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. Unlike mutual funds, which trade at the end-of-day NAV, ETFs trade like any exchange-traded security (with intraday pricing). Of course, there is also the increasing prevalence of active ETFs that have additional unique aspects.
However, there are some prevalent misconceptions associated with ETFs. Here are 5 aspects of equity (i.e., stock) ETFs that may surprise you.
1. Are all ETFs relatively cheap?
A characteristic of ETFs that has helped drive their popularity among investors is cost relative to other funds. Indeed, the decline in expense ratios for both ETFs and mutual funds is a longer-term trend that largely reflects competition driving down costs (see Fund expenses have been in decline for over a decade).
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 comparable ETFs continue to be less expensive than mutual funds. But it’s a mistake to assume that all ETFs are cheaper.
For example, mutual fund Fidelity® 500 Index Fund (FXAIX) has a net expense ratio1 of 0.015%, 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% and the iShares Core S&P 500 ETF (IVV) with an expense ratio of 0.03%. It is worth noting that Fidelity offers zero expense ratio index mutual funds.
Of course, 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 performance of a benchmark, 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 receive as payment—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. By comparison, mutual funds trade at the net asset value and the buyer/seller is not subjected to a bid-ask spread.
2. Do ETFs 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.
3. Are all ETFs 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.
"Smart beta" ETFs are a category of ETFs that are passively managed; however, they seek to either improve their return profile or change their risk profile, relative to a market benchmark. This is to say that smart beta ETFs are passively managed in that they attempt to replicate the exposures of a benchmark, but that the composition of the benchmark may not necessarily look like that of any market index, as it has been engineered to represent a targeted factor exposure. This is accomplished by tilting one or more factors of the corresponding benchmark, such as increasing or decreasing exposure to growth or value characteristics relative to a market index.
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.
4. Are all ETFs tax-efficient?
Taxes are an important consideration for any investment held in a taxable account. In general, passive ETFs are considered tax-efficient on an absolute basis 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. As a result, this creation/redemption structure avoids triggering a taxable event.
With that said, not all ETFs are equally 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. ETF investors, like mutual fund investors, are subject to the relevant tax rates on distributions that flow through to end investors, whether they take the form of dividends on stocks or coupon payments on bonds.
It's also possible to invest tax-efficiently with ETFs by selecting those that minimize capital gains distributions and maximize exposure to qualified dividends, as well as holding tax-inefficient ETFs in tax-deferred or tax-exempt accounts. If minimizing taxes is a concern, consider consulting a qualified tax advisor.
5. Are all ETFs relatively liquid?
A primary advantage of ETFs, compared with other similar mutual funds, is their trading flexibility—continuous pricing and the ability to place limit orders. However, these characteristics do not ensure that all ETFs are highly liquid (with highly liquid meaning you may be able to buy or sell your desired quantity at or near the prevailing market 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. Of course, it may not be indicative of the prevailing spread for trades of significantly different size. 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. Additionally, IVV is in the top quintile of 90-day average volume among ETFs, as shown on Fidelity.com. Some more narrowly focused ETFs have much wider bid-ask spreads, which could cause trading in them to be relatively more expensive.
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. And make sure to evaluate any investment option with your time horizon, financial circumstances, and tolerance for risk in mind.