ll understand:
Selecting individual investments can feel overwhelming.
Which companies should you choose?
How many stocks do you need?
What happens if one company fails?
How do you invest in hundreds of businesses without purchasing each one separately?
Exchange-traded funds, commonly called ETFs, offer one possible solution.
An ETF can combine many investments into a single fund. Instead of choosing and purchasing every stock or bond individually, you can buy shares of the fund that owns them.
One ETF might hold:
ETFs have helped make diversified investing more accessible.
However, the word “ETF” describes how an investment is structured and traded. It does not tell you whether the fund is diversified, inexpensive, appropriate, or safe.
Understanding what is inside an ETF is far more important than simply knowing that it is an ETF.
An exchange-traded fund is an investment fund whose shares trade on a stock exchange.
The fund pools money from many investors and uses that money to hold a portfolio of assets.
Depending on its objective, an ETF may hold:
When you purchase a share of an ETF, you receive an interest in the fund’s investment portfolio and the income it may produce. The SEC describes ETFs as pooled investments in which each share represents a proportionate interest in the portfolio. Investor.gov provides an overview of ETFs.
You generally do not directly own each individual security inside the ETF.
You own shares of the fund that owns the securities.
Imagine you want to purchase groceries from 100 different stores.
Visiting every store would require considerable time and effort.
Now imagine someone creates one organized basket containing an item from each store. You can purchase an interest in the entire basket through one transaction.
An ETF works similarly.
A broad-market stock ETF might hold shares in hundreds or thousands of companies.
By purchasing one ETF share, you gain financial exposure to a small portion of the fund’s entire portfolio.
The contents of the basket determine:
The ETF wrapper does not make a poor basket into a good one.
You must still understand what is inside.
Every ETF has an investment objective.
The objective explains what the fund is designed to do.
For example, an ETF may seek to:
Before purchasing an ETF, read its stated objective and review its holdings.
The ETF’s name may not tell the complete story.
A fund called a “technology ETF” may be heavily concentrated in only a few large companies. An “income ETF” may use investments that involve greater credit or interest-rate risk. A “global ETF” may have most of its assets in one country.
Look beyond the label.
Many ETFs use a passive investment strategy.
A passive ETF usually seeks to track the performance of a particular index or benchmark.
For example, it might track:
The fund is not necessarily trying to identify which securities will outperform.
Instead, it seeks to reproduce the index’s results as closely as reasonably possible, before considering fees and expenses.
Passive ETFs often have relatively low operating costs, but not every passive ETF is inexpensive.
They can also track narrow, complicated, or risky indexes.
An actively managed ETF has a manager or management team that selects investments according to the fund’s strategy.
The manager may decide:
An active ETF attempts to achieve a stated objective through management decisions rather than simply following an index.
Active management may provide flexibility, but it can also involve:
Active management does not guarantee better performance.
These funds may hold hundreds or thousands of companies across multiple industries.
They can provide a foundation for a diversified stock portfolio.
These funds focus on companies of particular sizes.
Each category may respond differently to economic and market conditions.
International ETFs invest outside the United States.
They may provide geographic diversification but can introduce:
Bond ETFs hold collections of bonds.
They may focus on:
Bond ETFs can lose value. Their prices may be affected by interest rates, credit quality, and market conditions.
Sector ETFs focus on a particular part of the economy, such as:
Sector funds may provide targeted exposure, but they are usually less diversified than broad-market funds.
Dividend ETFs invest in companies selected partly for their dividend characteristics.
Some focus on:
A dividend ETF does not guarantee income. Its holdings may reduce or eliminate their dividends.
Thematic ETFs focus on an investment theme, such as:
Themes can be exciting, but thematic funds may be concentrated, expensive, or launched after investor excitement has already raised valuations.
A compelling story does not guarantee a strong investment return.
Some exchange-traded products provide exposure to commodities, currencies, futures, or other alternative investments.
These products may be structured differently from traditional stock and bond ETFs.
Their tax treatment, risks, and performance can be more complex.
Do not assume every product commonly called an ETF works the same way.
When you purchase an individual stock, your investment depends heavily on one company.
When you purchase an ETF, your results depend on the collection of assets held by the fund.
Suppose:
If the technology company fails, Investment A could lose most or all of its value.
The same company’s failure would probably have a smaller effect on Investment B because it represents only one holding among many.
This does not make Investment B risk-free.
If the overall market declines, the broad ETF may decline too.
The difference is that a diversified ETF reduces your dependence on one company’s success.
ETFs and mutual funds both pool money from investors.
