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Dec. 21, 2019, 9:52 a.m. EST

What is an ETF?

They may sound technical, but exchange-traded funds are investor-friendly: low-cost, tax-advantaged, transparent, and more

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By Andrea Riquier

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The Index tracked by an ETF may be something already known in the market — say the S&P 500 /zigman2/quotes/210599714/realtime SPX +2.62%   — or may be something fund managers create on their own. That strategy could be a broad investing theme, like only “momentum” stocks, or it could take a more tailored approach like the idea described in this story about a fund that invests in Chinese companies, but avoids those owned by the Chinese government.

Every so often, usually annually, an ETF manager will review the holdings in the fund and make sure they still match up to the mission set out as the fund’s original objective. But in general, there’s far less buying and selling of the securities that make up a passively-managed fund than an actively-managed one, which helps keep investor fees much lower.

Investors pay less for ETFs in both the active and passive categories than for mutual funds.

You should always read the fund documentation before investing to be sure. Some ETFs offer lower teaser fees to start off, with the understanding that the fee may increase in time.

Also make sure you know the specifics behind the index that the fund tracks. Some funds may have similar-sounding names or themes. Here’s one example:

Three granddaddies of the ETF universe, iShares’ Core S&P 500, /zigman2/quotes/204263249/composite IVV +2.61%  , Vanguard’s 500 Index Fund, /zigman2/quotes/201209218/composite VOO +2.56%  and the SPY ETF, formally known as SPDR S&P 500 Trust /zigman2/quotes/209901640/composite SPY +2.56% , all passively track the benchmark S&P 500 stock index.

But there’s another set of funds that takes the same 500 stocks, but assigns them all an equal index weighting, rather than letting stocks with bigger market capitalizations dominate the index. One example of an equal weight ETF that tracks the S&P 500 index comes from Invesco: /zigman2/quotes/202854823/composite RSP +3.69%  A tweak like that can sound small but have a sizable impact on returns, so it’s important to know what you’re buying into.

ETF drawbacks

There is one downside: ETFs are far less available in traditional employer-sponsored retirement plans. Like stocks, ETFs can’t easily be bought in fractions, Stevens notes, which is what needs to happen when small percentages of employee paychecks are making regular, ongoing purchases of a fund.

More to the point, “many of the key features of ETFs become far less appealing in a 401(K) plan,” Morningstar’s Ben Johnson says. Most employer-sponsored retirement plans offer access to low-cost indexed mutual funds. What’s more, the tax efficiency mentioned above is moot in a pre-tax investment structure like 401(k)s. Finally, the other advantage of ETFs mentioned here, tradeability, “is not something you want 401(k) participants to be doing,” Johnson says. “You want them focused on the long-term.”

ETF investing opportunities

There are all kinds of ways to slice and dice the ETF universe. Some funds track specific asset classes — that is, they include only stocks or bonds or commodities. Some take a thematic approach, like this one that includes shares of companies that have a commitment to “conscious capitalism” and accountability to multiple stakeholders.

Like SPY, VOO, and IVV, mentioned above, many funds simply track an index that already exists. Such passive funds often beat those that are proactively managed, although there’s also research showing bond managers do better than those who invest in stocks.

Some ETFs have specific purposes, like this one that offers to provide a “buffer” against a drastic decline in stocks.

Related coverage:

What is asset allocation?

Want to invest in Saudi Aramco? There’s an ETF for that.

Tech innovation is changing the world, and this ETF manager has big bets on how it’s going to work

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Andrea Riquier reports on housing and banking from MarketWatch's New York newsroom. Follow her on Twitter @ARiquier.

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