ETFs have become one of the all-time most popular investment vehicles. Consider the explosive growth of this category of investment funds. With just over $100 billion sitting in ETFs in 2002, they held more than $7 trillion as of 2021. But what is an ETF, why are they so popular, and how are they different from mutual funds? We take a close look at everything ETF-related.
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What Is an ETF?
Exchange-traded funds (ETFs) are investment funds comprising large numbers of underlying securities. Each represents a portfolio that can invest in stocks, bonds, real estate, commodities, currencies, and other asset classes.
Most ETFs are considered index funds because they track an underlying investment index. For example, an ETF may track the S&P 500 – the individual stocks held inside the fund will match the S&P 500 and rise and fall with that market. In theory, an index fund will neither outperform nor underperform the underlying index.
Investors buy and sell ETFs on the major stock markets, much like stocks. As they trade throughout the day, the price fluctuates. Most ETFs are considered open-ended funds, allowing an unlimited number of investors.
ETF Pros and Cons
Pros:
- Ultra-low fees (often below 0.10% yearly)
- Invest in an entire portfolio of stocks in a single fund.
- Highly liquid. Trades are settled instantly, like stocks.
- You can begin investing in an ETF for the cost of a single share.
- ETFs can be purchased commission-free with many online brokers.
- ETFs tend to be more tax efficient than other types of securities
- There is an ETF for almost every industry sector and even most countries.
- There are many ways to invest in ETFs (see below).
Cons:
- Most ETFs are index-based and will never outperform the market.
- You’ll generally need to hold several ETFs to achieve adequate diversification.
- Not ideal for dividend-growth investors
ETFs vs. Mutual Funds: What’s the Difference?
People often confuse ETFs and mutual funds because they appear very similar. But while the two products share things in common, there are key differences.
- Active vs. Passive Management: Most mutual funds are usually actively managed. That means the fund manager’s goal is to outperform the benchmark, not just match it. This requires them to buy and sell securities (and employ other strategies) to outperform the general market. Not only do 80% of mutual fund managers fail, but the frequent trading and costly overhead results in higher fees.
- ETFs have lower fees. An actively traded mutual fund can charge annual MERs of 1.5% or more, while the management fees for broad market index ETFs are often less than 0.10%.
- ETFs trade like stocks on the exchange. When you buy or sell units of an ETF, the trade is settled instantly, the same as if you’re trading a stock. Mutual fund trades are settled once daily. In that way, ETFs are even more liquid than mutual funds.
- ETFs are often more tax efficient. The high frequency of trading within mutual funds often leads to a high tax liability, especially if the fund makes frequent short-term trades. Those trades are subject to ordinary income tax rather than lower long-term capital gains taxes.
- ETFs require a smaller upfront investment. While a mutual fund usually requires positions in round amounts, like $1,000, $3,000, or even $5,000 or more, ETFs can be purchased for the price of a single share of the fund. If the fund is trading at $50, that will be the minimum investment in the ETF.
Key Features of ETFs
ETFs have the following unique features:
- More than $7 trillion is invested in ETFs
- ETF trades are settled instantly, like stocks.
- As passively managed investments, ETFs keep management fees low.
- Most ETFs only generate tax-efficient capital gains income when you sell your investment.
- An ETF that holds securities in a currency other than your home country may carry the risk of loss due to changes in the foreign exchange rate.
- Because of the flexibility and low fees offered by ETFs, they are commonly used as the primary investment vehicles within popular robo-advisor investment platforms.
Key Features of Mutual Funds
Mutual funds have the following unique features:
- Mutual funds are priced only once daily, at the end of the day, when the market closes. They can only be sold and redeemed at the end of the day.
- Investments are put into “share classes,” which determine the fees investors will pay to brokers. This makes the structure of mutual funds more complex than that of ETFs.
- Mutual funds are usually actively managed investments. Because fund managers have a more complex job of identifying securities for purchase and sale within the portfolio, management fees (expense ratios) may be higher than those of ETFs.
- A mutual fund may hold various asset classes, including stocks, bonds, and other investments. ETFs focus on a single asset class.
- Some mutual funds charge load fees between 1% and 3% of your investment value in addition to the MER. This fee can be charged upon purchase, sale, or both.
Different Types of ETFs
As the ETF industry has grown, so have the types of funds offered. There are currently nearly 3,000 ETFs available in the US, almost as many as the number of publicly traded stocks.
Popular ETF categories include:
- Bond ETFs: Invest in corporate bonds, government bonds, foreign bonds, and municipal bonds. They are designed to provide income and safety of principal to investors.
- Index funds: Designed to track a particular investment index, like the S&P 500 or NASDAQ.
- Stock funds: Invests pools of stocks in a specific industry or market sector.
- Commodity ETFs: Invest in certain commodities like oil and gold.
- Dividend ETFs: Hold stocks in companies with a history of regularly paying dividends to shareholders.
- Currency ETFs: Hold investments that track the prices of currencies based on political and economic changes.
- Industry/Sector ETFs: Attempt to gain exposure to a specific industry sector or market by matching the performance of that sector or market based on a specific index.
- Inverse ETFs: These funds attempt to earn gains on failing or declining stocks. They are considered high-risk funds.
- Fixed Income ETFs: Designed to provide income from a combination of dividend stocks, bonds, and interest-bearing cash investments.
- Leveraged ETFs: These are very high-risk funds that seek to return two to three times more on the return of the underlying investments. This is done using leverage, similar to margin investing for the entire fund, rather than with individual securities.
- International market ETFs: Track non-US markets. These funds can invest in the markets of developed economies, like Japan and Europe, or emerging markets, like Latin America.
Interestingly, this is just a small sampling of the most common ETF types. There are many more that we don’t have space to list.
ETF Examples
Below is a list of some of the most popular and top-rated ETFs.
- iShares Core S&P 500 ETF (IVV)
- SPDR S&P 500 ETF (SPY)
- BNY Mellon US Large Cap Core Equity ETF (BKLC)
- SoFi Select 500 ETF (SFY)
- JP Morgan Betabuilders U.S. Equity ETF (BBUS)
- The SPDR Dow Jones Industrial Average (DIA)
- The Invesco QQQ (QQQ) (“cubes”)
- The iShares Russell 2000 (IWM)
What Is an ETF? Final Thoughts
Generally speaking, ETFs should represent the primary investment holdings in the average person’s investment portfolio. That’s because they provide a combination of broad market exposure at low cost and can easily diversify between different asset classes and investment sectors.
This is exactly what investment managers and robo-advisors do, and it’s a practice worth repeating if you manage your own investments. With a base of ETFs making up most of your portfolio, you can speculate in individual stocks or alternative investments.