Both may hold portfolios of stocks, bonds, or other assets.
However, they generally trade differently.
ETF shares:
Traditional mutual fund shares:
Neither structure is automatically better.
The best choice depends on the available funds, costs, account features, investment strategy, and investor behavior.
An ETF’s net asset value, or NAV, represents the value of the fund’s assets minus its liabilities, divided by the number of shares outstanding.
A simplified formula is:
An ETF trades at a discount when its market price is lower than its NAV.
For example:
The SEC notes that investors may pay more or less than NAV when buying ETF shares and may receive more or less than NAV when selling them. Investor.gov explains ETF premiums, discounts, and market pricing.
Small premiums and discounts may occur during normal trading.
Larger differences can emerge when:
An expense ratio represents the annual operating expenses charged by a fund as a percentage of its average net assets.
Suppose you invest $10,000 in an ETF with an expense ratio of 0.20%.
The approximate annual fund expense would be:
$10,000 × 0.20% = $20
You usually do not receive a separate $20 bill.
The expenses are deducted within the fund and reduce its investment return.
The actual dollar cost will change as the value of your investment changes.
A lower expense ratio does not guarantee better performance, but costs matter because they reduce the return you keep.
The expense ratio is not the only cost to consider.
Many brokerages offer commission-free trading for certain ETFs.
Commission-free does not mean cost-free.
The bid-ask spread is the difference between the highest current buying price and the lowest current selling price.
A wider spread can increase the cost of entering or leaving an investment.
Heavily traded ETFs often have narrower spreads, although this is not guaranteed.
ETF distributions and sales may create tax consequences in a taxable brokerage account.
The result depends on:
Tax treatment can differ for commodity funds, currency products, partnerships, and certain other exchange-traded products.
If an investment adviser or managed account selects ETFs for you, you may pay an advisory fee in addition to each ETF’s internal expenses.
Review the complete cost, not only the ETF’s expense ratio.
The SEC’s 2025 investor bulletin explains that mutual-fund and ETF costs may include operating expenses, transaction costs, bid-ask spreads, and premiums or discounts. Review the SEC’s current guide to mutual-fund and ETF fees.
An ETF’s total return can come from:
An ETF may distribute income to shareholders.
Depending on your brokerage and account settings, you may be able to:
A distribution is not free money.
When a fund makes a distribution, its value may adjust to reflect the assets that left the fund.
Investors should evaluate total return, not only the amount of income distributed.
An index ETF seeks to follow a benchmark, but its return may not match the benchmark exactly.
The difference is known as tracking difference or tracking error, depending on how it is measured.
Differences can result from:
An ETF that tracks an index will generally trail the index by at least some costs over time, although other factors can occasionally create different results.
When comparing similar index ETFs, review how closely each has followed its benchmark.
Some ETFs hold thousands of securities.
Others hold only a small number.
An ETF can be concentrated in:
Even an ETF with 100 holdings may be heavily dependent on its largest five positions.
Before assuming an ETF is diversified, review:
The number of investments alone does not determine the quality of diversification.
Leveraged and inverse ETFs are specialized products.
A leveraged ETF may attempt to produce a multiple of a benchmark’s return.
An inverse ETF may attempt to produce the opposite of a benchmark’s return.
Many of these products seek their stated objective for a specific period, often one day.
Their returns over longer periods can differ significantly from a simple multiple or inverse of the benchmark’s long-term return because of daily resetting and compounding.
These products may be intended for short-term trading or specialized strategies rather than traditional long-term investing.
FINRA warns that leveraged, inverse, and single-stock exchange-traded products can involve complex strategies and may not be designed for holding periods beyond their stated objective. FINRA explains the risks of exchange-traded funds and products.
Beginners should not assume a leveraged ETF is simply a faster version of a regular ETF.
Greater potential movement means greater potential loss.
ETFs are investments.
They are not bank deposit accounts.
An ETF is not protected by FDIC deposit insurance simply because:
Brokerage protections and bank-deposit insurance serve different purposes.
Investment values can decline.
You should understand where your money is held and what protections apply.
Before purchasing an ETF, review the following areas.
What is the ETF trying to accomplish?
Does that objective support your financial goal?
What does the fund actually own?
Review the largest holdings, industries, countries, credit quality, and asset types.
Is the fund broadly spread out, or does it depend heavily on a few investments?
How much does the fund charge each year?
Compare the expense ratio with similar funds pursuing similar objectives.
What benchmark does it track?
If it is actively managed, what is the manager permitted to do?
Has the fund followed its benchmark reasonably closely?
