Most investors understand what stocks are and how they work. A lot of investors also know about exchange-traded funds (ETFs), which trade like stocks in that they are available to buy and sell while the market is open, but typically mimic a basket of securities similar to index mutual funds.
However, there are some prevalent misconceptions associated with ETFs. Here, we explain 5 facts of ETFs that may surprise you.
Fact #1: Not all ETFs are relatively cheap
Overall, investors paid lower expense fees than ever before, benefiting from the largest yearly decline in fund expenses on record. The average expense ratio for all mutual funds and ETFs was 0.52% (meaning investors paid $0.52 for every $100 dollars invested for all funds on average), an 8% decline from 2017, according to Morningstar. That amounted to $4 billion in year-over-year savings for investors.
The decline in expenses is a longer term trend, and has been quite dramatic in some cases. For example, the average expense ratio for equity mutual funds has fallen 8 consecutive years on an asset-weighted basis, and declined from 0.99% in 2000 to 0.59% in 2017.1 On an asset-weighted basis, the average index equity ETF expense ratio has declined from 0.28% in 2005 to 0.21% in 2017.1
Fund expenses have been in decline for several years.
Several factors have contributed to the trend, including expense ratios varying inversely with fund assets, a shift toward no-load share classes for long-term mutual funds, economies of scale, investor preferences, and competition from ETFs.
Most ETFs continue to be less expensive than actively managed funds. But it’s a mistake to assume that all ETFs are cheaper.
For example, mutual fund Fidelity® 500 Index Fund – Premium Class (FUSVX) has an expense ratio of 0.035%, and it has no transaction fee on Fidelity.com.2 That compares favorably with similar ETFs, such as the SPDR S&P 500 ETF (SPY) with an expense ratio of 0.09%. The iShares Core S&P 500 ETF (IVV) has an expense ratio of 0.04%, but has the added benefit of being among iShares® ETFs that are available for purchase commission-free on Fidelity.com. This example assumes a minimum $10,000 investment in the Fidelity® 500 Index Fund; ETFs do not require a minimum investment.
It’s worth noting that expense ratios aren’t the only thing to consider when evaluating ETF costs. Tracking error, which is a measure of how well the ETF tracks the index, can affect the total return of an ETF. If you are looking to simply emulate the performance of a benchmark, like the S&P 500® Index, it may be prudent to seek out ETFs with low tracking error.
Bid-ask spread is another factor that can affect your total cost. An ETF with a wider bid-ask spread—the difference in price between what a buyer is willing to pay and what a seller is willing to sell—may be more costly, all else being equal. You can find an ETF’s bid-ask spread, along with its tracking error and other trading costs, on Fidelity.com on an ETF’s snapshot page.
Fact #2: ETFs can pay dividends
If a stock is held in an ETF and that stock pays a dividend, then so does the ETF.
While some ETFs pay dividends as soon as they are received from each company that is held in the fund, most distribute dividends quarterly. Some ETFs hold the individual dividends in cash until the ETF’s payout date. Others reinvest the dividends back into the fund as they are received, and then distribute them as cash on the ETF’s payout date.
ETFs may provide the option of forgoing receiving cash in exchange for the purchase of new shares with the dividends received. And certain brokers, including Fidelity, might allow you to reinvest dividends commission-free. You can find out if and how an ETF pays a dividend by examining its prospectus.
Fact #3: Not all ETFs are passive
Most ETFs track an index, such as the S&P 500® Index. These types of investments are considered "passively managed." Any purchases or sales of securities by the fund are made to keep the portfolio in line with the index it attempts to track. As previously mentioned, tracking error is a metric that can help you see how well an ETF replicates the performance of an index.
"Smart beta" ETFs are a growing category of ETFs that are passively managed; however, they seek to either improve their return profile or change their risk profile, relative to a benchmark. This is accomplished by tilting one or more factors of the corresponding benchmark, such as increasing or decreasing exposure to growth or value characteristics.
There are some ETFs that, by design, do not strictly track an index. Instead, they are actively managed with the goal being to outperform a benchmark like the S&P 500. The fund manager for an actively managed ETF may choose to hold different securities, and/or in different weights versus those of the index that the ETF seeks to outperform.
