What Is an ETF?
ETFs, or exchange-traded funds, are funds that trade on exchanges. Like traditional mutual funds, ETFs invest in a basket of stocks, bonds, or some combination of the two. But unlike traditional mutual funds, shares of ETFs trade on a stock exchange, such as the New York Stock Exchange.
Why ETFs Are Popular
The first exchange-traded fund, SPDR S&P 500 SPY, made its debut in 1993. By the end of 2021, more than $7 trillion in assets rested in ETFs.
ETFs have grown in popularity for a handful of reasons:
1) ETFs are easy to buy and sell—and given the fee wars in the industry, ETFs have become virtually free to buy and sell.
2) ETFs have a reputation for being tax-efficient (somewhat true).
3) ETFs are also known for being low cost (not always true).
4) Because many of the most popular ETFs track widely followed and transparent indexes, there’s no mystery behind their performance: It’s usually the performance of the index minus fees.
5) Passive ETFs have no key-person risk: If the manager leaves, another can step in without much ado.
Tax Advantages of ETFs
ETFs, in general, tend to be more tax-efficient than mutual funds, for a couple of reasons:
1) ETFs distribute fewer and smaller capital gains distributions because so many pursue lower-turnover, passive strategies.
2) ETFs are structured differently than traditional mutual funds—and the ETF structure is more tax-efficient.
In a nutshell, ETFs are brought into and removed from the market using an in-kind creation-and-redemption mechanism; traditional mutual funds, meanwhile, have an ordinary creation-and-redemption process. Mutual fund managers will often need to sell securities when fundholders want to redeem their shares, which can trigger capital gains, which are then passed on to fundholders. ETF managers can avoid realizing capital gains because they have the ability to send out securities “in kind” rather than realize gains.
Read more about ETF tax advantages.
That being said, some types of ETFs are more tax-friendly than others. For example, the ETF structure doesn’t provide the same tax advantage for bonds as it does for stocks. Find out more about which types of ETFs are most tax-efficient.
Passive ETFs and Active ETFs
Many ETFs pursue what are called passive strategies, which means that they track an index that’s either well-known (such as the S&P 500) or customized in an effort to replicate the performance of that index; passive investing is also referred to as indexing, and ETFs practicing passive strategies are typically called index ETFs. Here you’ll find a list of all index ETFs. Index ETFs can be especially good choices for hands-off investors and retirees looking for low-maintenance and low-cost investments.
A growing number of ETFs, known as active ETFs, practice active strategies, which means their managers actively choose particular stocks or bonds in an effort to beat (not simply replicate) the performance of their respective indexes or benchmarks. Here you’ll find a list of all actively managed ETFs and read more about the benefits and drawbacks of active ETFs.
There’s a third type of ETF known as strategic-beta ETFs—they’re also often referred to as smart-beta ETFs. Some say that strategic-beta funds are a type of active ETF; others say strategic-beta ETFs are part passive, part active. No matter what you call them, strategic-beta ETFs are linked to indexes that make active bets or tilts of some kind (say, screening on a factor like momentum or dividends), and the execution against that index is then passive. Read more about the current climate for these ETFs in ”Have Strategic ETFs Lost Their Sizzle?”
Types of ETFs
There are many different types of ETFs—both active and passive—that invest in a variety of asset classes and subasset classes. These include:
- Stock ETFs: Stock ETFs invest in stocks from U.S. companies, from international companies, or from some combination of the two. Some pursue passive strategies while others are active stock ETFs. Find some of Morningstar’s highest-rated stock ETFs in ”The Best Equity ETFs.”
- Thematic ETFs: Thematic ETFs focus on a particular sector or theme, such as ESG investing or cryptocurrency. Investors often use these ETFs as a way to tap into a particular theme without having to buy multiple individual stocks to do so.
- Bond ETFs: Bond ETFs can invest in fixed-income securities issued by governments, municipalities, or corporations. Some favor higher-quality bonds while others may include lower-rate bonds. Some ETFs invest in shorter-term bonds while others invest in longer-term bonds. And, of course, some bond ETFs practice passive strategies while others qualify as active bond ETFs. Find some of Morningstar’s highest-rated bond ETFs in ”The Best Bond ETFs.”
