Advantages of Exchange-Traded Funds (ETFs)

Exchange-traded funds (ETFs) combine some of the best characteristics of stocks and mutual funds into a single investment. They offer real-time trading flexibility like stocks and the built-in diversification of mutual funds.

ETFs have been traded in U.S. markets since the early 1990s. Inflows began to take off around the turn of the millennium, when there were about 80 ETFs and $66 billion in assets under management (AUM). In the mid-2020s, there are more than 3,600 ETFs with over $11.3 trillion in AUM in worldwide. ETFs are also a significant part of the wider market, representing about 30% of the annual trading volume on U.S. exchanges.

However, like any investment, ETFs have drawbacks that you should review carefully before adding them to your portfolio.

Understanding ETFs

ETFs have characteristics of both mutual funds and individual stocks. Their purpose is to provide investors with a convenient way to achieve diversification. Most, but not all, ETFs track a specific index, such as a stock market or bond index. Only about one in 20 ETFs actively manage their holdings. The reason is historical: early on, all ETFs were used to invest in broad indexes. However, in the 2000s, fund managers found these funds convenient for investors wanting exposure to off-exchange assets through their regular brokerage accounts. For example, the first bond, commodity, and volatility index ETFs opened in 2002, 2007, and 2009, respectively. The first actively managed ETFs didn't appear until 2008.

Still, the most-traded ETFs are passive index funds. "With this approach, an investor can keep fees low while diversifying their portfolio across industries, sectors, and geographies," said David Tenerelli, a certified financial planner at Strategic Financial Planning in Plano, Texas. "This can result in the investor approximating 'universal ownership'—owning a representative slice of the entire global economy —and positioning yourself to benefit from broad economic growth, regardless of the fortunes of individual companies." But this, too, can have risks, like all investments, he noted, should the market the ETF tracks go down.

Unlike mutual funds, ETFs trade on public exchanges like individual stocks. This means that investors can buy and sell ETF shares at prices based on supply and demand throughout the trading day. Meanwhile, mutual fund prices, valued according to their net asset values (NAVs), are calculated only at the end of each trading day.

Here's a comparison of ETFs and mutual funds:

While ETFs aim to replicate the returns of the indexes they track, there might be slight discrepancies between each ETF's performance and that of the index, which is called a tracking error. ETFs can be used to target specific sectors, themes, or asset classes. They can also be used to cover equities, fixed-income securities, commodities, or alternative investments. Here are the major types, and below that is a chart of their relative market share:

1. Index or broad market ETFs: These track the performance of broad market indexes, such as the S&P 500 or the whole of the market, packaged with slight differences by different funds as total stock market indexes. They provide investors with diversified exposure to a wide range of companies across various sectors and market capitalizations. In recent decades, index ETFs have often outperformed their actively managed peers.
2. Sector-based ETFs: These focus on specific industries such as technology, healthcare, or energy. You can use these ETFs to target areas of the economy you believe will outperform others or to balance out other parts of your portfolio.
3. Factor-based ETFs: Also known as smart-beta ETFs, factor-based ETFs seek to outperform traditional market-cap-weighted indexes by selecting stocks based on value, growth, quality, or momentum. These ETFs offer investors a rule-based approach to capturing returns.
4. Bond ETFs: These invest in fixed-income securities such as government, corporate, or municipal bonds. Certain funds concentrate on specific segments of the bond market, such as short-term, long-term, or high-yield bonds.
5. Commodity ETFs: These track the performance of underlying commodities or related indexes such as gold, silver, oil, or agricultural products. They provide investors with exposure to the price changes of physical commodities without having to directly invest in or hold them or trade commodity futures contracts.
6. International or global equity ETFs: As is easy to guess, these invest in stocks or bonds issued by companies or governments outside the investor's home country. These ETFs offer exposure to foreign markets and currencies, enabling you to diversify your portfolio geographically.
7. Thematic ETFs: These are different from sector ETFs in that they focus on topics or trends that are found across different industries, like clean energy or artificial intelligence. Thematic ETFs can be worthwhile for investing in holdings that match your values, e.g., climate-friendly firms, or to speculate on a strong new direction in the economy.
8. Inverse and Leveraged ETFs: Not for the inexperienced or the faint of heart, these funds are far from the passive index trading strategies of most ETFs. Inverse ETFs seek to profit from the decline in the value of an underlying index or asset by using derivatives or short-selling. Leveraged ETFs aim to amplify the returns of an underlying index or asset, often by using financial derivatives or borrowing. If you think a set of stocks is due to go up, you might buy shares in a leveraged ETF that offers two or three times the returns of simply buying the stocks. But returns can go both ways—you could also be doubling or tripling your losses.
   

Crypto ETFs

Cryptocurrency ETFs are designed to track the performance of one or more cryptocurrencies, such as bitcoin. For many years, the U.S. Securities and Exchange Commission (SEC) kept a protective wall between American retail investors and the crypto world's well-publicized incidents of
market manipulation and outright fraud. However, that has been changing, with virtual currencies gradually becoming more accepted as a mainstream asset class.

After rejecting applications for years, the SEC allowed bitcoin and ether futures ETFs to begin trading in 2021 and 2023, respectively. Then, in 2024, the SEC went a step further by authorizing the first spot crypto ETFs, which invest directly in the cryptocurrencies they are supposed to track rather than gaining exposure to them through future contracts.

