In the 1990s, investors talked about mutual funds. In the 2000s, they talked about index funds. And since 2010, investors have been all-in on exchange traded funds, or ETFs.
ETFs are a package that has proven appeal for investors. That’s because ETFs are pools of many investments (stocks, bonds, or both) that you buy as a single investment, just as you would a stock. Within ETFs, there are two broad investment strategies: indexing and active management.
Actively-managed ETFs are portfolios of investments hand-selected by a portfolio manager (or, often times, a team of portfolio managers). Meanwhile, indexed ETFs are tied to particular indices, like the S&P 500 or Russell 2000 Index, and are typically much less expensive to run and own. Think about it: indexing can carry lower fees because you are buying the whole market rather than paying someone to research each company and select individual stocks or bonds for you!
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Yes, mutual funds and ETFs have a lot in common, but there are also some important (and major) differences. Mutual funds can be either active or index, stocks, bonds, or both. So can ETFs, which just operate under a more modern framework, meaning you can buy and sell them just like a stock: they are bought and sold on exchange, any time the market is open, unlike a mutual fund, which must be bought and sold through a fund company at end-of-day valuations. Another big, important difference is their tax efficiency — more on that below!
There are currently more than 4,000 different ETFs, and at the end of last year, total ETF assets under management were $6.7 trillion across the US and Europe. This represents a compound annual growth rate of 15% over the last decade. That’s three times faster than traditional mutual funds!* If you’ve been thinking of dipping a toe into these waters, here are some easy-to-parse answers to your frequently asked ETFs questions.
How Do ETFs Work?
ETFs are so named — Exchange Traded Funds — because these pools of investments trade on the exchanges. A company, for example, BlackRock, which is the owner of iShares, decides that it wants to create an ETF, based on a particular investing methodology. It might track a certain index, or only hold companies in a set industry or sector. It might invest in commodities or currencies, or even follow a specific investment strategy. Once an ETF is developed, it is listed on an exchange (like the NYSE or the NASDAQ) and individual and institutional investors can begin buying and selling it.
Why Are ETFs So Tax-Efficient?
ETFs are traded on exchange, while mutual funds are bought and sold directly from the fund company. How people enter and exit these funds makes all the difference: if a new investment is made in an ETF, shares of that ETF are typically bought on exchange as an existing unit, meaning that the underlying stocks or bonds it holds don’t have to be traded at all. Even in instances where very large investors enter or exit the fund, the creation and redemption process of ETFs means that almost all trading in the underlying securities happens outside of the fund. That means the fund itself doesn’t realize capital gains just because someone is coming or going.**
Mutual funds are very different. Whenever new shares are created, the buyer’s cash is typically used to go buy stocks or bonds. When an investor leaves, the mutual fund manager may have to go sell down stocks or bonds to deliver out cash. In other words, more trading happens inside the fund, potentially creating many small taxable events that build up over the year. At the end of every year, all funds must pay out any capital gains they have realized in the fund. For those reasons, mutual funds tend to pay out more capital gains distributions than ETFs. In fact, in 2022, 90% of ETFs did not pay out a capital gain distribution.***
Importantly, that doesn’t mean that you get to avoid capital gains taxes when you invest in ETFs: it just means you typically realize them when you make the decision to buy or sell your ETF, not because someone else did. This can help you manage your taxes based on your own circumstances. The benefit to that, notes Gargi Pal Chaudhuri, Head of iShares Investment Strategy Americas at Blackrock, “is that you get to control the timing of your tax bill, because you get to decide when to buy or sell your fund.”
How And Where Can You Buy ETFs?
To buy and sell ETFs, you’re going to need a brokerage account. You may already have one — say a retirement account like a 401(k) or IRA, or even a 529 college savings account, all of which may have access to ETFs — but you can also open a taxable brokerage account at any brokerage firm or robo-advisor. If you go with a taxable brokerage account, understand that you’ll be responsible for taxes each year resulting from investments that you sell for a gain or loss, or for any funds you own that paid out a capital gain distribution. Once you’ve opened an account, you can start researching ETFs. A good place to start could be with a core ETF or two (more on those below) before expanding your horizons. Keep an eye on underlying costs, which may include ETF management fees or brokerage commissions paid when trading ETFs (these days there may not be any, as many brokers have gone to commission-free trading) as well as whether there’s a minimum investment. In Chaudhuri’s view, this is a great thing — particularly for women. “Women and people of color have historically shied away from the market,” she notes. “Commission-free trading is really important because it means you’re less likely to be held back by the cost to enter.”
What’s The Best Way To Get Started With Them?
For any investor getting started, the best thing to do is to focus on controlling the things that you can control, says Kristy Akullian, CFA, Director on the iShares Investment Strategy Team and author of the iShares Institutional Weekly newsletter. “That means making sure you choose low-cost products and have a strategy around taxes,” Akullian explains. And although she says that eventually, you may have a specific sector or industry or country that you want to invest in, you should consider starting with a handful of core holdings.
For example, let’s say you are a younger investor (in your 30s or early 40s) looking to build a portfolio for your longer-term retirement goals. You’re comfortable with a mix of 80% stocks and 20% bonds. So, you might start with half of your portfolio in three U.S. ETFs (the lion’s share in IVV, the iShares Core S&P 500 ETF for large company exposure, with smaller positions in IJH, the iShares Core S&P Mid-Cap ETF for mid-caps, and IJR, the iShares Core S&P Small-Cap ETF for small-caps) then round out the picture with some international ETFs, such as IDEV, the iShares Core MSCI International Developed Markets ETF for developed markets, and IEMG, the iShares Core MSCI Emerging Markets ETF, for emerging markets. Finally, consider adding bond ETFs such as IUSB the iShares Core Total USD Bond Market ETF for broad US bond exposure, and IAGG, the iShares Core International Aggregate Bond ETF for international bond exposure. iShares.com provides a tool that allows investors to see how a mix of core holdings can work together, but importantly, as Akullian points out, “these are meant to be the kind of products that you buy and hold. Maybe you add to your portfolio over time. Occasionally, you rebalance. That way, you can keep more of what you earn by seeking to minimize fees and taxes.
What Disciplines Are Helpful If You Own ETFs?
The big one is rebalancing, Akullian says. No matter what the economy is doing, markets move and those movements can drive your asset allocations — the mix of stocks and bonds, large caps and small, domestic and international that you’ve selected as your optimal mix — out of whack. Rebalancing is fixing your mix. It’s understanding that your portfolio has drifted and the asset allocation needs to be brought back in line. “ETFs make that process of rebalancing much easier,” she says. “Both because they are transparent and you know exactly what you own, and because the cost of trading is generally low —or even free,” Akullian explains.
What If You Don’t Want To Rebalance Your Portfolio?
There’s a product for that as well. Asset allocation ETFs exist. You essentially pick the level of risk you want to take — conservative, for example, vs. aggressive — and you’ll get a mix in the portfolio that adheres to those basic tenets. For example, someone who wants to put together the 80/20 portfolio described above can select the individual ETFs, but they could also buy AOA, the iShares Core Aggressive Allocation ETF, an all-in-one solution that provides a mix of stock and bond ETFs for investors willing to accept a higher level of risk to target higher return. “These products make investing for your future as easy as saving for it,” says Akullian. “So many of my female friends, especially those with busy careers in other professions, use these products as their secret to staying invested without needing to make investing another full-time job.”
MORE ON HERMONEY:
- How to Handle Sudden Stock Market Moves
- Market Volatility: Is It Time To Get Used To It?
- Active vs. Passive Investing: Your 101 Guide
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