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What Is an ETF?

Key Takeaways

  • Exchanged-traded funds (ETFs) are pooled investment vehicles similar to mutual funds.
  • ETFs track a particular index and can be actively traded throughout the day.
  • Since ETFs are passively managed, they tend to be lower cost than mutual funds that are more actively managed.

Exchange-traded funds, or ETFs, are pooled investment vehicles that offer exposure to a particular area of the market.

The first American ETF, the S&P 500 Depository Receipt (SPDR), was released in January 1993 by the American Stock Exchange and was designed to mimic the S&P 500 Index. Today, SPDR has more than $86 billion in assets under management and roughly 250 million shares are traded on a daily basis, according to Investopedia. The first actively-traded ETF came 15 years later.

Investors buy shares of these pooled assets just like mutual funds, but while there are similarities between the two funds, there are also stark differences and certain benefits.

ETFs vs. mutual funds

ETFs and mutual funds both bundle together securities, but there are notable differences between the two:

  • Trading: ETFs are similar to common stock since they can be actively traded throughout the course of a day, while mutual funds are only priced at the end of the day.
  • Management style: Most ETFs are passively managed since they are designed to track a market index. Most mutual funds, however, are actively managed — a portfolio manager selects securities to outperform a given benchmark.

Benefits of ETFs

Generally speaking, ETFs have the following advantages:

  • Lower cost: As a result of the passive management style, ETFs tend to keep costs low in contrast to mutual funds, which require more active management of select securities. As a result, ETFs are common in robo-advisor platforms, which are lower-cost, automated investing programs.
  • Tax implications: The IRS taxes ETFs and mutual funds similarly, however because of the way they are traded, there may be different tax implications. ETFs tend to be more insulated from capital gains taxes due to their trading structure. ETFs trade on an exchange in-kind between investors, which typically results in the funds distributing less capital gains per year. When it comes to mutual funds, since the investor doesn’t own the actual underlying security, if a manager chooses to liquidate a certain security, you may incur a capital gain despite not participating in the appreciation.

The bottom line

Adoption of ETFs continues to grow, particularly as robo-advisors — whose portfolios are predominately ETFs — become more prevalent. Robo-advisors, also known as digital investing, can keep overhead costs low due to the cost benefits of ETFs. Speak with a financial professional to see if ETFs are worth incorporating into your portfolio.

More information

Investing can be a helpful method of planning for the future, whether it’s your retirement or any other financial goal. To learn how we can help you invest for the future, visit us online or schedule a Citizens Retirement Checkup at your nearest Citizens Bank branch.

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