24 Aug 2025 4 min read Educational

What is an ETF?

Most people buy ETFs without knowing what’s inside. That mistake can cost you. Here’s the no-BS guide to how ETFs really work.

The biggest risk with ETFs isn’t the fund itself — it’s how investors use them.

An ETF — exchange-traded fund — is just a basket of investments you can trade like a stock. Buy one share and you instantly get exposure to a group of holdings. Sounds easy. Too easy.

The Simple Example

You want the S&P 500. You could buy 500 companies one by one (nobody does that). Or you buy one S&P 500 ETF and instantly own a slice of all 500. That’s the pitch.

The problem? People stop thinking right there. They assume “ETF” equals safe and diversified. Wrong. An ETF only spreads money inside its specific basket. If that basket is all tech stocks, you’re still all-in on tech. If it’s one of those gimmicky “AI” or “cannabis” ETFs, you’re basically gambling with a prettier label.

Want an example of how investors get sold shiny products that aren’t really in their best interest? I covered that in How to Choose a Financial Advisor.

A Quick History Lesson

ETFs aren’t ancient. The first big one, SPY (tracks the S&P 500), launched in 1993. Mutual funds ruled the roost back then — clunky, expensive, and built for a world where you had to call your broker.

ETFs caught fire because they solved two big problems:

Cost — no star managers charging high fees.
Access — you could trade them all day like stocks, not just once at market close.

Fast forward to today: ETFs hold trillions worldwide. Mutual funds are slowly dying.

ETF vs. Mutual Fund

On the surface, both pool money into baskets of stocks or bonds. That’s where the similarities end.

Mutual funds: Trade once a day. Place an order at 10 a.m., you won’t know your price until 4 p.m. Higher fees because you’re paying a manager. Most don’t beat the market anyway.
ETFs: Trade all day like stocks. You see your price the second you buy. Fees are lower because most ETFs just track an index.

Old school vs new school. One’s slow and expensive. The other’s fast and cheap.

The Real Cost of ETFs (Beyond the Expense Ratio)

Everyone loves to point out “this ETF only charges 0.03%!” and yes, that matters. But that’s not the whole story.

Bid-ask spread: Every time you buy or sell, you’re paying the gap between what buyers will pay and sellers want. On big, liquid ETFs like SPY, the spread is pennies. On thinly traded niche ETFs? It can quietly eat your returns.
Tracking error: ETFs are supposed to mirror their index. Sometimes they don’t — maybe the manager lags behind or the mechanics don’t line up. A “cheap” ETF that doesn’t track well ends up costing more than its expense ratio.
When you buy matters: At the open, spreads are often wider because the market is still settling. At the close, you may get whipped around by end-of-day trading. Those hidden execution costs add up.

The expense ratio is just the tip of the iceberg.

Taxes: Why ETFs Usually Win

ETFs are often more tax-efficient than mutual funds. Here’s why.

Mutual funds: When other investors sell, the manager may have to sell underlying stocks to raise cash. That creates capital gains that get passed on to you, even if you didn’t sell a thing.
ETFs: Built differently. They use “in-kind creation and redemption.” Translation: when big institutions buy or sell ETF shares, they swap securities in and out without triggering taxable events.

For taxable accounts, that’s huge. Less surprise capital gains, more control over when you pay taxes.

But here’s the catch: in tax-sheltered accounts (IRAs, 401(k)s), the ETF tax advantage doesn’t matter. The benefit is all about taxable brokerage accounts.

When ETFs Go Wrong

ETFs aren’t bulletproof. They can blow up.

Remember 2020 when oil prices went negative? Retail investors piled into oil ETFs like USO, thinking they’d “buy the dip.” Problem: USO didn’t track oil the way people thought. It rolled futures contracts, and when those imploded, the fund had to restructure. Many investors lost big, even while oil later recovered.

Same story with leveraged ETFs — the ones promising “2x” or “3x” returns. They’re designed for day traders, not long-term investors. Hold them for weeks or months, and compounding decay destroys returns. People treat them like free money, then wonder why they blew up their portfolio.

Moral: Just because it says “ETF” doesn’t mean it’s safe.

Portfolio Construction: Core and Satellite

Here’s how ETFs actually fit into a portfolio.

Core: Your foundation. Usually 70–90% of your portfolio. Broad, low-cost ETFs that cover the market — S&P 500 (SPY), total market (VTI), or international exposure. This is your base.
Satellite: Smaller, intentional bets. Maybe 10–30% of your portfolio. This could be QQQ for tech, XLE for energy, or a specific strategy ETF.

The mistakes people make:

Making the “satellite” bigger than the core. Suddenly they’re concentrated, not balanced.
Owning five different ETFs that all overlap — SPY, QQQ, VOO, VTI — and thinking they’re diversified. In reality, they’re just overweight in the same names.
Chasing whatever sector is hot, turning the “satellite” into a roulette wheel.

Keep it simple: strong core, selective satellites.

What ETFs Get Right

ETFs aren’t hype. They’ve reshaped investing for the better: cheaper, easier, more accessible. You don’t need to overpay a manager or overthink every stock pick. That’s why they’ve exploded in popularity.

What People Get Wrong

But don’t confuse “easy” with “safe.” ETFs don’t erase risk — they just package it differently. A broad market ETF can steady your portfolio. A narrow theme ETF can wreck it just as fast as one bad stock pick.

Bottom line: An ETF is just a tool. Used wisely, it’s efficient, cheap, and practical. Used blindly, it’s another way to pile into the same risks — just with a shinier name.