Past performance does not guarantee future results, but persistent tracking problems deserve attention.
Review:
A small or newly launched ETF is not automatically a bad investment.
However, it may have:
Understand the possible tax treatment, particularly for specialized or alternative exchange-traded products.
Ask the most important question:
If you cannot answer that question, you may not need the fund.
A simple portfolio of carefully selected ETFs may provide more useful diversification than a complicated collection of overlapping funds.
Meet Natalie.
Natalie wants to begin investing $250 each month for retirement.
At first, she considers dividing the money among five individual companies.
After reviewing the risks, she decides that she does not want her retirement plan to depend heavily on five businesses.
She researches a broad-market stock ETF that:
If Natalie eventually invests $10,000 in the ETF, the approximate annual expense represented by a 0.08% expense ratio would be:
$10,000 × 0.08% = $8
The ETF does not guarantee a profit.
If the overall stock market falls by 20%, her investment could experience a substantial decline.
However, Natalie is no longer depending on the success of only five companies. Her investment is spread across a much broader collection of businesses.
She selects the ETF because its objective, diversification, cost, and risk align with her long-term plan, not because someone online predicted it would rise.
A fund’s name may sound broad even when its holdings are concentrated.
Always review the portfolio.
Three different ETFs may all have the same large companies among their biggest holdings.
More funds do not always create more diversification.
A small percentage can create a meaningful long-term cost, especially when a cheaper fund follows a very similar strategy.
Some ETFs are actively managed.
Others follow complex rules, derivatives, commodities, or specialized strategies.
An industry may attract attention after its stocks have already risen substantially.
Excitement and strong recent performance do not guarantee future returns.
Leveraged, inverse, commodity, volatility-linked, and single-stock products may behave very differently from broad-market ETFs.
Because ETFs trade throughout the day, investors may feel encouraged to buy and sell constantly.
Easy trading does not mean frequent trading is necessary.
Every ETF is diversified.
Some ETFs hold thousands of securities. Others focus on one industry, theme, commodity, or individual stock.
ETFs cannot lose money.
An ETF can decline when its underlying investments decline. Some ETFs can lose most or all of their value.
All ETFs are index funds.
Many ETFs track indexes, but others are actively managed or use specialized strategies.
The lowest expense ratio always identifies the best ETF.
Costs matter, but investors must also consider the fund’s objective, holdings, diversification, tracking, trading costs, and risks.
Owning several ETFs always creates better diversification.
Multiple ETFs can hold many of the same securities and create unnecessary overlap.
A commission-free ETF is free to own.
The fund may still charge operating expenses, and investors may encounter bid-ask spreads, premiums, discounts, taxes, and advisory fees.
There is no universal number.
One broad ETF may hold thousands of investments. Several narrow ETFs may still leave a portfolio poorly diversified.
Focus on coverage and purpose rather than the number of funds.
Many 401(k)s, IRAs, and other retirement accounts allow ETF investing, although available choices depend on the account provider and plan.
An ETF may receive dividends, interest, or other income from its holdings and distribute that income to shareholders.
The amount and timing depend on the fund and its investments.
Yes.
An ETF sponsor may decide to liquidate or merge a fund.
Shareholders generally receive notice and may receive cash based on the liquidation value, but taxes, market changes, and transaction costs may apply.
A broadly diversified ETF may reduce the company-specific risk associated with one stock.
However, the ETF can still decline because of market, industry, credit, interest-rate, currency, or strategy-related risks.
Yes.
ETF shares may trade at a premium or discount to NAV. The size of that difference can change based on trading conditions and the fund’s underlying assets.
A market order prioritizes execution but does not guarantee the exact price.
A limit order provides greater price control but may not execute.
The appropriate choice depends on the ETF’s liquidity, spread, volatility, and your priorities.
An ETF generally holds a portfolio of assets.
An exchange-traded note, or ETN, is generally an unsecured debt obligation whose return is linked to a benchmark.
ETNs introduce the credit risk of the financial institution issuing the note and should not be assumed to work like traditional ETFs.
Choose one ETF and complete a five-point review without purchasing it.
Write down:
The ETF’s investment objective
Its five largest holdings
Its expense ratio
The number of investments it holds
The specific role it could perform in a portfolio
Then answer:
Do the ETF’s actual holdings match what I expected from its name?
This one habit can help you avoid buying an ETF based on marketing language alone.
Many ETFs are designed to track market indexes, but “ETF” and “index fund” do not mean exactly the same thing.
In the next lesson, you will learn:
Understanding index funds will help you evaluate one of the most widely used approaches to long-term investing.
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