Know your ETFs: key reasons to invest

There are many great investment tools available for investors to reach their objectives. Choice, as every consumer knows, is wonderful, but understanding the various options is important.

For millions of people, the chosen option continues to be exchange-traded funds (ETFs). From humble beginnings in the 1990s, ETFs have become a veritable juggernaut in the world of investments (Chart 1). The ETF is a transformational vehicle, and its crucial benefits have won over both individuals and institutions.

Chart 1. Development of assets of global ETFs 2003–2023 (in billion US dollars)

Diversify your portfolio

We’ve all heard the adage, “Don’t put all your eggs in one basket.” In an investment context, this advice speaks to the importance of being properly diversified. Diversification can enhance risk-adjusted returns over time, helping to protect a portfolio against a sharp drop in one holding or asset class. (1)

ETFs can offer compelling benefits in terms of diversification. From an asset allocation standpoint, owning ETFs can complement and augment the other building blocks of an investor’s portfolio – whether that’s cash or cash equivalents, individual securities (equities or fixed income), or alternative investments (e.g. private equity, hedge funds, real estate, etc.).

Meanwhile, ETFs allow for diversification because they offer investors access to such a wide range of stocks and bonds. There are ETFs that seek to track broad market indices (such as the Nasdaq 100®), strategies that complete parts of a portfolio such as value, growth, or income, as well as funds that focus on specific countries or sectors. Each investor can buy the mix of ETFs that helps to meet their unique needs and objectives.

Individual and institutional investors can also choose from passive and active ETFs. Passive ETFs buy and hold a basket of securities, which are typically representative of an index, sector, or country. Unlike, say, a traditional active mutual fund, a passive ETF does not have portfolio managers who aim to buy certain securities (and avoid others) in a quest for outperformance. These types of ETFs often sport lower fees, as the fund provider doesn’t need to maintain expensive teams of analysts and portfolio managers.

While passive funds still dominate the ETF space, investors now have increasing access to actively managed ETFs. These function in the same way as traditional (i.e., passive) ETFs but have professional managers at the helm buying and selling in a bid to outperform an index or other benchmark.

Low cost and easy access

Two features that have made ETFs so popular are their lower fees and ease of access. Take cost, for starters. Compared to mutual funds, ETFs have significantly lower management expense ratios (MERs). ETF fees generally range from around 0.1%–0.45%, depending on the strategy and whether they are passively or actively managed.(2) For comparison, the average expense ratio for actively managed mutual funds is between 0.5% and 1.0% and rarely exceeds 2.5%.(3)

ETFs are also super-easy to access. Anyone with a brokerage account (whether self-directed or through an advisor) can buy and sell ETFs. Indeed, with online trading, this can literally be done with the click of a few buttons. Moreover, the management fees associated with owning an ETF tend to be inexpensive. For a simplified example, an investor who buys $10,000 of an ETF with a 0.1% management expense ratio would pay $10 to the fund provider each year. Trading costs (which are paid to an investor’s broker) are a separate cost.

ETFs are accessible in another way as well: there’s no minimum purchase. This makes them ideal for individuals who are just starting to build a portfolio. Mutual funds, on the other hand, typically require a minimum investment.

Intra-day trading

Another advantage of ETFs is that you can buy and sell them throughout the trading day. So, while we don’t recommend attempting to time the market, you do have the ability to respond to market changes as they happen.

Intra-day trading is also crucial because it allows investors to buy and sell a holding instantaneously. This allows you, for instance, to quickly raise funds if you spot another investment opportunity. You don’t have to wait for the close of trading to know the price you’ll receive, either.

Intra-day trading is available for all ETFs, including those that trade less frequently. For those ETFs, which can have more price fluctuations, it is best practice to use a limit order or wait until after the market has been open for an hour or so.(4)

Tax efficiency

Returns matter for investors, but what really matters are after-tax returns. Fortunately, the way ETFs are designed can help minimize the taxes paid by investors holding the ETF. Without going into too many details, ETFs can engage in ‘in kind’ transactions for their underlying securities, which avoid the realization of capital gains. Although rare, it is possible for an ETF to experience a capital gain based on trading activity within the ETF. This leads to lower capital gains taxes payable for those who hold an ETF in their portfolio. So, while investors will still realize capital gains for the increase in their purchase price vs. their sale price, trading activity within the ETF likely won’t have any tax implications.5

Price efficiency

Price matters. Whether you’re buying a sweater, a car, or an ETF, you want to feel confident that you won’t pay more than something is currently worth or sell for less than you could get. The good news is that ETFs have two mechanisms that contribute to the price efficiency. First, each ETF has one or more designated authorized participants (APs). These are typically brokerage firms or other trading companies. APs may deal both in a given ETF, as well as that ETF’s underlying assets – creating and redeeming units of a fund in the process.

