What Is an ETF? Morningstar’s ETF Guide (2024)

What Is an ETF?

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.

Why ETFs Are Popular

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:

1) ETFs are easy to buy and sell—and given the fee wars in the industry, ETFs have become virtually free to buy and sell.

2) ETFs have a reputation for being tax-efficient (somewhat true).

3) ETFs are also known for being low cost (not always true).

4) Because many of the most popular ETFs track widely followed and transparent indexes, there’s no mystery behind their performance: It’s usually the performance of the index minus fees.

5) Passive ETFs have no key-person risk: If the manager leaves, another can step in without much ado.

Tax Advantages of ETFs

ETFs, in general, tend to be more tax-efficient than mutual funds, for a couple of reasons:

1) ETFs distribute fewer and smaller capital gains distributions because so many pursue lower-turnover, passive strategies.

2) ETFs are structured differently than traditional mutual funds—and the ETF structure is more tax-efficient.

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.

Passive ETFs and Active ETFs

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?”

Types of ETFs

There are many different types of ETFs—both active and passive—that invest in a variety of asset classes and subasset classes. These include:

  • Stock ETFs: Stock ETFs invest in stocks from U.S. companies, from international companies, or from some combination of the two. Some pursue passive strategies while others are active stock ETFs. Find some of Morningstar’s highest-rated stock ETFs in ”The Best Equity ETFs.”
  • Thematic ETFs: Thematic ETFs focus on a particular sector or theme, such as ESG investing or cryptocurrency. Investors often use these ETFs as a way to tap into a particular theme without having to buy multiple individual stocks to do so.
  • Bond ETFs: Bond ETFs can invest in fixed-income securities issued by governments, municipalities, or corporations. Some favor higher-quality bonds while others may include lower-rate bonds. Some ETFs invest in shorter-term bonds while others invest in longer-term bonds. And, of course, some bond ETFs practice passive strategies while others qualify as active bond ETFs. Find some of Morningstar’s highest-rated bond ETFs in ”The Best Bond ETFs.”

More ETF Picks and Insights

″3 Exceptional Core ETFs”

These stock and bond exchange-traded funds are low-cost building blocks for any portfolio.

″3 Great Core Bond ETFs”

These low-cost ETFs provide investors with broad exposure to the fixed-income market.

″3 Great ETFs for Rocky Markets”

These exchange-traded funds could provide a smoother ride and provide a little peace of mind.

″3 Excellent Dividend-Stock ETFs”

These exchange-traded funds all provide low-cost exposure to dividend-paying stocks.

“3 Great ETFs to Play a Supporting Role in Your Portfolio”

These stock exchange-traded funds are well-suited to complement your core holdings.

″3 Great Specialized ETFs”

Here’s some top stock and bond ETF picks for particular investment tastes.

″3 Stellar Multifactor ETFs”

These highly rated exchange-traded funds combine factor investing with diversification.

″3 ETFs for an IRA”

Income-producing ETFs are great choices for tax-deferred accounts.

″5 Tips for Trading ETFs”

It’s always a good time to brush up on best practices.

”Are Dividend ETFs Still Worth a Look?”

Maybe. Managing risk is the name of the game.

The author or authors do not own shares in any securities mentioned in this article.Find out about Morningstar’s editorial policies.

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ETFs: An Overview

Exchange-Traded Funds (ETFs) are investment funds that trade on stock exchanges. Similar to traditional mutual funds, ETFs invest in a basket of stocks, bonds, or a combination of both. However, unlike mutual funds, ETF shares can be bought and sold on stock exchanges, such as the New York Stock Exchange.

Popularity of ETFs

ETFs have gained popularity for several reasons:

  1. Ease of buying and selling: ETFs are easy to buy and sell, and with the fee competition in the industry, they have become virtually free to trade.
  2. Tax efficiency: ETFs are generally considered more tax-efficient than mutual funds. They distribute fewer and smaller capital gains distributions due to their lower turnover and the in-kind creation-and-redemption mechanism they use.
  3. Lower costs: ETFs are known for their relatively low expense ratios compared to some mutual funds.
  4. Transparency: Many popular ETFs track widely followed and transparent indexes, making their performance easy to understand.
  5. Key-person risk: Passive ETFs, which track indexes, do not have key-person risk. If the manager leaves, another can step in without much disruption.

Tax Advantages of ETFs

ETFs tend to be more tax-efficient than mutual funds due to their structure and lower turnover. ETFs distribute fewer and smaller capital gains distributions because they pursue lower-turnover, passive strategies. Additionally, the in-kind creation-and-redemption mechanism used by ETFs allows them to avoid realizing capital gains when investors redeem their shares. However, the tax advantage of ETFs may vary depending on the type of assets they hold. Bond ETFs, for example, may not provide the same tax advantage as stock ETFs.

Passive ETFs and Active ETFs

ETFs can be categorized into passive ETFs and active ETFs based on their investment strategies:

  • Passive ETFs: These ETFs track well-known indexes, such as the S&P 500, or customized indexes designed to replicate the performance of a specific index. Passive ETFs are often referred to as index ETFs and are suitable for hands-off investors looking for low-cost investments.
  • Active ETFs: Active ETFs are managed by professionals who actively select stocks or bonds in an attempt to outperform their respective indexes or benchmarks. Active ETFs aim to beat the performance of the index they track.
  • Strategic-Beta ETFs: Strategic-beta ETFs, also known as smart-beta ETFs, are linked to indexes that make active bets or tilts based on factors like momentum or dividends. The execution against the index is passive, but the index itself makes active decisions.

Types of ETFs

There are various types of ETFs that invest in different asset classes and subasset classes:

  • Stock ETFs: These ETFs invest in stocks from U.S. companies, international companies, or a combination of both. They can be passive or active, depending on their investment strategy.
  • Thematic ETFs: Thematic ETFs focus on specific sectors or themes, such as ESG investing or cryptocurrency. They allow investors to tap into a particular theme without buying individual stocks.
  • Bond ETFs: Bond ETFs invest in fixed-income securities issued by governments, municipalities, or corporations. They can focus on higher-quality or lower-rate bonds and can be passive or active.
  • And more, including ETFs that invest in commodities, real estate, and other asset classes.

These are just a few examples of the types of ETFs available. Each type has its own characteristics and investment objectives.

I hope this information helps you understand the concepts discussed in the article. If you have any further questions or need more details, feel free to ask!

What Is an ETF? Morningstar’s ETF Guide (2024)

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