What Are ETFs and How Do They Work?

The key benefit of stock market investing compared to other mediums is that it allows you to invest in different investment instruments. In addition, there are Exchange-Traded Funds (ETFs) that again provide access to a wide range of markets. They are also low-cost, flexible and help in portfolio diversification.

This is the main reason that global ETF assets reached a record US$19.44 trillion at the end of November 2025. In this ETF basics guide, we will understand what are ETFs, how to invest in them and the key benefits.

What are Exchange-traded funds? ETFs Explained

Exchange-traded funds or ETFs are a type of collective investment that pools funds from investors to buy a portfolio of assets and securities, such as shares, bonds, and/or commodities. This means that when an investor invests in ETFs, they will hold a diversified portfolio by buying a single investment.

Consider an ETF as a fruit basket. You could purchase apples, oranges, and bananas individually, or you could purchase a single basket that already has all three. That is what an ETF does to your money. It provides diversification in one purchase to reduce investing risk.

ETF vs Stocks vs Mutual Funds

To know why ETFs are an excellent investment to start with, we will compare them to other investments:

This flexibility, transparency, and diversification make ETFs a brilliant introduction to the investing world for ETF beginners. You do not have to select stocks individually, and you can begin with a small sum and still create a balanced portfolio.

How do Exchange-traded funds Work

An ETF for beginners can be a little challenging to understand, but it doesn't have to be. Investing in an ETF is like buying a piece of that whole group, as opposed to selecting each asset separately. Here is how ETFs work:

• Portfolio Structure: ETFs collect the funds from investors to form a diversified portfolio of investments (Stocks, bonds, and commodities) that replicates an underlying index.
• Market Price vs NAV: ETF units are traded on the exchanges at prices that are dictated by the supply and demand, as opposed to the Net Asset Value (NAV) of the fund.
• Buy and Sell Matching: Buying ETF units requires a matching sell order, and selling requires a matching buy order for execution.
• Trading Orders: As an investor, you track the orders:
  • Market Order: Immediately executes at the best available market price.
  • Limit Order: It is only executed when the market price is at or below the price set by the investor.
• Liquidity & Volume: ETFs that trade in large volumes are more liquid, and it is more likely to execute an order at the desired price.
• Authorised Participants (APs) & Market Makers (MMs): AMCs assign APs/MMs to give two-way quotes throughout market hours to maintain liquidity.
• Stock Exchange Trading: ETF units are traded as normal stocks under a Demat trading account, and the orders are placed during the exchange hours.

In contrast to mutual funds, which are valued only once a day, ETFs are traded in stock markets. This implies that you can sell or purchase ETFs at any time of the day, as with a stock. The prices can vary during the day, as a result of supply, demand, and the value of underlying assets. ETF investing for beginners is a simple way to enter the market without picking individual stocks.

Different Types of ETFs: Selecting the Right Basket

Here are the different types of exchange-traded funds you can invest in:

1. Equity ETFs

Equity ETFs invest in stocks of firms in a market, industry or region. For example, an international equity fund may contain stocks of the leading corporations of various nations. The key benefit of equity ETFs is that they give a wide exposure to the stock market at a lower risk as compared to selecting individual stocks. These are some of the best ETFs for beginners to invest in and diversify with.

2. Bond ETFs

Bond ETFs are the funds that invest in government or corporate bonds. A key example is that of a corporate bond ETF that contains bonds of several companies. It is more stable and predictable in terms of income, which offsets riskier equity investments

3. Commodity ETFs

Commodity ETFs are the funds that monitor tangible goods such as gold, oil or farm goods. They provide an effective portfolio diversification, but are usually better used in a small portion of your investments.

4. Thematic ETFs

Thematic ETFs target a particular trend or industry, including but not limited to clean energy, technology, or robotics. The reasons why beginners consider them are that they can offer exposure to exciting growth areas, but they may be more volatile than broad ETFs.

Top Benefits of ETFs Every Investor Must Know

ETFs are among the simplest ways of entering the stock market investment, especially when you are a beginner. They provide simplicity and flexibility that make the process of creating a portfolio significantly simpler. Here are the key ETF benefits you must know:

1. Portfolio diversification

An ETF diversifies your portfolio by investing in a large number of assets instead of investing everything in one stock or bond. Consider investing in 50 stocks simultaneously, without purchasing the stocks individually. It minimises your risk since your funds are not pegged to the performance of a single company.

2. Lower Fees than Mutual Funds

ETFs are cheaper than traditional mutual funds. That is, your money is kept invested, and this will grow your portfolio in the long run. ETFs are particularly attractive to beginners who are only starting out because of lower costs.

3. Liquidity

ETFs are traded during the trading hours, as opposed to mutual funds, which can only be purchased or sold at the end of the trading day. This allows you to buy or sell positions at any time the market is open, just as with a stock.

4. Transparency

ETFs are mandated to report their holdings on a regular or often daily basis. This implies that you are always aware of what you own, and hence it is easier to monitor what you have invested in and know how your portfolio is performing.

How to Invest in ETFs

Here are the steps you can follow to invest in the ETFs:

1. Select a broker: Select a stockbroker that deals in ETFs and then open a trading platform with it. Look for one that offers:
   1. Low fees or commissions
   2. A wide selection of ETFs
   3. Convenient tools and accessible information
2. Select ETF: Login to your trading platform and find an exchange-traded fund that fits your objectives, such as a broad-market ETF to diversify. Consider:
   1. ETF type: Equity, bond, commodity or thematic
   2. Holdings: What will be included in the fund?
   3. Costs: Check the cost ratio (the lower the better)
   4. Performance history: Check long-term returns as opposed to short-term trends
3. Choose the investment amount: Choose an investment amount that you want to invest. Invest little when you are still learning the ropes.
4. Place your order: Place a buy order for the ETF, just like you place an order to buy stocks.
5. ETF units are credited: Once your order is placed and executed, the ETF units are credited to your demat account.
6. Monitor your investment: Check performance every now and then, but keep in mind that ETFs are long-term investments.

Common Mistakes to Avoid when Investing in ETFs

Here are the tips you can follow and the mistakes you must avoid when investing in the stock market:

• Chasing Hot ETFs: It is tempting to invest in an ETF since it has been doing well in the recent past. Invest in ETFs that suit your long-term objectives rather than trends.
• Ignoring diversification: Diversification is one of the top benefits of ETFs. Avoid putting money in one sector or an excessively focused ETF.
• Trading too frequently: ETFs may be traded all day long, but high trading may cannibalise your returns as a result of fees and taxes. Remember that ETFs can be the most suitable for long-term growth.
• Overlooking Costs: Even minor expense ratios can accumulate with time. Research ETFs with close strategies and compare the check fees prior to investing to get the best value.

Conclusion

For both beginners and experienced investors, ETFs offer a simple and low-cost way to start investing while managing risk through diversification. Investing in ETFs, however, is a long-term strategy as it will grow with you. Whether you invest in a broad-market equity ETF or a bond ETF, begin small and remain consistent.