Exchange-Traded Funds (ETFs)

An exchange-traded fund is a pooled investment vehicle that provides investors with low-cost, diversified exposure to an asset class or group of asset classes. ETFs are sponsored by some of the largest, most reputable investment companies in the world, and they trade just like individual stocks on securities exchanges like the New York Stock Exchange and the Nasdaq.

Most ETFs are designed to be passively managed, tracking well-known indices such as the S&P 500 Index and the Bloomberg Barclays U.S. Aggregate Bond Index. However, as the popularity of these vehicles has grown, investment companies have introduced more exotic products, many of which utilize leverage and employ smart beta and derivatives-based strategies.

ETFs can be sensible in any investment plan, but they are especially strong options for retirement plans, given their inherent diversification, low-cost structure and hands-off nature. Mutual funds are an alternative to ETFs, but these vehicles have subtle differences, which we discuss in a subsequent section.

The first comes in the form of commission fees. Some brokerage platforms charge commissions up to $20 per ETF trade. However, this is growing increasingly uncommon. Today, the most competitive brokerage firms offer a large array of commission-free ETFs on their platforms.

The bid-ask spread is another common cost associated with ETFs. It arises because there is normally a difference, or spread, between the ask price (the per-share price at which an ETF can be bought) and the bid price (the per-share price at which an ETF can be sold).

The ask is normally higher than the bid, and the spread is compensation to the broker-dealer. It fluctuates over time, and it varies from one ETF to the next. It tends to be larger for ETFs with low trading volume.

Generally, the most significant fees associated with ETFs are the ongoing management fees charged by the sponsors. Generally, you can expect to pay less than 0.010% per year for passively managed domestic and international stock and bond funds. However, the expense ratios for actively managed and specialty ETFs may run much higher.

At the highest level, ETFs can be categorized as either passively or actively managed. Passively managed vehicles are designed to track specific indices, with little to no managerial discretion. Actively managed vehicles involve substantially more strategic and tactical decision-making and may incorporate specialized trading algorithms.

Beyond the passive vs. active distinction, there are many different types of ETFs. Some are designed to be portfolio solutions, providing exposure to a variety of asset classes. Others focus on specific asset classes, and still others focus on sectors or styles within asset classes. The offerings are increasingly broad.

In addition to the vehicles described above, there are a handful of more exotic ETFs in the market. Inverse ETFs are designed to profit from a decline in a specified index or market. Leveraged ETFs use borrowed money to amplify returns. Bitcoin ETFs provide exposure to bitcoin or assets closely related to the value of the cryptocurrency.

A stock is a financial security that represents an ownership interest in a specific company. When you buy a share of stock, you obtain a proportionate claim on the company’s net assets and future earnings.

A stock ETF share is different. It represents an ownership interest in a basket of underlying stocks and an indirect claim on all their net assets and future earnings.

For most investors, buying individual stocks is not an efficient way to build an investment portfolio. Doing so is costly, time-consuming and unlikely to produce an optimal degree of diversification. Utilizing low-cost ETFs is a better approach.

ETFs and mutual funds are both fund-style investment vehicles that provide investors access to a basket of assets. However, these vehicles trade differently.

ETFs trade like stocks and can be bought and sold throughout the day at fluctuating prices determined by the intersection of marketplace supply and demand. Conversely, the purchases and sales of open-ended mutual funds are transacted directly with the issuing fund company. Their prices are determined at the end of each trading day based on the fund’s underlying assets and liabilities.

Both ETFs and mutual funds can be passively or actively managed. Most ETFs are designed to be low-cost and passively managed, tracking well-known indices such as the S&P 500 and the Nasdaq Composite. Most mutual funds are actively managed, but passively managed vehicles, commonly referred to as index funds, do exist.

The most prominent benefit of ETFs is the fact they offer investors a very low-cost means to achieve a high degree of diversification. This is especially true for passive ETFs.

Investors also value that most ETFs are also highly liquid and easy to trade. You can buy or sell them at any time during regular trading hours, entering into and out of positions with minimal effort. Most ETFs are also very transparent, with regulations mandating clear visibility into their holdings daily.

ETFs, though, are not without their notable drawbacks. Some thinly traded ETFs exhibit relatively wide bid-ask spreads, which can be costly — especially if the investment is held for a very short time. In these circumstances, buying at the high end of the spread and selling at the low end of the spread can lead to an automatic loss.

ETFs are also exposed to the risk of tracking error, which means actual investment performance may deviate from the intended investment performance. For large, low-cost and passive ETFs, this usually isn’t a big issue. However, for low-volume, relatively expensive and more exotic ETFs, tracking error can be significant.

And finally, the popularity of ETFs has led to the introduction of an array of vehicles, many of which are complicated with a high degree of risk. For novice investors, exposure to these vehicles can detract from your ability to accumulate wealth.

The primary advantages and disadvantages of ETFs, whether implemented inside or outside of retirement plans, are highlighted below.

ETFs can be a great investment vehicle for all types of investment portfolios, but they are an especially strong option for retirement portfolios. Their highly diversified and passively managed structures are ideal for long-term, hands-off investing, and their modest fees enable you to fully capitalize on the power of compound interest.

That said, not all ETFs are the same. It’s important to do some research to identify an ETF (or collection of ETFs) that aligns with your investment objectives and tolerance for risk. If you have access to educational materials and research tools as part of your 401(k) plan or individual retirement account (IRA), be sure to leverage them to better understand your options. Ideally, discuss your situation with a fiduciary financial advisor.