In January 2024, the SEC approved the first 11 spot bitcoin ETFs to begin trading on the NYSE Arca, Cboe BZX, and Nasdaq exchanges. Then, in May, it approved applications from Nasdaq, CBOE, and NYSE to list ETFs tied to the price of ether, the second most popular cryptocurrency. It then gave several issuers permission to launch spot ether ETFs, which began trading on U.S. exchanges in July 2024.

These breakthroughs are a big deal for cryptocurrencies and essentially make it easier, safer, and cheaper for people to invest in them.

Advantages and Disadvantages of ETFs

We can now discuss not just what ETFs are but their specific advantages and disadvantages. Tax efficiency and liquidity are seen as advantages, popular disadvantages are potentially lower returns and higher costs.

Advantages of ETFs

Tax Efficiency

ETFs minimize capital gains distributions through the creation and redemption processes. This strategy is not available for mutual funds. That said, mutual funds have worked to catch up to offering the tax efficiency that ETFs have. The conventional wisdom that ETFs are more tax-efficient is still true—we'll touch on the data in a second—but not so much that the fund manager or family and other differences might outweigh tax efficiency when choosing between a mutual fund and an ETF.

A 2024 Villanova and University of Pennsylvania study put the average annual after-tax advantage of ETFs over mutual funds at 0.92%, a significant difference. However, the study used a method that could overemphasize the differences between the funds and was based on data up to 2017. Other researchers have found the average differences to be narrower. For example, one study showed that ETFs have a 0.20% better post-tax performance than their mutual fund counterparts. The differences vary across asset classes, from 0.33% for international equity to 0.03% for fixed-income ETFs and mutual funds.

Liquidity

ETFs are traded on stock exchanges at market prices during the trading day. You can buy and sell shares when the market opens and throughout the day until markets close. Mutual funds trade during the day, too, but you do so based on an estimate. The exact cost is calculated at the end of the day, along with the mutual fund's NAV.

Lower Expenses

ETFs are usually passively managed. The portfolio manager doesn't need to analyze the specific stocks to know which to trade and how much since the index sets that. Actively managed exchange-traded and mutual funds need more staff and expertise. This dramatically reduces costs for analysts and other resources. As such, ETFs generally have lower expense ratios than mutual funds.

Nevertheless, it's best to compare similar mutual and exchange-traded funds since they are often comparable, given the significant cut in mutual fund fees in recent decades.

Transparency

ETFs usually have to disclose their holdings, so investors are rarely left in the dark about what they hold. This transparency can help you react to changes in holdings. Mutual funds typically disclose their holdings less frequently, making it more difficult for investors to gauge precisely what is in their portfolios. This won't make much of a difference for many investors, especially when it's a passive index fund.

Where transparency greatly helps is when funds are invested in off-exchange assets like currencies, crypto, real estate, and so on, where reporting requirements give you far more knowledge—or at least more comfort in the veracity of fund claims—than you might when accessing these assets in other ways.

Diversification

ETFs are designed to offer diversification by tracking a particular index or asset class. You can thus access a broad range of assets without having the cost in time or money of buying these different stocks on your own. This diversification is a key part of modern portfolio theory. While an investment in one stock or set of assets might plunge and take your entire portfolio with it, a diverse basket of assets will have some rise while others fall and vice versa. Be mindful that the underlying components of an ETF may still be correlated with each other, and you might still need to diversify—a large-cap equity index should be balanced against other assets. This is especially true if they're all related to the same industry, such as an ETF investing in commercial real estate.

No Minimums

Many ETFs have no minimum investment, making them more accessible to those without a lot of upfront capital. This accessibility allows new investors to test the waters with diversified funds.

ETF Drawbacks

ETFs come with a wide range of benefits but also some downsides.

Intraday price volatility and bid-ask spreads can occur because ETFs are traded throughout the day and face the same market risks as other securities. Investors have flexibility in selling their ETF shares exactly when they want, but this can mean the ETF's prices can be volatile.

Some ETFs, like leveraged and inverse ETFs, can be complex and have higher risks. You'll want to have a thorough understanding of their strategies before investing. Leveraged ETFs magnify the potential return of another ETF, providing greater potential returns and losses. Inverse ETFs attempt to take the opposite position and bet on the inverse of a stock or index.

Another drawback to ETFs is that with most, you can only match the market—most are index funds, after all—not beat it.

Examples of Popular ETFs

These are among the most traded ETFs:

• The SPDR S&P 500 (SPY) is the best-known ETF. It tracks the S&P 500 Index.
• iShares Russell 2000 (IWM) tracks the Russell 2000 small-cap index.
• Invesco QQQ (QQQ) tracks the Nasdaq 100.
• The SPDR Dow Jones Industrial Average (DIA) tracks the Dow Jones Industrial Average, which includes 30 stocks.

The Bottom Line

ETFs have elements of both mutual funds and stocks. Listed on stock exchanges, they can be traded throughout the day like individual stocks. ETFs typically track a specific market index, sector, commodity, or other asset class, exposing investors to a range of securities in a single investment. Their benefits include liquidity, lower expenses than mutual funds, diversification, and tax advantages.