What Is an ETF? Morningstar’s ETF Guide
Learn more about exchange-traded funds, how to invest in them, and which types of ETFs may be best for you.
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.
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:
ETFs, in general, tend to be more tax-efficient than mutual funds, for a couple of reasons:
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.
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?
There are many different types of ETFs—both active and passive—that invest in a variety of asset classes and subasset classes. These include:
These stock and bond exchange-traded funds are low-cost building blocks for any portfolio.
These exchange-traded funds could provide a smoother ride and provide a little peace of mind.
These exchange-traded funds all provide low-cost exposure to dividend-paying stocks.
Income-producing ETFs are great choices for tax-deferred accounts.
It’s always a good time to brush up on best practices.