Exchange-traded funds (ETFs) began in 1993. Today, they’re one of Wall Street’s most popular investment vehicles, accounting for more than $1 trillion in invested assets and roughly 1,000 ETF products traded on U.S. stock exchanges.
But most Americans don’t even know what “ETF” stands for. To understand it, you first have to draw a distinction between mutual funds, index funds, and ETFs. Forbes has more:
1. What is a mutual fund?
Once upon a time, only sophisticated investors had enough capital to justify hiring professional help. Now, a much larger number of investors of much more modest incomes seek a return.
Mutual funds rely on a professional adviser to actively manage investments on behalf of others, at a fee. The hope is that active management can take advantages of trends in the market or informational discrepancies to “beat” the overall market return.
2. What is an index fund?
In 1976 the first index fund was launched by the investment firm Vanguard Group. It was known as “Bogle’s Folly,” for John C. Bogle, the founder of Vanguard. He believed that it was far more important to stay invested than to trade in and out. So, Bogle created a fund that tracked the S&P 500. It was the Vanguard 500 (VFINX). It promised to keep up with the broad index of stocks at a rock-bottom cost, and it still does.
3. What is an ETF?
You can think of an ETF as a form of index fund, in the sense that is has the same goal: To provide investors with a benchmark return at minimal cost. There is one important difference, however. Index funds are costly to trade, while ETFs often trade commission-free.
Not all ETFs are designed to mimic index funds, so be careful. Some have become little more than trading tools. If you want to have the flexibility of an ETF’s low trading cost and performance similar to an index fund, it’s best to use only the largest, most widely traded ETFs on the market.