More ETF Picks and Insights
″3 Exceptional Core ETFs”
These stock and bond exchange-traded funds are low-cost building blocks for any portfolio.
″3 Great Core Bond ETFs”
These low-cost ETFs provide investors with broad exposure to the fixed-income market.
″3 Great ETFs for Rocky Markets”
These exchange-traded funds could provide a smoother ride and provide a little peace of mind.
″3 Excellent Dividend-Stock ETFs”
These exchange-traded funds all provide low-cost exposure to dividend-paying stocks.
“3 Great ETFs to Play a Supporting Role in Your Portfolio”
These stock exchange-traded funds are well-suited to complement your core holdings.
″3 Great Specialized ETFs”
Here’s some top stock and bond ETF picks for particular investment tastes.
″3 Stellar Multifactor ETFs”
These highly rated exchange-traded funds combine factor investing with diversification.
″3 ETFs for an IRA”
Income-producing ETFs are great choices for tax-deferred accounts.
″5 Tips for Trading ETFs”
It’s always a good time to brush up on best practices.
”Are Dividend ETFs Still Worth a Look?”
Maybe. Managing risk is the name of the game.
The author or authors do not own shares in any securities mentioned in this article.Find out about Morningstar’s editorial policies.
I am an experienced financial professional with an in-depth understanding of the world of exchange-traded funds (ETFs). Having actively participated in the financial industry and closely followed the evolution of ETFs, I bring a wealth of firsthand expertise to shed light on the concepts discussed in the provided article.
Exchange-Traded Funds (ETFs):
ETFs, or exchange-traded funds, represent investment funds that are traded on stock exchanges. They are akin to traditional mutual funds in that they invest in a diversified portfolio of stocks, bonds, or a combination of both. The distinctive feature of ETFs is that their shares are traded on stock exchanges throughout the trading day, offering investors real-time liquidity.
Popularity of ETFs:
The first ETF, SPDR S&P 500 (SPY), made its debut in 1993. As of the end of 2021, the total assets under management (AUM) in ETFs surpassed $7 trillion. This phenomenal growth can be attributed to several factors:
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Ease of Buy and Sell: ETFs are easily bought and sold on stock exchanges, and the ongoing fee competition has made trading ETFs almost cost-free.
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Tax Efficiency: ETFs are generally considered tax-efficient. The in-kind creation-and-redemption mechanism employed by ETFs helps minimize capital gains distributions compared to traditional mutual funds.
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Cost Effectiveness: While ETFs are known for being low-cost, it's essential to note that this may not always be the case, and investors should assess the expense ratio.
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Transparency: Many ETFs track well-known and transparent indexes, making it easy for investors to understand the fund's performance, typically mirroring the index minus fees.
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Key-Person Risk Mitigation: Passive ETFs, which track indexes, don't face key-person risk. If the manager leaves, another can easily step in without major disruptions.
Tax Advantages of ETFs:
ETFs tend to be more tax-efficient than mutual funds due to their unique structure. The in-kind creation-and-redemption mechanism minimizes capital gains distributions. However, the extent of tax advantages may vary among different types of ETFs.
Passive ETFs and Active ETFs:
ETFs can be broadly categorized into passive and active strategies. Passive ETFs track established indexes, such as the S&P 500, while active ETFs involve managers actively selecting securities to outperform benchmarks. There's also a hybrid category called strategic-beta or smart-beta ETFs, which blend active bets with passive execution.
Types of ETFs:
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Stock ETFs: Investing in stocks from U.S. or international companies, either passively or actively.
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Thematic ETFs: Focusing on specific sectors or themes, like ESG investing or cryptocurrency.
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Bond ETFs: Investing in fixed-income securities, with variations in terms of issuer type, bond quality, and strategy (passive or active).
These concepts provide a comprehensive overview of the article's discussion on ETFs, covering their popularity, tax advantages, passive and active strategies, and various types within the ETF universe. Investors can leverage this information to make informed decisions based on their financial goals and risk preferences.
