As of January 2019, there were 2,007 exchange-traded funds (ETFs) listed in the United States, with about $3.6 trillion in total assets. Assets held in ETFs have more than tripled since 2010, while the number of ETFs has more than doubled.1
An ETF is a portfolio of securities assembled by an investment company, similar to a mutual fund. An ETF's underlying investments are often selected to passively track a particular market index, but some may be actively managed.
The proliferation of ETF choices means they can now be used to create a broad portfolio of core investments, to target narrower sectors, or to gain market exposure that might otherwise be too difficult or costly to access. They are also being used to implement more sophisticated investment themes and strategies.
Mutual funds are typically purchased from and sold back to the investment company and priced at the end of the trading day, with the price determined by the net asset value (NAV) of the underlying securities. By contrast, ETFs can be traded throughout the day on stock exchanges, like individual stocks, and the price may be higher or lower than the NAV because of supply and demand.
In relatively calm markets, ETF prices and NAVs are generally close. However, when financial markets become more volatile, ETFs may quickly reflect changes in market sentiment, while NAVs — adjusted once a day — may take longer to react, resulting in ETFs trading at a premium or a discount.
Expenses and taxes
ETFs typically have lower expense ratios than mutual funds. However, you must pay a brokerage commission whenever you buy or sell an ETF, so your overall costs may be higher if you trade frequently, or they may be lower if you hold shares over a long period of time.
The way ETFs are structured also makes them relatively tax-efficient. Normally, ETFs don't distribute capital gains, so investors are not hit with capital gains taxes unless shares are sold for a profit. For this reason, high-income investors may favor ETFs over mutual funds for assets held in taxable accounts. (Some ETFs may occasionally distribute capital gains if there is a shift in the composition of the underlying assets.)
One fixed-income strategy involves laddering exchange-traded bond funds that have defined maturity dates. Such ETFs typically hold many bonds that mature in the same year the ETF will liquidate and return assets to shareholders. ETFs may enhance liquidity, but unlike individual bonds, the income payments and final distribution rate are not fully predictable.
Smart beta ETFs use clearly defined factors (other than market capitalization) to select and weight investments in order to track an existing factor-based index or create a new index. Some of these factors are momentum, risk, volatility, growth potential, dividend growth or yield, earnings, cash flow, and equal weighting of all securities, among others.
The principal value of ETFs and mutual funds fluctuates with market conditions. Shares, when sold, may be worth more or less than their original cost. Bond ETFs are subject to the same inflation, interest rate, and credit risks associated with their underlying bonds.
Exchange-traded funds and mutual funds are sold by prospectus. Because sector funds are typically concentrated in a particular industry or market sector, they carry a significant level of volatility and risk. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
1 Investment Company Institute, 2019