Before you can really understand how an exchange-traded fund (or ETF) works, you should first understand indexes. An investment index is a way to observe a big cross-section of stocks or bonds. For example, the Standard & Poor's 500 (better known as the S&P 500) is one of the world's best known indexes. It's the most commonly used benchmark for the overall stock market. But because, technically, you can't actually buy an index, an ETF is one way to invest in a broad market segment or the market as a whole. That's because ETFs trade on a stock exchange and experience price changes throughout the day as they are bought and sold.

What is passive management?

In the financial industry, most ETFs are "passively managed." This simply means that they're designed to follow a particular index and that there is no portfolio manager actively trading stocks and bonds inside the fund (like there is with an actively managed mutual fund).

How can ETFs fit into my portfolio?

The first ETF in the U.S. was launched in 1993 and was designed to track the S&P 500. Since then, the ETF market has expanded significantly, and it now includes hundreds of funds, including very specific, narrowly focused funds tracking smaller and smaller segments of the stock and bond markets. 

When building your portfolio, your first thoughts may go to stocks, bonds or mutual funds. But ETFs can also be used as the building blocks of your portfolio. ETFs can also complement investments you already own, fill in gaps or provide diversification. It all depends on your individual situation. One of the reasons your financial advisor wants to get to know more about you and what you're trying to achieve is so we can provide the most appropriate investment recommendations for you. ETFs may be one of those ideas.

Our take on ETFs

At Edward Jones, we believe you should focus on the traditional, more broadly diversified and passively managed ETFs because they are designed to provide you with exposure to multiple securities and sectors. And their performance isn’t overly dependent on how well a certain type of company performs. Because there are so many ETFs available, we can help you narrow down your choices using the following criteria: 

• Track record – One year of actual performance history is necessary to see how accurately an ETF tracks against its benchmark index. Your financial advisor can also help you review the benchmark itself to see how it has performed over time and whether that benchmark meets your needs.
  
• Low expenses – In general, because they are passively managed, ETFs tend to have low expenses. But we can help you compare ETF fees and give you the information needed so you can decide what's right for you.
  
• Underlying holdings – It's important to understand exactly what investments an ETF holds. Some ETFs have significant weightings to individual stocks, industries, sectors or geographic locations, and they may not be as diversified as you think. Making sure you are comfortable with how the ETF is invested can lead to fewer surprises.

How we can help

Work with your local financial advisor to determine if ETFs may be right for you.