Fact #4: Not all ETFs are tax-efficient
Taxes are an important consideration for any investment. In general, ETFs are considered tax-efficient compared with actively managed funds due to their unique structure, generally lower portfolio turnover, and how they are managed. One of the primary advantages of the ETF structure is that when an investor buys or sells shares of the ETF, the ETF administrator can match purchases and sales with other investors so that no actual security purchases inside the fund need to be made.
With that said, not all ETFs are absolutely tax-efficient.
For example, ETF dividends are subject to taxes, and ETFs that pay nonqualified dividends may be less tax-efficient than those that pay qualified dividends. Annual distributions from an ETF to investors may be treated as qualified or nonqualified dividends. Qualified dividends are taxed at no more than 15%. However, just because the ETF reports that its distribution was a qualified dividend, that does not automatically make it qualified for the investor. The investor must have held the ETF for at least 61 days during the 121-day period beginning 60 days before the ex-dividend date.
It may be possible to invest tax-efficiently with ETFs by selecting those that minimize capital gains distributions and maximize exposure to qualified dividends. If minimizing taxes is a concern, consider consulting a qualified tax advisor. And make sure to evaluate any investment option with your time horizon, financial circumstances, and tolerance for risk in mind.
Fact #5: Not all ETFs are highly liquid
A primary advantage of ETFs, compared with other funds, is their flexibility—continuous pricing and the ability to place limit orders. However, these characteristics do not ensure that all ETFs are highly liquid, meaning you are able to buy or sell at or near your desired price.
There are several ways you can find highly liquid assets—including ETFs. As previously mentioned, a low bid-ask spread may indicate a robust market of buyers and sellers. Average daily volume is another indicator of liquidity. Volume is the number of shares traded: Investments with high volume and, consequently, greater liquidity, tend to be more efficient.
For example, iShares Core S&P 500 ETF (IVV) has a bid-ask spread one-month average of 0.01%, which is as low as this spread can be. Some more narrowly focused ETFs have much wider bid-ask spreads, which could cause trading in them to be relatively more expensive. Additionally, IVV is in the top quintile of 90-day average volume among ETFs, as shown on Fidelity.com.
A few last tips
Once you have identified an ETF in the asset class, sector, or region of the market that you want to invest in, you can use a tool like an ETF screener, for example, to find ETFs in this space with your desired attributes, such as a low average daily bid-ask spread and high average daily trading volume.
Other tools, like Fidelity’s ETF research page, can help you investigate additional characteristics of an ETF you are analyzing, including the underlying fundamentals of the stocks within the fund. Once you home in on an ETF that looks attractive to you, it may also be beneficial to utilize limit orders when placing a trade to ensure that you are executing at a price you are comfortable with.
Next steps to consider
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ETFs are subject to market fluctuation and the risks of their underlying investments. ETFs are subject to management fees and other expenses. Unlike mutual funds, ETF shares are bought and sold at market price, which may be higher or lower than their NAV, and are not individually redeemed from the fund.
Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.
Indexes are unmanaged. It is not possible to invest directly in an index.
Exchange-traded products (ETPs) are subject to market volatility and the risks of their underlying securities, which may include the risks associated with investing in smaller companies, foreign securities, commodities, and fixed income investments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks, all of which are magnified in emerging markets. ETPs that target a small universe of securities, such as a specific region or market sector, are generally subject to greater market volatility, as well as to the specific risks associated with that sector, region, or other focus. ETPs that use derivatives, leverage, or complex investment strategies are subject to additional risks. The return of an index ETP is usually different from that of the index it tracks because of fees, expenses, and tracking error. An ETP may trade at a premium or discount to its net asset value (NAV) (or indicative value in the case of exchange-traded notes). The degree of liquidity can vary significantly from one ETP to another and losses may be magnified if no liquid market exists for the ETP's shares when attempting to sell them. Each ETP has a unique risk profile, detailed in its prospectus, offering circular, or similar material, which should be considered carefully when making investment decisions.
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