Recently, I was reviewing how exchange-traded funds (ETFs) actually work, and honestly, they are one of those instruments that deserve more attention than they get. An ETF is basically like owning a fund that is traded in real-time just like a stock, but with the advantage that you replicate the performance of an entire index or sector.

What’s interesting is that these products originated from an idea that Wells Fargo and the American National Bank implemented back in 1973 with index funds. But the real revolution came in the 1990s when the Toronto Stock Exchange launched the TIPs 35, and then in 1993 with the SPDR (SPY), which remains one of the most traded in the world. Since then, the numbers don’t lie: we went from fewer than a dozen in the 90s to over 8,700 ETFs in 2022, with assets under management jumping from $204 billion to $9.6 trillion.

So, why are people so hooked on ETFs? Mainly for three reasons: costs are ridiculously low compared to traditional funds (between 0.03% and 0.2% versus over 1%), intraday liquidity allows you to buy and sell whenever you want during market hours, and diversification is instant. You buy a single ETF and you already have exposure to dozens or hundreds of assets.

The types that exist are quite varied. There are index ETFs that replicate the S&P 500 or MSCI, sector-specific ones focused on tech or energy, commodity ETFs like gold, geographic ETFs to access specific markets, and also leveraged or inverse ETFs if you want to play more aggressive strategies. Each has its purpose.

The mechanics are simpler than they seem. Authorized participants create ETF units that are listed on the stock exchange, and then arbitrage keeps the price close to the net asset value. Basically, it’s a self-adjusting system.

But not everything is rosy. Specialized ETFs can have tracking errors, which occur when the fund doesn’t exactly replicate the index it’s supposed to follow. Leveraged ETFs amplify both gains and losses, so they’re not for everyone. And although they are tax-efficient, the dividends they generate are still taxable.

If you’re going to choose an ETF, pay close attention to the expense ratio, daily liquidity, and that tracking error I mentioned. Then you can build more sophisticated strategies using multi-factor ETFs, hedges, or combining them to balance your portfolio.

The conclusion is that an ETF is a versatile tool that gives you access to real diversification without breaking the bank with fees. But like everything, it requires doing your homework and not confusing diversification with the absence of risk.