Advantages of Exchange-Traded Funds (ETFs) (2024)

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

In recent years, cryptocurrencies have gained significant attention, even as their ETFs still have a small market share post-approval, as the chart above shows. Like funds for commodities, volatility, and real estate, these ETFs allow access within U.S. exchanges of off-exchange assets. Still, it's important to set out cryptocurrency ETFs from other such funds. Cryptocurrency ETFs are designed to track the performance of one or more cryptocurrencies, such as bitcoin. However, the U.S. Securities and Exchange Commission (SEC) has attempted to keep a protective wall between American retail investors and the crypto world's well-publicized incidents of market manipulation and outright fraud. The regulator's concerns initially prevented futures-based crypto ETFs from being listed on U.S. exchanges. However, after rejecting applications for years, the SEC allowed bitcoin and ether futures ETFs to begin trading in 2021 and 2023, respectively. The thinking was that futures markets are far more regulated and offer greater investor protection than spot cryptocurrency markets (these funds can hold cryptocurrencies directly, not futures contracts tied to their expected value).

In January 2024, the SEC authorized 11 new spot market bitcoin ETFs to begin trading on the NYSE Arca, Cboe BZX, and Nasdaq exchanges. These moves led to a massive influx of capital into these funds, spiking the price of bitcoin and these ETFs' returns in the first quarter of trading. Soon, however, bitcoin prices pulled back, and trading settled into the usual volatility expected of these currencies—which is to say, a lot.

Fidelity, Grayscale, and other fund managers followed this action with applications for spot ether ETFs. If approved, these funds would directly hold the Ethereum platform's native currency, ether (ETH). However, the SEC seems unlikely to approve these applications in the short to medium term. In addition to the concerns the SEC had previously over spot bitcoin funds, the regulator seems to think that, unlike bitcoin, ETH could be securities. This is because Ethereum uses a staking mechanism in which randomly selected ether holders lock up their funds as collateral and are rewarded with additional ether for supporting the blockchain network. As we've reported, the SEC thinks this could make ether a security. This would mean that trading in ether would need to meet the same U.S. regulations for transparency, reporting, and so on, as your typical stocks and bonds before ETFs holding them could begin trading.

Forspot ether ETFs to be granted SEC approval, the applicants must, among other things, show that ether is a commodity and that these funds can resist the effects of fraud and manipulation in the wider crypto world. Proving these things won’t be easy.

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 throughout the trading day. You can buy and sell shares when the market opens and throughout the day. 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.