What are ETFs, and are they right for you?

Faced with a range of investment vehicles that might always seem to be changing, it’s important for investors to understand the options that are available to them.

In recent years, exchange-traded funds (ETFs) have become an increasingly popular choice for investors looking to diversify their portfolios. ETFs are a basket of investments, such as stocks, bonds and commodities, that trade on an exchange.

ETFs are typically compared to mutual funds in how both products provide access to a diversified pool of investments. But ETFs differ from mutual funds in a few key aspects that may make them more appealing to some investors.

For example, the price of ETF shares fluctuate throughout the day on the market, which means ETFs provide intraday liquidity compared to mutual funds, which trade once a day after the market closes. Additionally, most ETFs also have less-expensive management fees than mutual funds.

Although mutual fund assets still remain high, with more than $17.7 trillion in assets under management in 2022, according to Federal Reserve data, that number is dropping as ETF assets continue to rise. ETFs have taken in nearly $400 billion in 2022 alone, bringing the total assets under management to over $6 trillion, according to Morningstar.

“ETFs are recognized as efficient investment vehicles offering investors exposure to a wide variety of asset classes,” says Matt Heerey, ETF portfolio analyst, Managed Portfolio Strategies at RBC Wealth Management–U.S.

Democratize investing

Heerey says ETFs are an appealing choice for many investors because they “democratize investing” by enabling both new and experienced investors to access markets and strategies previously not available to them, and typically at lower costs.

For instance, beyond traditional equity and fixed income asset classes, you can also purchase ETFs that invest in natural resources, commodity markets, alternative strategies, and more. ETFs can be used as core portfolio positions for a long-term oriented investor, or used to express a near-term view on the market or a sector.

“They’re truly multi-functional tools,” Heerey says. “I think of them as building blocks that you can use to build a diversified portfolio, utilizing a transparent, liquid investment vehicle that many investors can understand.”

ETFs can be used to fill gaps in a portfolio, such as adding commodity exposure or more investments in gold or real estate. There are also a growing number of thematic ETFs on the market that cover emerging trends, such as cybersecurity or clean energy.

“The adage that ‘there’s an ETF for everything’ is close to true,” Heerey says.

New to ETFs? What to look for

Investors new to ETFs should start by choosing the desired asset class exposure, says Tylar Lunke, senior manager, Managed Portfolio Strategies at RBC Wealth Management–U.S.

Lunke suggests investors then decide where within the market they would like to invest. The answers will often depend on what else you own in your portfolio. For instance, if you already own physical real estate assets, you may not want to buy real estate investment trust ETFs.

“Once you’ve determined your desired asset class, sector, region, assess the different available options,” Lunke says.

Although finding a product that offers the desired exposure is paramount, he also recommends reviewing other structural aspects such as the expense ratio, which is the amount an investment company charges investors to manage the fund. Similar to most investment products, the expense ratio for ETFs can be quite broad. However, many products are known for having very competitive pricing, which often tends to be significantly less than competing mutual funds or separately managed accounts.

ETFs should also have a relatively strong asset base, which is the total value of assets in the fund. Generally speaking, Lunke says, RBC seeks out funds with diversified asset bases above $100 million, which often means a fund is more stable and able to weather near-term flows in to and out of the fund.

What are the pros and cons of ETFs?

Like all investments, ETFs have pros and cons, although Heerey and Lunke believe the positives, such as the tax efficiency, low cost, liquidity and transparency, outweigh the negatives.

“Tax efficiency is one of the biggest advantages of ETFs,” says Heerey. He explains because of how ETFs are structured, capital gains aren’t passed on to ETF investors as much as they are to mutual fund investors.

“That lighter tax burden relative to mutual funds is significant,” Heerey says.

Additionally, Lunke says many investors prefer to buy ETFs over individual stocks because they get diversified exposures and liquidity without the individual company risk. “I view them as tools to get exposures that otherwise might be difficult to own,” he says.

But, Lunke says, ETFs also have downsides. One of the cons of ETFs relative to similar investment vehicles, such as mutual funds, is the potential for a reduction in diversification as many capitalization-weighted indexes are concentrated toward larger holdings, he says.

Additionally, another downside to ETFs, when compared to mutual funds, is that investors seeking to make small periodic investments would potentially be subject to fixed commissions on each trade, which can significantly eat into the net amount invested.

But despite those downsides, Lunke says, ETFs are good for short- and long-term investors looking to diversify at a low cost.

“To me, it’s all of these individual pieces that lead to a diversified portfolio that you can trade efficiently, at a low cost and feel comfortable you’re getting the market exposure you want,” he says.