Exchange-traded funds (ETFs) have emerged as a popular vehicle through which investors big and small can access the world of stocks, bonds, and more. An ETF is simply a basket of assets packaged into a portfolio that can be easily traded or owned for the long term. They are an ideal way to get started investing without taking too much risk, and there are more ETF strategies than you can even imagine given today’s technology and low-cost trading. There are important details to know, however, and having a firm knowledge of the ins and outs can make you a better investor no matter what your goals are.

Understanding ETFs

An ETF is a type of investment fund. It’s such a broad term for all it can be. As with stocks, ETFs trade on exchanges like the NYSE and Nasdaq and can be bought and sold throughout the trading day. Unlike owning shares in individual companies, though, an ETF spreads out risk by owning dozens or even hundreds of stocks within the ETF wrapper. What’s more, there are ETFs focused in the bond space, commodities, and even cryptocurrencies. ETFs can be a solid choice for active investors since they are designed to closely track the net asset value (NAV) of the basket of securities it owns – that simply means the ETF’s price is usually very close to its true worth. 

ETFs indeed have some characteristics of stocks, but they also resemble mutual funds in certain ways. Mutual funds are pools of capital that trade under a specific ticker symbol and are priced once per day at the close of trading. Mutual funds are always priced at their NAV, whereas ETFs can technically stray from NAV, though the difference is often small. ETFs, since they trade throughout the day, have more liquidity than mutual funds. Another key difference? ETFs generally have preferential tax treatment compared to most mutual funds. Finally, mutual funds are bought directly from a fund company while ETFs are traded on open exchanges.

ETF Key Terms

You’ll come across a variety of financial jargon when researching ETFs. We have already mentioned a few of them! ETF language is important to grasp since understanding the basics of ETFs will help you figure out which funds are ideal to help you reach your short-term and long-term goals. 

Among the most critical metrics to weigh is the expense ratio. The expense ratio is like the annual fee to own the ETF, and it’s expressed as a percentage. A 1% expense ratio means you will pay $10 annually per $1,000 invested in the fund. Some ETFs have dirt-cheap expense ratios of under 0.1% while others might be pricey, above 1%. In general, the lower the expense ratio, the better, but there can be certain strategies that are worth their high cost. 

Since their launch in the early 1990s, ETFs have gathered significant money flows from both everyday retail investors and large institutional investors. At more than $10 trillion, total ETF assets under management (AUM) has risen big time. You want to be wary of parking your money in an ETF with a very low AUM, say, under $50 million, as it might not be easy to buy and sell at a favorable price with a thinly traded ETF. 

That brings us to “liquidity.” Liquidity is simply how efficiently you can trade an ETF while still receiving a fair price. Be sure to check out an ETF’s 90-day average trading volume (the higher the volume, the better) as well as its 30-day median bid/ask spread (a gauge of the typical difference between the buy price and sell price in the open market). The narrower the spread, the more liquid the ETF is.

ETF Types

If you can think of a unique investing strategy, chances are there is an ETF for it. Today, there are almost as many ETFs in existence as individual stocks. We mentioned that there are stock, bond, and crypto ETFs, but the gamut is far wider. Many investors like to trade sector ETFs which own stocks from one of the market’s 11 sectors. Another popular method to get equity exposure is to go overweight or underweight a “style,” as can be accomplished through a “value” or “growth” ETF. You’ll also come across ads for unique thematic funds, perhaps centered on impact investing, precious metals and gold, dividend strategies, or even pot stocks. 

ETFs span geographies, too. Many US investors own either an S&P 500 index ETF or a total market index fund, but don’t forget about international markets. There are diversified ETFs that track the entire global stock market that cost around 0.1% per year. Imagine owning bits and pieces of thousands of companies in a single fund. You can do it thanks to ETFs. 

One way to distinguish one type of ETF from another is to break them out between passive and active. Passive ETFs are by far the more popular variety, but active funds are hot on their heels. A passive ETF is one that simply aims to track an index - there isn’t a goal of beating the market or even avoiding losses. The caveat is that some ETF issuers create an index out of thin air so that their fund is technically an index fund – there might be a complex strategy behind it. Active ETFs, by contrast, seek to generate stronger returns than a pre-specified benchmark. The manager will buy and sell securities with the goal of earning “alpha,” or an above-benchmark performance. Cathie Wood’s Ark Innovation ETF (ARKK) is one such strategy.

