An exchange-traded fund — ETF for short — is an investment fund that lets you buy a large basket of individual stocks or bonds in one purchase. You could say that the ETF is a relative of a mutual fund. But index based ETFs have one big advantage over their actively managed cousins: lower fees. It’s not unusual for a mutual fund to charge a 1% annual fee; ETFs usually charge less than half that — between 0.05% and 0.25% is the normal range.
Why are index ETFs so inexpensive? Because you’re not paying a fund manager to pick winners in the stock or bond markets, or to make large numbers of expensive trades, or even respond to ups and downs in the market. Instead, index ETFs select an entire category of securities and invests in it broadly — by investing this way you’re said to be “tracking” a particular market. This is called passive investing. There are lots of flavours of ETFs — some invest in the companies of the S&P 500, some in real estate, some in a particular country’s stock market – but they all more-or-less work the same way. Historically, funds that track major stock indices, for example the S&P 500, have performed better than many actively managed investments.