It feels like everyone is talking about ETFs lately, and the numbers back that up. In 2022, global exchange-traded funds (ETFs) brought in a fresh $754B. Interestingly, it seems much of that money shifted over from the $1.3T outflow of mutual fund shares that same year. If you're wondering where the smart money is going or just want to understand the mechanics behind the acronym, you're in the right place to build your knowledge.
What is an exchange-traded fund (ETF)?
Think of an ETF as a best-of-both-worlds financial instrument. It combines the structure of a mutual fund with the trading style of individual stocks. Like a mutual fund, it holds a collection of underlying assets. These can be stocks, bonds, commodities, or currencies. This gives you instant diversification.
However, the key difference is in how you buy and sell them. ETFs trade "intra-day." That is just a fancy term that means their price fluctuates throughout the day as they are traded, exactly like stocks. This gives you the flexibility to buy or sell your shares at any time during market hours. In contrast, mutual funds only trade once a day at the closing price.
Financial institutions create and manage these funds. They buy the underlying assets and issue shares to the public. Because these shares trade on an exchange, market supply and demand determine the price. Naturally, the performance of the underlying assets influences that price, along with general market sentiment.
For example, if you want to invest in the S&P 500 without buying all 500 stocks individually, you can buy a single share of an ETF that tracks that index. It is a simple way to get exposure to a broad market or sector.
The different types of ETFs
While the concept is simple, there are several flavors of ETFs depending on your goals. Here is a breakdown of the most common types.
Equity ETFs
These track the performance of a specific stock market index or sector. You can choose funds that cover large corporations, small businesses, or even stocks specific to a single country. They also allow you to target specific sectors that might be performing well, such as banking or technology.
Bond ETFs
These are fixed-income investments that hold securities like government or corporate bonds. Much like bond mutual funds, they hold a diverse portfolio ranging from conservative US Treasuries to high-yield options, with varying holding periods.
Commodity and Currency ETFs
- Commodity ETFs: These track the performance of physical goods like gold, oil, or agriculture.
- Currency ETFs: These invest in a specific foreign currency or a basket of currencies.
Specialty ETFs (Leveraged and Inverse)
These are newer, more complex, and riskier funds. They allow investors to take aggressive or defensive stances.
- Leveraged ETFs: These funds use borrowed money (leverage) to try and increase returns. You can usually spot them by the multiple they advertise, such as "2X." This means they borrow an additional $1 for every $1 invested by the public.
- Inverse ETFs: These move in the opposite direction of the asset they track. If the S&P 500 goes down, an inverse ETF tracking it would go up. These are typically used to hedge portfolios against downturns.
Active vs. passive management
When you look at the ETF landscape, you will see two main management styles. However, one is far more common than the other.
Passively managed ETFs
These funds aim to mimic the performance of a benchmark, like an index. They comprise over 99% of the ETF ecosystem. Because there isn't a manager actively picking stocks, they generally have lower fees. For equity ETFs, the average expense ratio is just 0.16%. These are often called "set it and forget it" investments.
Actively managed ETFs
These are rare, accounting for just 0.12% of all ETFs. Here, a fund manager buys and sells securities to try and outperform a benchmark. Because you are paying for that human expertise, they typically have higher fees, with an average expense ratio of 0.70% for equity ETFs. The reality is that active ETFs are less popular largely because they often don't perform as well as passive ETFs.
ETFs vs. mutual funds
There are three main areas where ETFs differ from their mutual fund cousins: trading mechanics, fees, and taxes.
We already mentioned that ETFs trade throughout the day, while mutual funds trade at the end-of-day net asset value (NAV). But the cost difference is also significant. According to the Investment Company Institute, actively managed equity mutual funds had an average expense ratio of 0.66% in 2022. That is 50 basis points (0.50%) more expensive than the average equity ETF.
Tax treatment is another major differentiator. ETF portfolios typically have low turnover, which measures how often the manager buys and sells securities. Because of this structure, ETFs usually generate fewer capital gains. This means you often pay less in capital gains tax compared to mutual funds.
The pros and cons of ETFs
The Pros
- Low cost: Since the overwhelming majority are passively managed, overhead is lower. You pay the investment company less than you would for most actively managed mutual funds.
- Tax efficiency: Lower turnover rates generally lead to fewer taxable capital gains distributions.
- Transparency: ETFs typically reveal their holdings daily, so you always know exactly what assets you own.
The Cons
- Trading costs: If you trade ETFs frequently in a brokerage account, you might pay more in fees compared to holding individual securities. You have to account for the expense ratio combined with any potential trading commissions.
- Lower dividend yields: Your dividend is tied to the average yield of the fund's assets. Since ETFs track a broad market, the yield will be an average, meaning it may be lower than if you cherry-picked specific high-yield stocks.
- Speculative risks: Leveraged ETFs can be dangerous. Some aim to "2X" or "3X" the return of an index. While exciting, they can also drop more than 2X or 3X if the market turns. Losses can snowball fast, especially if you hold these funds for too long. They require extensive research and caution.
Why Facet focuses on your whole financial life
At Facet, we believe investments are just one engine in your broader financial journey. While ETFs are excellent tools for building a diversified, low-cost portfolio, simply buying a fund isn't a financial roadmap. You'll work with a CFP® professional who looks at how your investments interact with your taxes, your retirement goals, and your cash flow.
Our flat-fee membership model means we don't charge a percentage of your assets. We recommend the right investment vehicles - often low-cost ETFs - because they fit your life, not because they generate commissions for us. It's about ensuring your money reflects your values and helps you achieve self-fulfillment.
