Exchange-traded funds (ETFs) are investments that hold a collection of assets similar to a mutual fund but that trade on an exchange, like a stock. ETFs give investors an efficient way to gain diversified exposure to a particular asset class or market segment in a single security rather than having to select and buy multiple individual securities. ETFs provide access to a variety of asset classes such as stocks, bonds, commodities, etc. ETFs have been widely adopted in building investment portfolios due to a variety of benefits, including diversification, low costs, tax efficiency, and transparency.
Benefits of ETFs
- Diversification: Rather than trying to pick winners and losers from across thousands of individual securities, ETFs provide diversified exposure to an entire asset class by tracking a market index. That might be the S&P 500® Index for U.S. large cap stocks, or the Bloomberg Barclays Corporate Bond Index for investment-grade corporate bonds. With research consistently showing that most active managers underperform their market benchmark, indexing has grown in popularity as an efficient and effective way to invest.1
- Low Costs: ETFs tend to have low management costs because their underlying securities are traded less frequently than actively managed funds and because ETFs trade on an exchange rather than through the issuer, requiring less paperwork and record-keeping by the fund provider. For example, the Schwab U.S. Large Cap ETF (SCHX) has an expense ratio of 0.03%, which translates to management costs of $3 per year for a $10,000 investment.
- Tax-efficient: The indexing approach of ETFs inherently results in low turnover. But the unique structure of ETFs provides tax-efficiency in other ways as well. Because ETFs trade on an exchange, in the majority of transactions, the underlying securities that the ETF holds are not bought or sold. The result is that most ETFs have few if any of the taxable capital gains distributions that are common to mutual funds each year. Additionally, ETFs also avoid capital gains distributions due to the way that ETF shares themselves are created and redeemed, which allows the ETF issuer to shed shares of its underlying securities with the lowest tax basis through "in-kind" transactions with institutional investors.2
- Transparency: With ETFs, you always know what securities you own. That's because ETF providers publish their holdings daily while mutual funds typically report their underlying securities quarterly, with a 30-day lag.
How do ETFs compare to mutual funds?
ETFs have some similarities with index mutual funds, but there are key differences. For example, you can only buy a mutual fund at the end of the day, at its closing price or net asset value (NAV). Because ETFs trade on an exchange like stocks, you can buy and sell shares at any time during the trading day at market price. This means that you can buy an ETF at its current intraday price.
While there are about six times more mutual funds than ETFs available in the market, ETFs have grown quickly in popularity. Over the last 10 years, ETF assets have grown from $777 billion to $3.4 trillion as of the end of 2018.3 Although the $14.7 trillion in total assets managed by equity, bond and hybrid mutual funds is significantly larger than that, ETFs' percentage of the two industries' combined assets has increased over that same time period, from less than 10% at the end of 2009 to more than 18% by the end of 2018.1
Schwab Intelligent Portfolios® uses ETFs because they provide an efficient, diversified investment vehicle for building and managing your portfolio at a low cost. Investing in a portfolio of ETFs that includes a diversified mix of asset classes based on your goals and risk profile can help you work toward achieving your financial goals, moderate the ups and downs of market volatility along the way, and keep costs low to avoid the potential for fees to erode your long-term returns.
1S&P Indices Versus Active (SPIVA®) report.
2ETF.com, "Why Are ETFs So Tax Efficient."
3Investment Company Institute Fact Book.