How do ETFs work? A beginner's guide to exchange-traded funds

Exchange-traded funds (ETFs) have become one of the most popular ways to invest and maintain a diversified portfolio. By the end of 2025, U.S.-listed ETFs held more than $13.4 trillion across 4,495 funds, reflecting their growing role in investors' portfolios.

Like mutual funds, ETFs give you access to a collection of investments, such as stocks, bonds or other securities, through a single fund. Unlike mutual funds, however, ETFs trade on an exchange throughout the day, allowing investors to buy and sell shares much like individual stocks.

Whether you're new to investing or just want to understand more options available to you, here’s what you need to know about how ETFs work, the different types available, and how they can fit into your overall financial strategy.

ETFs enable investors to purchase an interest in a diversified portfolio of securities. These might include stocks, bonds or other assets. But unlike a mutual fund that is not exchange-traded and only trades once at the end of the day, ETFs are more like conventional stocks. Investors buy and sell shares at fluctuating market prices on exchanges throughout the trading day.

An ETF's market price is typically close to its net asset value (NAV), which represents the total value of the fund's underlying holdings divided by the number of shares outstanding. A process known as creation and redemption helps keep those prices aligned. Large financial institutions called authorized participants (APs) can exchange baskets of securities for new ETF shares or redeem ETF shares for the underlying securities. When an ETF's market price moves too far above or below its NAV, APs may step in to help bring prices back in line.

Many ETFs track the performance of a market index.* For example, an ETF that tracks the S&P 500 Index would invest in most or all of the large-cap U.S. equities within that index. There are ETFs that track all kinds of indexes, so it's likely you can find one that gives you exposure to assets that fit your objectives. There are corporate bond ETFs, for example, as well as those that track indexes of emerging markets, the technology sector and mid-sized companies.

Since ETFs invest in most or all the securities in an index, the ETF returns typically mirror the returns of the index it's tracking rather than outperform it. But a growing number of ETFs attempt to achieve a better rate of return than particular indexes. These are called "actively managed ETFs" because they're run by an advisor who buys and sells securities to accomplish a specific investment objective.

Not all ETFs invest in the same kinds of assets or follow the same approach. Some are built to track broad market indexes, while others focus on a specific sector, investment style or geographic region. Here are a few common types of ETFs you'll come across:

Index ETFs: These funds track a market benchmark, such as the S&P 500 Index, and are designed to closely follow its performance. They can offer a relatively low-cost way to gain exposure to a broad segment of the market.

Actively managed ETFs: Rather than tracking an index, actively managed ETFs are overseen by investment professionals who select and manage holdings based on a specific investment strategy or objective.

Sector and thematic ETFs: Some ETFs focus on a particular sector of the economy, such as healthcare, technology or energy. Others invest around a theme or trend, such as artificial intelligence, clean energy or cybersecurity.

Bond ETFs: Bond ETFs hold collections of fixed-income investments, including government and corporate bonds. They are often used by investors seeking diversification or income potential.

Dividend ETFs: These ETFs invest primarily in companies that regularly pay dividends. They may appeal to investors looking for a combination of income and long-term growth potential.

International ETFs: International ETFs provide exposure to companies and markets outside the United States. They can help broaden diversification by expanding investments across different regions and economies.

Like any investment, ETFs can generate returns in different ways. While performance will vary based on market conditions and the investments held within the fund, ETFs generally provide investors with three potential sources of return:

Depending on what the ETF owns, it may receive dividend payments from stocks or interest payments from bonds. Many ETFs pass this income on to shareholders through regular distributions, which can provide an additional source of return.

As the value of an ETF's underlying holdings changes, the ETF's share price may rise or fall. If you sell your shares for more than you originally paid, you may earn a profit from your investment.

An ETF occasionally may sell investments within the fund at a profit. When this happens, some of those gains may be distributed to shareholders. While ETFs are often more tax-efficient than mutual funds, capital gains distributions can still occur, especially in actively managed ETFs.

ETFs have become a popular investment choice because they combine diversification, flexibility and accessibility in a single investment. Depending on the fund and your financial goals, ETFs may offer several advantages that can help support a long-term investment strategy.

