Key Takeaways
Why are investors embracing ETFs? Four attractive attributes stand out: trading flexibility, transparency, tax efficiency, and lower costs. ETFs can be used in multiple ways and may be suitable for a variety of investors.
ETFs have grown well past their passive origins. Now, there are more than 3,500 funds covering many different asset classes and investment styles—including in-demand active ETFs.
By 2027, ETFs could account for 24% of total fund assets. With the benefits of its structure and innovation within it, ETFs are becoming foundational building blocks in portfolio construction.
More than 115 million U.S. investors own mutual funds, according to the Investment Company Institute. But exchange-traded funds (ETFs) are rapidly gaining ground: The amount of investor assets in ETFs has grown from less than $500 billion in 2005 to almost $9 trillion as of March 2024.1
Although many investors have a vague idea of what ETFs are and how they work, the market has changed significantly since the first ETF launched in 1993. It’s important to understand what ETFs have to offer today to help make better-informed decisions about using them in portfolios.
Revisiting ETF Basics
Why are investors embracing ETFs? Probably because they feature several attractive attributes:
Trading Flexibility: Unlike mutual funds, which are priced at the end of each trading day, ETFs are priced throughout the day like stocks and can be bought and sold relatively quickly.
Transparency: Most ETFs must list their full holdings daily pursuant to SEC regulations, which means investors have up-to-date information on what they currently own.
Tax Efficiency: ETFs are often sold from one investor to another in transactions that don't involve the sale of underlying securities. This direct trading and the mechanics of how ETF shares are issued and redeemed help mitigate capital gains for other shareholders.
Lower costs: The ETF vehicle typically has reduced processing and management costs. Commissions and other brokerage costs may remain so it’s important to understand the total cost of ownership.
A Growing Menu of ETFs
The first ETF was a passively managed fund that tracked the S&P 500® Index. Now there’s more than 3,500 funds as asset managers have responded to investor demand by offering many different asset classes and investment styles.
Key types of ETFs:
Passive, indexed ETFs: Seek to mirror the performance of a recognized, measurable benchmark; e.g., the broad market S&P 500 and the Bloomberg Aggregate Bond indexes.
Strategic beta or alternatively-weighted ETFs: Seek enhanced returns or reduced risk tracking a market-capitalization weighted index by selecting and weighting securities based on criteria other than market cap.
Active ETFs: Seek excess return over a benchmark through the same bottom-up, fundamental approach as many mutual funds—combining active management with the ETF structure. There are different kinds of active ETFs. Some are index-like, some follow a specific methodology and some are strategically managed according to market conditions.
ETFs can be used in multiple ways, including combining with mutual funds and individual securities to build diversified and flexible portfolios. It’s important to do your homework to determine what type of ETF would be most beneficial for your risk tolerance and portfolio goals.
ETFs and Mutual Funds at a Glance
Like mutual funds, ETFs are baskets or pools of individual securities, such as stocks or bonds. And like mutual funds, ETFs are structured as open-end investment companies. Both ETFs and mutual funds post net asset values (NAVs) of their underlying securities at the end of each trading day.
However, there are key differences between the two vehicles.
MUTUAL FUNDS | ETFS | |
|---|---|---|
Purchases and Sales | Buyer purchases shares directly from the fund company or through a brokerage firm. | Buyer purchases shares through a brokerage firm that clears the transaction directly through a stock exchange. |
Pricing | Priced once per day at the end of the day based on NAV of fund’s holdings. | Priced continuously throughout the day while financial markets are open and may be priced at a premium or discount to NAV. |
Capital Gains Taxes | Managers buy or sell underlying holdings to accommodate inflows and outflows or to reallocate assets. These are cash transactions within the fund, which could create capital gain liabilities. | Shares of individual securities exchanged in-kind for ETF shares to accommodate inflows and outflows generally does not create taxable capital gains. The ETF structure helps mitigate capital gains until shares are sold. |
Transaction Costs | No transaction costs for no-load funds (fees may apply when buying or selling through a brokerage platform). | Brokerage commission and bid/ask spread are applied to each purchase or sale. |
Who ETFs May Be Suitable For
Buy-and-hold investors — Buying and selling ETFs generally triggers transaction costs outside the funds, so they may better suit individuals who do not trade frequently.
Lump-sum investors — Because of potential transaction costs, ETFs may be better suited for investors looking to invest a single, larger amount than for those investing smaller amounts at regular intervals.
Investors seeking flexibility — Investors interested in applying a variety of trading strategies may find ETFs appealing. Unlike mutual funds, ETFs let investors sell short, buy on margin, purchase options, and place stop and limit orders and more.
Investors interested in market niches — Some ETFs focus on narrow slices of the market, which can suit investors seeking specific market exposures.
Questions to Ask Before Investing in an ETF
As more ETFs become available, it can be challenging to distinguish between approaches. Getting answers to these questions can help:
What is the fund’s objective?
How does the fund seek to achieve its objective?
Can the fund be purchased at a fair price?
Can the fund be sold easily?
Does the fund offer the exposure the investor needs, or are there underlying concentrations that could create unintended risk?
Does the fund align with the investor’s goals?
ETFs Are Here to Stay
Product development continues to support the growth of ETFs, with new funds hitting the market seemingly daily as investors seek out more cost- and tax-efficient investment choices. By 2027, ETFs could account for 24% of total fund assets, up from 17% at the end of 2022.2
The benefits of its structure and innovation within it have taken ETFs far beyond their passive origins to become foundational building blocks in portfolio construction.
Explore More Insights
Source: Morningstar. March 31, 2024.
Source: Kaczmarski et al. (2023). The Renaissance of ETFs, Oliver Wyman.
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
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This information is for educational purposes only and is not intended as tax advice. Please consult your tax advisor for more detailed information or for advice regarding your individual situation.
Exchange Traded Funds (ETFs) are bought and sold through exchange trading at market price (not NAV), and are not individually redeemed from the fund. Shares may trade at a premium or discount to their NAV in the secondary market. Brokerage commissions will reduce returns.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.