How an ETF Works

• ETFs work much like an index mutual fund, but unlike mutual funds, they trade more like a stock. You can only buy or sell a mutual fund at the end of the day. An ETF, on the other hand, can be bought and sold at any time during market hours. Like index funds, ETFs are designed to represent an index or an industry group. For example, some ETFs own the exact same shares as the S&P 500 index, so they move in direct correlation with the S&P 500.
  
  

Expense Ratios

• Expense ratios for mutual funds and ETFs represent the costs of owning them. These costs include administrative expenses, trading commissions and management fees if the fund is actively managed. Expenses are deducted directly against the fund's performance. For example, if a fund with a 1 percent expense ratio owns stocks that grow 10 percent in one year, investors will earn 9 percent that year.
  
  

ETFs Versus Managed Funds

• According to The Motley Fool, between 2003 and 2008, the S&P 500 outperformed 69 percent of all managed mutual funds that use the S&P 500 as their benchmark. In fact, the average market index outperforms managed funds by roughly 2 percent each year. The message here is that ETFs, which are designed to track with market indexes, will outperform most mutual funds that are actively managed.
  
  

Why Expenses Matter

• On average, ETFs charge roughly 1 percent less than most mutual funds. One percent may not sound like a lot, but it can add up over time. Assume stocks grow at an average rate of 10 percent per year. If you invest $10,000 into a mutual fund with a 1.57 percent expense ratio, in 50 years it will grow to $572,101. If you were to buy an ETF with an expense ratio of 0.54 percent instead, it would grow to $917,851 during that same period.