What Is an ETF? A Beginner's 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 be comprised of 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 (AUM) grow from about $200 billion in 2003 to more than $6 trillion in 2019.

[Read: What Are Mutual Funds? The Ultimate Guide.]

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

-- How do ETFs work?

-- Differences between ETFs and ETNs.

-- ETFs versus mutual funds.

-- ETFs versus index funds.

-- The 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 Standard & Poor's 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 like market volatility.

There are also leveraged ETFs 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.

ETF vs. ETN: The Differences

ETNs, or exchange-traded notes, are sisters to ETFs -- but up close, they look very different. Both typically track benchmarks, often an index, and trade like stocks. But that's where the similarities end.

The differences between ETFs and ETNs boil down to how they're built. ETNs are structured products, meaning they're part bond, part derivative. The bond portion is meant to provide principal protection, while the derivative portion offers upside potential.

Like bonds, banks and brokerage firms issue ETNs with maturity dates, but ETNs don't pay regular interest. Instead, the owner receives repayment at maturity based on the value of the underlying benchmark.

Repayment is guaranteed by the issuer -- in other words, your money is only as safe as the issuer. If the issuer goes bankrupt, your ETN goes up in smoke. This additional layer of credit risk makes ETNs riskier than ETFs.

Once issued, ETNs charge annual fees and trade on exchanges just like ETFs. Investors can hold their note until maturity or sell it early on the stock market.

But structurally, ETFs and ETNs work differently. An ETF is a fund. It owns shares of the stocks, bonds or other securities in its portfolio. When you buy an ETF, you become a fractional owner of those securities.

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An ETN doesn't own securities directly. There are no shares of the S&P 500 companies in your S&P 500 ETN. Instead, it uses derivatives, such as futures and options, to speculate on the price of the S&P 500.

Some ETNs are secured against an asset the investor can claim if the issuer defaults, but most ETNs in the U.S. are unsecured. So investors' returns depend solely on the issuer's ability to repay them.

Where an ETN shines is taxation -- or lack thereof. Since ETNs don't hold securities directly, investors aren't taxed on dividends paid by the underlying securities. The only taxes are on any capital gains incurred at maturity or when you sell.

By not holding securities directly, ETNs also avoid the dreaded K-1 form, which some ETFs -- particularly those investing in commodities -- get hit with. Because of this, some experts say ETNs are better for commodity exposure than ETFs. But other than that, an ETF is generally a better choice, they say.

ETF vs. Mutual Fund

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 extremely 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 in and out of.

One of the most impressive advantages of ETFs over their closest rivals, mutual funds, is that ETFs typically charge lower management fees. In 2019, the average expense ratio of index-following equity ETFs was 0.18%, while equity mutual funds charged an average of 0.52% a year. That's a huge difference, especially when you invest a meaningful amount of money over a long time.

These cost advantages are driven by how ETFs and mutual funds are run. Mutual 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, ETFs are almost exclusively passive: Securities are bought in exact proportions to the index the ETF 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.

ETFs also provide tax advantages. 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.

"Mutual fund managers can trade securities during the year, and if there are capital gains realized, they are passed on as a taxable event to the shareholder," says Thomas E. Nugent, executive vice president of Victoria Capital Management. 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. "If ETF shares are held, there is no annual tax liability," Nugent says.

But probably the most important advantage ETFs have over mutual funds -- although lower fees and the aforementioned edges are all pretty impressive -- is that passively managed funds absolutely smoke actively managed funds over time.

Consider this startling statistic: Over the past 15 years, only 37% of active fund managers have outperformed their benchmarks. In 2019, they did even worse, with only 29% of active fund managers beating their benchmarks.

That's absolutely 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 2010 and 2019, outflows from actively managed mutual funds totaled $185 billion. Meanwhile, inflows into index-tracking ETFs and mutual funds were $3.8 trillion over the same period. Today, passive funds account for 45% of all U.S. stock funds, up from about 25% a decade ago.

ETF vs. Index Fund

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, but not as low as their ETF counterparts. For example, the Vanguard 500 Index Fund (ticker: VFINX), which tracks the S&P 500 index, has an expense ratio of 0.14%. Meanwhile, the Vanguard S&P 500 ETF ( VOO) has an expense ratio of 0.03%.

The lower expense 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 deduct from 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 transactions costs.

[Read: Guide to Low-Cost Index Funds.]

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 a quarter century and $6 trillion later, these once-exotic instruments are here to stay.

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