Net asset value (NAV)

If the market price of an ETF is trading at a discount to its net asset value (NAV), an AP can deliver units of the ETF to the fund’s provider, taking the ETF’s basket of securities in return.

On the flip side, if an ETF is trading at a premium to its NAV, an AP can profit by doing the reverse: Buying securities and delivering them to the fund provider in exchange for ETF units. This kind of arbitrage is profitable for the AP and brings the market price of a fund in line with its value.

Market markets

A second layer of price efficiency in ETFs arises due to the actions of what are known as market makers. Market makers are trading firms designated to provide liquidity when required. These firms post bids and ask for quotes throughout the trading day, allowing prospective buyers and sellers to trade in an ETF. As with APs, market makers can help arbitrage away any significant premium or discount in an ETF relative to its underlying NAV – buying if an ETF is trading at a discount and selling if it’s trading at a premium.

Transparency (know what you own)

A final but still crucial benefit of ETFs is their transparency. In other words, investors know what they’re buying, and they know what they’re selling. ETFs differ in the amount of transparency they provide, but in both cases, there is sufficient disclosure for someone to make an informed decision.

Fully transparent ETFs publish their complete list of holdings daily. That means the market knows at the end of each trading day which securities an ETF owns – and exactly how many. On the other hand, semi-transparent ETFs shield some level of detail to protect their investment process. To facilitate transparency, these funds publish what is known as an indicative NAV. Usually updated every 15 seconds throughout the trading day, an indicative NAV tells the market what a fund’s underlying holdings are worth.

Semi-transparent ETFs also publish a proxy basket for market makers. While not a fund’s actual portfolio holdings, this basket is designed to be sufficiently representative to encourage trading firms to keep providing liquidity to the market.

Examining the ETF landscape

Historically, most ETFs have been passive. But that’s starting to change, with more and more active ETFs coming to market. The growth in active ETFs is largely the result of traditional fund managers realizing that the ETF is a great wrapper and investment vehicle for a broad range of strategies. The result is that investors have more choice than ever before.

Active vs. passive ETFs defined

Passive ETFs are designed to track a particular index or sector and do not aim to “beat the market.” Rather, they tend to own a basket of securities (based, for example, on market capitalization). The buying, selling, and rebalancing process for these strategies is based on a specific set of rules outlined in the product’s methodology.

While they can be rebalanced occasionally if, say, an index is altered, they don’t engage in buying or selling for the purpose of generating excess returns.

By contrast, active ETFs are designed to outperform a benchmark index or sector. Helmed by professional fund managers, these ETFs may employ a proprietary mix of quantitative and qualitative investment strategies to inform buy and sell decisions. Ideally, an active ETF will deliver ‘alpha’ to investors, that is, a risk-adjusted return that beats a given benchmark.

Why investors might choose either an active or passive ETF

Both styles of ETFs have merits. Passive ETFs might be the right choice for investors who seek index-like returns and prioritize very low fees. Meanwhile, investors may gravitate toward active ETFs due to a desire to outperform the market – and a belief that their ETF is led by professional managers with the ability to do so.

Final thoughts

The scope of ETFs has broadened considerably in recent years. Investors can still access a wide range of passive vehicles but now have the choice of adding active ETFs to their portfolios. Understanding the nuances behind the different products is a must to help ensure you own the ETF that best fits your objectives.

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1) Diversification does not eliminate the risk of experiencing investment losses.
2) "Key Benefits of ETFs." Nasdaq, March 2023.
3) "What Is a Good Expense Ratio for Mutual Funds?" Investopedia, March 2024. https://www.investopedia.com/ask/answers/032715/when-expense-ratio-considered-high-and-when-it-considered-low.asp.
4) A limit order is a direction to purchase or sell a stock or other security at a specified price or better. This stipulation allows traders to better control the prices at which they trade.
5) Please note that (i) any discussion of US tax matters contained in this communication cannot be used by you for the purpose of avoiding tax, penalties and/or interest which may be imposed by the IRS or any other taxing authority; (ii) this communication was written to support the promotion or marketing of the matters addressed herein; and (iii) you should seek advice based on your particular circumstances from an independent tax advisor. Investors should confer with their personal tax advisors regarding the tax consequences of investing based on their particular circumstances. Investors and their personal tax advisors are responsible for how the transactions conducted in an account are reported to the IRS or any other taxing authority on the investor’s personal tax returns. abrdn assumes no responsibility for the tax consequences to any investor of any transaction.