What Are ETFs? The Ultimate Guide

Exchange-traded funds, or ETFs, made their debut in 1993 as a little-known, obscure financial security.

Today, they’re an essential tool for both professional and retail investors, and they’re driving big changes in the field of investment management.

As with any type of investment, of course, there are some pros and cons to consider before you add ETFs to your portfolio.

What Is an ETF?

At their core, ETFs are funds — which can comprise stocks, bonds, commodities or other assets — that are designed to track a particular index. Like stocks, ETFs trade daily on stock exchanges, their prices fluctuating throughout the day.

And to say their popularity is on the rise would be putting it mildly. Globally, ETFs saw assets under management grow from about $200 billion in 2003 to more than $9 trillion in 2020.

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More data on that later, but first, the basics:

— How do ETFs work?

— ETFs versus mutual funds.

— ETFs versus index funds.

— Risks of investing in ETFs.

How Do ETFs Work?

ETFs are created by large money managers such as iShares and the Vanguard Group, which bundle the underlying instruments of the fund together. After a series of regulatory steps, an ETF can be offered for sale to the public and can be purchased through a broker.

And importantly, they’re liquid: You can buy or sell an ETF throughout the trading day, just like stocks. There are ETFs available to suit almost any taste, style, asset class or industry. Many track an index, like the S&P 500, for example. If the value of the S&P 500 goes up, the value of the ETF increases, too.

Stock ETFs track stock indexes, while other ETFs track indexes for commodities, currencies and bonds. Still, others invest in precious metals such as gold, and more esoteric offerings can be designed to mimic the fluctuations of something intangible such as market volatility.

ETFs can even track cryptocurrencies, and the first U.S. Bitcoin ETF debuted in October. The ProShares Bitcoin Strategy ETF (ticker: BITO) was soon followed by the Valkyrie Bitcoin Strategy ETF ( BTF). Both ETFs are derivative-based funds. ETFs can invest in derivatives like options or, in the case of these two Bitcoin ETFs, futures contracts. Futures contracts are an agreement between a buyer and seller to trade a certain asset at a future date and price.

ETF managers will use derivatives to track the performance of their benchmark or an asset such as Bitcoin without needing to own the asset directly. But derivatives are aggressive investing strategies that can increase the risk of an ETF, especially if they use leverage.

Leveraged ETFs are designed to multiply the daily returns of a particular index or asset class. Of course, that comes with increased risk.

“Leveraged ETFs can produce incredibly high returns,” says Kyle J. McCauley, managing partner at City Center Financial. “However, these ETFs are extremely volatile and can lose a lot of money very quickly.”

“Telltale signs you’re looking at a leveraged ETF are words like ‘ultra,’ ‘3X,’ ‘2X’ and ‘enhanced,’ coupled with returns that are either significantly better or significantly worse than the overall market,” McCauley says.

ETFs vs. Mutual Funds

Mutual funds and ETFs are similar in some important ways. Like mutual funds, ETFs allow investors to instantly spread risk over a huge swath of investments — sometimes hundreds at a time — as opposed to buying a stock here, a bond there and so on. Both give investors an easy way to become well diversified without spending the time and transaction costs to build a diversified portfolio.

Diversification is a beautiful thing in any portfolio, but it’s particularly important for retail investors because it lets them participate in a market’s upside with lower risk and volatility than a three- or five-stock portfolio.

What are the advantages of ETFs over mutual funds? Almost all of the differences between ETFs and mutual funds favor ETFs.

Many mutual funds don’t have the liquidity that ETFs do; only closed-end mutual funds trade throughout the day, and even they are managed and can be leveraged with debt. More traditional, open-end mutual funds are priced at the end of each day’s trading session, and when money flows out, shares must be sold.

As ETFs become more liquid, their bid-ask spread narrows, making them easier and more practical to trade.

One of the most impressive advantages of ETFs over their closest rivals, mutual funds, is that ETFs typically charge lower management fees, but that’s rapidly changing. Index mutual funds have dropped their expense ratios to be in line with ETFs — or even below as managers like Fidelity Investments released their zero-expense-ratio mutual fund lineup. There are also zero-expense-ratio ETFs, but there are far fewer and are often only free for a certain period, like the first year of trading, to draw investor interest.

The real cost advantages come from whether the ETF or mutual fund is actively or passively managed. Active fund managers are the primary custodians of their funds. They make daily buy and sell decisions that are executed by stock, bond or commodity traders. By contrast, passive fund managers simply follow the lead of their index: Securities are bought in exact proportions to the index the fund tracks, then that fund is divided up into shares and sold. Management is only needed on a trivial basis, like when an index changes or when dividends must be distributed.

[See: How to Pick Stocks: 7 Things All Beginner Investors Should Know.]

