What is an exchange-traded fund?

We explain what ETFs are, how to use them, and how to find the best ones

Karen Wallace 19 November, 2019 | 1:38AM

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ETFs (or exchange-traded funds) are hybrid investment vehicles that can offer relatively low-cost and tax-efficient exposure to a variety of asset classes and investment strategies. Like traditional mutual funds, most ETFs invest in a diversified portfolio of stocks and bonds. Unlike traditional mutual funds, ETFs trade on a stock exchange. 

The majority of ETFs are passively managed, which means they track an index. That said, a growing minority of them are actively managed. Irrespective of whether they are tracking an index or delivering an active strategy, ETFs tend to have lower annual expenses relative to mutual funds. That said, because they trade like stocks, investors should account for transaction costs (commissions, bid-ask spreads, and so on).  

ETFs are often lauded for their tax efficiency compared with traditional mutual funds. There are two main reasons ETFs are often more tax-efficient. First, most ETFs are index funds. And index funds, especially large-cap index funds or total-market index funds that are weighted by market cap, have fairly low turnover. Low turnover means fewer opportunities to realize gains when securities are sold from the portfolio. ETFs' structure is the second, more important driver of their tax efficiency. ETF shares are created and destroyed via in-kind transactions between ETF sponsors and a special kind of market maker known as an authorized participant. As such, ETFs tend not to have to directly sell positions from their portfolios to meet redemptions, which protects investors from taxable capital gains distributions. 

Investors should be aware that tax-efficient doesn't mean tax-free, though. The primary benefit of ETFs from a tax perspective is that they can allow investors to defer the realization of capital gains taxes. Investors in ETFs will still pay taxes on regular distributions of income, and they will also pay capital gains taxes when they sell an ETF for more than they paid for it. Also, some ETFs will distribute capital gains, though they tend to be less frequent and of lesser magnitude than those their mutual fund counterparts generate. 

How to find the best ETFs
Morningstar Analyst Ratings can help you identify topnotch ETFs in nearly every asset class. Our analysts carefully evaluate exchange-traded funds, paying particular attention to the fund's process; they tend to favor ETFs that are very broadly diversified, low-cost, and sponsored by solid parent firms. 

The ETFs that attract the most investor dollars tend to be in "core" categories such as large-cap equity, foreign large-cap equity, and intermediate-term core bond, which are often used as the main building blocks of investors' portfolios. 

We assign positive (Morningstar Medalist) ratings to ETFs that we believe can outperform the median fund in the Morningstar Category, after fees. The ETFs we expect to outperform by the widest margin are rated Gold; our next-highest conviction picks are rated Silver, followed by Bronze. 

We hold ETFs that fall under the heading of strategic- or smart-beta to a different (higher) standard. At Morningstar, we think of strategic-beta ETFs as index funds that make active bets: They are linked to indexes that focus on one or more factors--such as value, momentum, or low volatility, in an effort to improve their returns or alter their risk profiles relative to traditional market benchmarks. Because of this, we require strategic-beta funds to surpass a tougher hurdle: They need to convince us they can beat the category index after fees (not the median fund in the category). Our assessment of process is the most important consideration behind the rating for those funds. 

We also assign Analyst Ratings to a number of actively managed ETFs. We put these funds through the same paces as we do actively managed mutual funds, while paying close attention to how the potential constraints of delivering an active strategy in the ETF format might affect the management team's process.

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About Author

Karen Wallace

Karen Wallace  Karen Wallace, CFP® is Morningstar’s director of investor education.