Exchange traded funds, or ETFs for short, are a popular type of investment for retirement savers and traders alike. In fact, as of the end of 2023, investors have poured over $8 trillion dollars into ETFs.1 So why are ETFs so popular? Read on to learn the advantages of investing in ETFs, and how to decide for yourself if ETFs could be a benefit to your portfolio and investing strategy.
What is an ETF?
ETFs are funds containing groups of securities, like stocks or bonds, often organized around a specific theme, like a sector or market index (for example, the S&P 500® Index or Nasdaq composite index). When you buy an individual stock, you’re only getting exposure to a single company. But with an ETF, just like a mutual fund, a single trade can gain you exposure to hundreds or even thousands of different companies or bonds—all bundled into a single fund. ETFs trade like a common stock on an exchange, and therefore, they experience price changes throughout the day as they're bought and sold. Individuals can buy an ETF through a broker—like a financial institution or a bank.
Why do investors choose ETFs? Here are some of the main advantages.
Advantages of ETFs
Low costs
To offset the administrative costs associated with running and managing an ETF, investors are charged an "expense ratio." These fees are represented and paid as a percent of your investment in the fund. However, fees for ETFs are often quite low compared to other investment alternatives—for example, the average ETF costs half as much as the average mutual fund (0.50% vs 1.01%).2
Ease of trading
ETFs help make trading easier in 2 main ways: 1. Bundling securities 2. Trading on exchanges.
When you buy an ETF, you are gaining exposure to potentially hundreds of different securities at once. If you were to try to replicate that on your own, it would not only be very expensive, but also very time-consuming. Imagine trying to replicate the S&P 500 on your own—that would involve placing more than 500 different trades—not to mention adjusting how much you invest in each to match the index. ETFs allow you to buy into ready-made portfolios that are managed to track specific themes or indexes.
And ETFs can be easy to trade. ETFs are listed on public exchanges, which means you can buy and sell them throughout market hours just like stocks. You can also see their prices change throughout the trading day in real time.
Diversification
You’ve heard it before: "Don’t put all your eggs in one basket." Investor-speak for this idiom is diversification, according to which, by spreading your money across many different investments, you help minimize your risk of loss from a single investment’s poor performance.
Because ETFs, like mutual funds, generally hold dozens if not hundreds of different investments, they are naturally more diversified than investing in an individual stock or bond. But be careful when choosing an ETF, to see exactly how diversified the fund is. Like mutual funds, some ETFs have a very narrow investment focus—tracking only the price of gold, or only Treasury bonds, or only pharmaceutical companies— and those funds will be less diversified than ETFs that track broad stock indexes, for example.
Wide menu of investment options
There are thousands of ETFs out there, each generally with a different mandate, a different strategy, or a different approach. There are now ETFs that track virtually every major asset class, commodity, and currency in the world. Whether you’re looking for an ETF that follows a popular stock-market index, invests in only a specific type of bonds like corporate bonds, or follows the performance of the US dollar, there’s likely an ETF out there that can help you gain that exposure.
Some aggressive investors who are looking to execute on a particular investing strategy may also appreciate the ability to buy levered or inverse ETFs. Some levered ETFs’ price will move 2 or 3 times the daily price movement of a given index, giving high-risk investors a tool to gain more exposure with their dollars over the short term. And inverse ETFs aim to move in the opposite direction of an index or benchmark’s performance, meaning an investor could use an inverse ETF to enter a short position and potentially profit off a price decline. Keep in mind, both of these options are significantly higher risk than traditional ETFs, and these funds are generally not suitable for buy-and-hold investors.
Curious where you can research ETF options? Check our ETF screener.
Tax advantages
When investing in a taxable account like a brokerage account, you generally have to pay taxes when your investments generate income (like a dividend, or bond coupon) or if you sell an investment for more than what you bought it for (generating a capital gain). These same taxes that apply when trading stocks or bonds also apply to funds, like ETFs and mutual funds.
However, ETFs are structured in a unique way that can help reduce the annual taxes investors face on the shares they hold. Learn more about the inside workings of ETFs. ETFs that track an index generally make few changes to their holdings, which can further help improve tax efficiency. Lastly, ETFs can be a useful tool for investors interested in tax-loss harvesting.
Transparency
ETFs provide investors a lot of transparency into what they invest in, more even than many mutual funds. ETFs that track an index generally tell investors their full portfolios daily, which can help you know more about how your dollars are invested. With your dollars, knowledge is power. And knowing where your dollars are employed can help you determine which ETF fits your investing goals.
Disadvantages of ETFs
Not all ETFs may be suitable
Although there are relatively low-risk ETFs that are diversified and invest in hundreds of different securities, others ETF options are more concentrated with aggressive investment strategies or investing in high-risk securities. These ETFs may not be suitable for the average investor. So just because something is an "ETF," don’t think that automatically means that investment is low-risk or diversified.
Trading costs may apply
Some financial institutions may charge commissions or fees to buy or sell ETFs. Before opening an account or placing a trade, it’s a smart idea to see what fees may apply to transactions. Fidelity does not charge any of these fees. Although many ETFs are bought and sold thousands of times a day, some more specialty ETFs may have a lower trading volume. That means when trading, there may be a gap between the bid (what someone is willing to pay to buy) and the ask (what someone is willing to pay to sell). If an ETF isn’t traded frequently, the spread between the bid and the ask may be large and could mean you’ll be forced to sell shares of that ETF for a small discount, buy for a small premium, or wait to trade until the spread shortens.
Lack of customization
By buying an ETF, you are buying into a fund. But because these securities are premade funds, you don’t get a say in what the fund invests in. ETFs can’t be personalized, so if you invest in one, you’re committed to owning whatever’s in the ETF.
Are ETFs right for you?
If you’re looking for a diversified investment, ETFs might be a great option for you. Whether you’re looking to invest in bonds, sectors of the stock markets, or major market indexes, like mutual funds, ETFs can help you gain diversified exposure in a single trade. Before buying any ETF or making any investment decision, make sure to thoroughly read and investigate the fund’s mission, what the fund is invested in, the expense ratio of the fund, and how the fund is rated by third-party research firms, like Morningstar. And also, make sure you have a plan for how the ETF fits into your broader asset allocation and investment plan, and consider whether the fund aligns with your investment goals, risk tolerance, and time horizon.