ETFs do have one other cost advantage over mutual funds, though: taxes. Capital gains taxed on money made with an ETF do not have to be paid until the fund is redeemed. For investors concerned with long-term growth, this makes annual tax reporting a much easier process.

When mutual funds trade securities during the year, any gains must be passed on to investors as a taxable event. These distributions can be taxed as high as your ordinary income tax rate if they’re from short-term gains.

This doesn’t happen with ETFs. As long as you hold your ETF shares, you won’t pay any taxes.

But probably the most important advantage that ETFs have over mutual funds is that passively managed funds generally outperform actively managed funds over time.

Consider this startling statistic: From 2005 to 2020, only 37% of active fund managers outperformed their benchmarks.

Some would argue that this is because active managers shine best in volatile markets when they can use their prowess to help shelter investors from the worst bumps in the road. This theory was put to the test during the March 2020 sell-off. The results? Only 47% of the nearly 3,000 active funds analyzed by Morningstar in its semiannual Active/Passive Barometer report outperformed their average passive counterpart.

That’s horrendous. Why not just buy the index itself and pay as little as possible for the right to do so?

The reliable underperformance of actively managed mutual funds has driven more investors to do just that. The financial crisis of 2008-2009 may also have encouraged the rush away from active management and into passive investing.

Between 2011 and 2020, outflows from actively managed mutual funds totaled $1.9 trillion. Meanwhile, inflows into index-tracking ETFs and mutual funds were $1.9 trillion over the same period. Today, passive funds account for 40% of all U.S. stock funds, up from about 19% a decade ago, according to the Investment Company Institute.

ETFs vs. Index Funds

There is a subset of passive mutual funds, called index funds, that aims to compete with ETFs on their home turf. And here the winner is less clear.

An index fund is a mutual fund that tracks an index. Both ETFs and index funds “shift an underlying portfolio assumption from manager-driven alpha to market-average-driven return,” says Brian McDowell, wealth manager at Cascadia Wealth Management.

Since there’s no active management involved, index funds tend to have lower fees than active mutual funds, bringing them in line with their ETF counterparts. For example, the Vanguard 500 Index Fund ( VFIAX), which tracks the S&P 500 index, has an expense ratio of 0.04%. Meanwhile, the Vanguard S&P 500 ETF ( VOO) has an expense ratio of 0.03%. The real difference between many mutual funds and ETFs is the minimum investment. VFIAX, for instance, requires an initial investment of at least $3,000, while to invest in VOO you only need to buy one share, which is currently trading around $430.

Not all mutual funds have minimum investments, however. Fidelity’s zero expense ratio mutual funds, for example, have no minimum and no expense ratio. The Fidelity ZERO Large Cap Index Fund ( FNILX) is basically an S&P 500 index fund except it tracks Fidelity’s own U.S. large-cap index of the largest 500 U.S. companies.

The lower expense on some ETFs is in part because ETF managers don’t have to conduct daily accounting of redemptions and purchases. These daily redemptions also force an index fund to trade more frequently within the fund than an ETF. This causes two cost consequences to index funds: First, the commissions incurred from trading reduce the fund’s overall return. Second, the need to keep cash on hand to satisfy redemptions means less money is invested at any given time.

However, index funds may compensate for this by automatically reinvesting dividends and interest. This makes “executing compound earnings effects to enhance total return easier,” McDowell says. By comparison, ETFs hold dividends received within the fund as cash until they’re distributed to shareholders, at which point investors are responsible for reinvesting their dividends and any associated transaction costs. Index funds often have zero transaction costs.

[SEE: 7 Best Funds for Retirement.]

What Are the Risks of ETFs?

ETFs are not a sure thing, as no investment is. Being too closely tied to one sector or index means that a crisis can immediately affect your bottom line. Asset allocation spreads the risk but doesn’t eliminate it. The universal rule of “no risk, no reward” still applies.

Another thing to keep in mind with ETF investing is how well a particular fund achieves its goal — that is, how well it replicates the returns of an index. The difference between the index’s return and the fund’s return is called the tracking error.

“Use tracking error to narrow down investment options. Greater tracking error typically means greater risk or less management efficiency,” McDowell says.

“All other factors equal, you want the ETF with less volatility and a narrower risk corridor,” McDowell says.

The major trade-off of ETFs stems from its defining nature: Indexes are diversified but may not carry the same explosive return potential of an individual stock. Investors who are a bit more accepting of risk might want to look into instruments that can provide more dramatic returns — excluding leveraged ETFs, which are rife with drama. ETFs are more suited for investors whose taste for risk is less strong.

At least one concern is settled. Some in the investment community once worried that ETFs might simply be a trend. Those fears may have held water when ETFs first emerged in 1993, but more than a quarter century and $9 trillion later, these once-exotic instruments are here to stay.

More from U.S. News

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What Are ETFs? The Ultimate Guide originally appeared on usnews.com

Update 11/15/21: This story was published at an earlier date and has been updated with new information.

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