What's an ETF?

What exactly makes up that basket of securities varies widely. The earliest ETFs were invested in stocks and sought to track the performance of broad-based, widely followed indexes such as the S&P 500 Index. Today, ETFs are invested not only in stocks, but also in bonds, commodities, and currencies; some more exotic ETFs seek to track market metrics such as interest rates or volatility. This diversity and flexibility have helped make ETFs popular choices for retirement plans and one of the fastest-growing segments of the investment universe globally.

The domestic ETF market has consistently grown in the past decade

Growth of ETFs ($B)

The difference between an ETF and a mutual fund

The main difference between an ETF and a mutual fund lies in how each is priced and traded. Buy and sell orders for mutual funds are processed after exchanges close at the end of the day. The value of all holdings in a mutual fund’s portfolio is then repriced, and the fund’s share price is recalculated; that figure is called a fund’s net asset value (NAV), and buy and sell orders are processed based on that figure.

An ETF, on the other hand, is bought or sold throughout the day on an exchange at a price the market determines, not at the NAV. Market makers use real-time pricing data of the ETF’s underlying investments to determine second-by-second pricing of the ETF during trading hours. The market price is generally very close to the value of the underlying securities in the fund because there’s a mechanism in place to either create new shares or redeem existing ETF shares. An NAV is still calculated after trading hours each day to align the value of the fund with the underlying securities.

Since employer-sponsored retirement plans often make their purchases after normal trading hours, this difference may be moot as both investments are bought at their end-of-day prices.

Why ETFs are generally less expensive: the potential built-in benefits of passive management

In the United States, only 3% of ETF assets regulated under the Investment Company Act of 1940 are in actively managed strategies—portfolios managed by teams of investment professionals with the goal of outperforming a benchmark index. Most ETFs—and the vast majority of ETF assets—are invested in passively managed strategies, which seek to track, rather than beat, the performance of a benchmark index, whether that index is the S&P 500 Index or the Bloomberg Aggregate Bond Index.² Over the past decade, passive ETFs have pulled in about $15 for every $1 in active ETFs.³

Tracking an index is one of the reasons ETFs tend to be relatively inexpensive. Once the benchmark index—in essence, an ETF’s blueprint—has been established, passive ETFs generally don’t need to finance research, management, and other functions to operate; actively managed strategies, on the other hand, do. The impact of a lower expense ratio over years of saving for retirement can potentially add up and may help put more money in your retirement account.

That said, there’s no inherent reason why passive ETFs have to track garden variety indexes. In fact, one of the newer trends among ETF providers has been to develop more targeted, outcome-oriented indexes; for example, indexes made up only of dividend-paying stocks or stocks that historically demonstrated low volatility. The sophistication of an ETF’s underlying index is limited only by the imagination of its creators. In addition, more and more active strategies are being deployed in the ETF structure to take advantage of the vehicle’s popularity and benefits.

How to incorporate ETFs into a portfolio

While there’s no one right way to use ETFs, one popular approach is to use passive ETFs to help gain broad exposure to particular markets and use actively managed mutual funds to seek to add value in other, more nuanced areas. Regardless of how it’s done, taking a purely active or purely passive approach is increasingly becoming the exception, rather than the rule.⁴ In fact, according to a recent survey, 66% of financial professionals recommended a blend of active and passive approaches for their clients’ portfolios.⁵

To see the role ETFs might play in your portfolio or retirement account, talk to your financial professional.

1 Owning exchange-traded funds (ETFs) generally reflects the risks of owning the underlying securities they are designed to track, which may cause lack of liquidity, more volatility, and increased management fees. Investing in an ETF involves risks, including the potential loss of principal. Investment return, price, yield, and net asset value (NAV) will fluctuate with changes in market conditions, and brokerage expenses and ETF expenses will reduce returns. ETFs traded in the secondary market may trade at prices above or below their NAV. ETF shares are generally not redeemable from the fund individually, but through units of shares that may be redeemed in aggregate. Investment policies, management fees, and other information can be found in the individual ETF’s prospectus. Certain non-index ETFs are non-diversified and may experience more volatility than index ETFs or mutual funds typically would. Certain single-stock or commodity-based ETFs may also pose increased risks or be more speculative in nature. As a result, investments in ETFs, and in particular certain single-stock or commodity-based ETFs, may not be suitable for all investors. 2 “2021 Investment Company Fact Book: A Review of Trends and Activities in the Investment Company Industry,” Investment Company Institute, 2021. 3 “Active ETFs Are Outperforming Expectations—Here Is Why,” Forbes, 6/25/21. 4 Diversification does not guarantee a profit or eliminate the risk of a loss. 5 “2020 Trends in Investing Survey,“ Financial Planning Association, Journal of Financial Planning, Janus Henderson Investors, August 2020.