ETFs can make it easier to build a diversified portfolio because a single fund may hold dozens, hundreds or even thousands of investments. By spreading investments across different companies and industries, diversification helps manage risk.

For example, buying shares in a single S&P 500 ETF gives you exposure to 500 companies across nearly every sector of the U.S. economy, including well-known names like Apple, Microsoft and Johnson & Johnson. Achieving a similar level of diversification on your own could require purchasing hundreds of individual stocks and managing them over time.

In most cases, ETFs can handle investor withdrawals without having to sell the underlying stocks or bonds in the fund. Instead, APs can exchange ETF shares for the actual securities the fund holds. This “in-kind” process helps keep the fund from frequently selling investments just to meet cash redemptions.

Because fewer sales take place inside the fund, ETFs may generate fewer capital gains distributions than mutual funds. The SEC has noted that, historically, this structure has helped make ETFs more tax-efficient for many investors compared to mutual funds.

You can buy and sell shares in ETFs through a brokerage account much like you'd buy individual stocks, and many brokerages offer commission-free trades. ETFs also come in a wide range of share prices, making it possible to start investing without committing a large amount of money upfront.

Another bonus: ETFs that passively track an index generally have low expense ratios because they require less ongoing management. Over time, lower fees can help you keep more of your investment returns.

ETFs generally make it easy to see both their market price and the investments they hold. Many funds regularly disclose their holdings, giving investors a clearer picture of where their money is invested.

That visibility can be helpful when evaluating whether an ETF aligns with your goals, risk tolerance and investment preferences. It can also make it easier to compare funds and understand how a particular ETF fits within your broader portfolio.

Mutual funds and ETFs have a lot in common. Both are designed to give you access to a diversified combination of assets, such as stocks, bonds and other securities, through a single investment. And you don't necessarily have to choose between one or the other. Many investors use both.

One of the biggest differences is how they're traded. ETFs trade on an exchange throughout the day, so their prices fluctuate while the market is open. That means you can buy or sell shares whenever the market is trading.

Mutual funds work differently. Rather than trading throughout the day, they're priced once daily. Whether you place an order in the morning or just before the market closes, your transaction will be completed at that day's closing price.

When deciding between ETFs and mutual funds, it often comes down to how you prefer to invest. You may appreciate the flexibility and potential tax advantages associated with ETFs. Or you may prefer features such as automatic investing or the way mutual funds are commonly used within workplace retirement plans.

Neither option is inherently better. Both can play a role in a diversified portfolio, and it can be smart to use them together as part of a long-term investment strategy.

Like stocks, bonds and other investments, ETFs can lose value, which means you could lose money. While ETFs offer several potential benefits, there are also some considerations to keep in mind.

Although many brokerages offer commission-free ETF trading, that isn't always the case. Depending on where you invest and how often you trade, commissions and other costs can reduce your overall returns. ETFs also charge operating expenses, which are reflected in the fund's expense ratio.

An ETF's market price doesn't always match the value of the investments it holds. In some cases, shares may trade at a premium or discount based on investor demand and market conditions. While the ETF structure is designed to help keep prices closely aligned with the value of the underlying holdings, differences can occur.

When you buy or sell an ETF, you'll generally pay the ask price or receive the bid price. The difference between the two is known as the bid-ask spread. For large, heavily traded ETFs, that spread is often very small. For more specialized or thinly traded funds, it can be wider and may affect your trading costs.

Index ETFs are designed to follow a benchmark, but they don't always match its performance exactly. Differences in fees, trading costs and fund management can create small gaps between an ETF's return and the return of the index it tracks. In some specialized ETFs, those differences may be more noticeable.

As you explore how ETFs work, you'll still want to take the time to research a particular ETF before investing in it. An ETF's prospectus can help you understand its investment strategy, fees, risks and performance history. It's also worth noting that some ETFs, such as leveraged ETFs, operate very differently from traditional ETFs and may carry additional risks including not being suitable for buy-and-hold investors.

Whether you're considering ETFs, stocks, mutual funds or a combination of investments, a Thrivent financial advisor can help you evaluate your options and build a portfolio aligned with your goals, time horizon and risk tolerance.