Popular ETFs

You’re probably familiar with some of the biggest passive index ETFs. The SPDR S&P ETF Trust (SPY) is the world’s largest ETF. Vanguard (VOO) the iShares (IVV) have their own versions which are in the top five biggest ETFs, too. Beyond the SPX, many US investors opt to allocate a chunk of their investable money into the Vanguard Total Stock Market Index ETF (VTI), which owns shares of small, medium-sized, and large companies.

One of the most successful ETFs in the last decade-plus is the Invesco QQQ Trust (QQQ) - because of the FAANG names and Magnificent Seven companies’ strong returns, QQQ is concentrated in a handful of single stocks. Outside of the good ole USA, the Vanguard Total International Stock ETF (VXUS) only holds foreign equities, which gives investors geographic diversification. The iShares Core MSCI EAFE ETF (IEFA) is another large non-US ETF with total assets of more than $100 billion while the Vanguard Total World Stock ETF (VT) is a low-cost global index fund. Finally, you can take part in all that capitalism has to offer in bond ETFs, as well. If you want to hold a balanced portfolio, the iShares Core U.S. Aggregate Bond ETF (AGG) and Vanguard Total Bond Market ETF (BND) allow you that opportunity. 

Largest ETFs by AUM

Source: VettaFi

ETFs and Taxes

Among the biggest drivers of growth in ETFs is that they are tax-efficient compared to old-school mutual funds. This gets into the weeds a bit, but ETFs trade on open exchanges. Shares move from one investor to another all day long, and rarely are new shares created. These “in-kind transactions” are viewed differently by tax authorities compared to a mutual fund that constantly creates new shares to accommodate growing investor demand. Mutual funds thus have to constantly buy and sell stocks and bonds to match that demand, triggering taxable events. ETFs do not face this requirement. 

Many investors choose to own ETFs in taxable brokerage accounts due to their relative tax advantages. Mutual funds, however, remain a popular vehicle for Individual Retirement Accounts (IRAs), 401(k)s, and even Health Savings Accounts (HSAs) since those accounts are tax-sheltered. Of course, ETF owners still owe taxes on fund distributions as well as if they sell for a gain. Be sure to understand the difference between short-term and long-term capital gains taxes, too!

ETFs & Portfolio Management

Since there are literally thousands of ETFs out there these days, it’s easy to feel overwhelmed by all the strategies and styles. Don’t sweat it. Take it one step at a time. Try investing in a low-cost index ETF to get a feel for how it all works. Thanks to today’s zero-commission trading environment, transacting a few funds probably won’t result in major fees. As with any investment endeavor, it’s imperative that you determine your return objectives and risk profile before diving into an asset allocation. You can also take a hands-off approach and invest with Allio’s team of macro strategists who can diversify your investments for you.

Most young investors have a long time horizon. That means they can usually take a significant amount of risk if they are, say, investing for retirement. If that’s the case, then choosing a few stock ETFs might be the right move. If you have a near-term goal, however, then sticking with a lower-risk ETF, perhaps a bond fund, is the prudent play. Meanwhile, an array of fixed-income ETFs is often owned by retirees who live off their dividends and interest generated from their nest egg. In another scenario, if you work for a tech company, then holding an allocation of ETFs that avoids the Information Technology sector may be a savvy move so that you do not double up on risk between your job and your portfolio.

It all boils down to your goals and time horizon. Once you have figured that out, building a basket of liquid ETFs is actually the easy part. Then sticking with a long-term buy-and-hold strategy could be the right solution for DIY investors along with applying the principles of dollar-cost averaging to take advantage of volatility and bear markets. Active portfolio managers, like the ones at Allio, use their expertise to dynamically shift between asset classes and  sectors and even put on protective  positions when managing money. 

The Bottom Line

ETFs have emerged as a popular way to invest across asset classes. Trillions of dollars are put to work across stocks, bonds, commodities, and cryptocurrencies through ETFs. Individual investors must understand how ETFs function before jumping into a portfolio of funds. ETFs offer the benefits of cost efficiency, diversification, favorable tax treatment, and overall versatility when building and maintaining an asset allocation. 

You can invest in ETFs on your own or with Allio’s team of expert macro portfolio managers. Build wealth your way using our investing app designed to help you reach your financial goals.