How to Profit From ETFs

Exchange-traded funds have never been hotter. Investors are pouring a record amount of money into ETFs, which hold baskets of securities like mutual funds do but trade like stocks. “It’s just explosive growth,” says Armando Senra, head of iShares America at BlackRock. Nearly as much new money has flowed into ETFs over the first half of 2021 than in all of 2020—which itself was a record year for inflows. “The pace has smashed the prior record to smithereens,” says Ben Johnson, director of global exchange-traded fund research for Morningstar.

In this age of skyrocketing “meme” stocks, it’s notable that much of the new ETF money is going—sensibly—into “boring, broadly diversified products,” such as S&P 500 index funds, says Todd Rosenbluth, head of ETF research at Wall Street firm CFRA. Investors use these ETFs as primary portfolio holdings; they spice up returns with sector or “thematic” ETFs, he says. Interest is broad: Individuals, advisers and institutions are all buying ETFs.

Some of the draw, as always, stems from how these funds work. Compared with mutual funds, ETFs charge lower annual fees. They also have no initial investment minimum, and they trade like stocks—meaning you can buy and sell shares throughout the day, buy on margin, and even sell them short. And because they dish out less in capital gains distributions to shareholders than mutual funds do, ETFs tend to be more tax efficient (more on that later). But a new batch of investing trends—including the growing prominence of environmental, social and corporate governance concerns and the increasing number of actively managed and specialized ETFs—are also fueling interest in these funds.

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Against this backdrop, we conducted our annual review of the ETF industry and the Kiplinger ETF 20, the list of our favorite exchange-traded funds (and made some changes).

For investors just getting to know ETFs, we’ve included a guide to different types of exchange-traded products, as well as a few tips for trading these funds, below. All returns and data are through July 9, unless otherwise noted.

Setting trends

ETFs aren’t just a side dish anymore. For many investors, especially those between 25 and 39 years old, they’re the main course. These funds make up nearly one-third of millennial investors’ portfolios today, according to the latest annual Charles Schwab ETF Investor Study. Looking ahead, nearly 70% of millennial investors who have bought or sold an ETF over the past two years said they think these funds will be a primary investment type in their portfolio. Only 30% of investors between 56 and 74 who have held an ETF shared that sentiment—but that’s changing, too. Wider acceptance combined with innovative new funds are making ETFs more attractive to older investors, too. And new developments are drawing investors of all sorts to the explosive ETF industry.

Bond investors are embracing ETFs. Investors—including the U.S. government—are increasingly buying bond ETFs in place of bond mutual funds and individual bonds. Last year, the Federal Reserve snapped up shares in 16 corporate bond ETFs to shore up the fixed-income market. At last report, the government’s ETF holdings had a market value of $8.6 billion.

In 2020, for the second year in a row, bond ETFs picked up more new money—$186.4 billion—than did stock ETFs. “As we were in the throes of COVID-19, bond ETFs became a go-to vehicle for investors for the liquidity that they provide,” says CFRA’s Rosenbluth, referring to the ease with which shareholders can buy and sell shares in ETFs. “These bond ETFs are still in demand in 2021, even as stock products have become more popular.”

They’re attracting an ESG crowd. In 2020, the pandemic, climate-change worries and the movement for racial justice intensified an already healthy interest in ESG funds, which focus on companies that meet distinct environmental, social and corporate governance measures.

Inflows into ESG-focused and sustainability-oriented mutual funds and ETFs more than doubled in 2020 from the previous year, to $51 billion. ETFs took in most of that new money (nearly $34 billion). Naturally, a profusion of new ESG funds sprang up to meet demand. Over the past 18 months, nearly 50 new ETFs have launched with a focus on ESG or sustainability.

There’s an ETF for every theme. Thematic ETFs offer investors a way to invest in long-term trends that will change the way we live and work. You can choose among funds that focus on online shopping, for example, or machine learning and robotics, or genetics and immunology. Occasionally, a new, attuned-to-the-zeitgeist fund comes along that’s even more nichey. “From space to cannabis to veganism, we’ve seen continued interest in all things thematic,” says Johnson.

The pandemic lockdown, for instance, spawned a number of work-from-home funds. Even buzzy meme stocks are getting their day with the FOMO ETF (for “fear of missing out”). Other times, says Johnson, “the themes are a reflection of where the economy might be headed.” Since April, a number of ETFs focused on hotels, restaurants, airlines and cruises have launched as a way to play the economic reopening.

These funds are popular, but they can be volatile, and some don’t survive for long. The Obesity ETF, which invested in companies focused on fighting fatness, opened in 2016, but it closed earlier this year.

Some are using hedge-fund strategies. Techniques once accessible principally to wealthy individuals are now available in ETFs. “It’s part of the democratization of investing,” says Simplify Asset Management cofounder Paul Kim. Simplify has launched 12 ETFs since last September. All of the strategies use options to enhance returns or to protect against losses. Kim says the firm’s biggest fund, Simplify US Equity PLUS Downside Convexity ETF, is “an S&P 500 index fund with seat belts.”

Then there are buffered ETFs, which use strategies once limited to so-called “structured” products usually sold by banks. Like those products, buffered ETFs track an index and use options to protect capital against a portion of market losses in exchange for a slice of upside returns. Says Morningstar’s Johnson, “They’re not as costly as structured products, you can get out when you want and you still maintain tax efficiency.” The ETFs appeal to retirees who want to hold stocks but also want to limit the risk. All told, 74 buffered funds are now available—most launched over the past 12 months—and they have garnered a total of $6.1 billion in assets.

But these strategies take some explaining (see Buffered ETFs Can Limit Your Losses). For now, they are selling mostly through advisers, who can explain the risks and benefits to their clients before they buy.

Active ETFs arrive. The world of actively managed ETFs is opening up, thanks to an SEC rule adopted in 2019 that enabled certain active ETFs to be “nontransparent.” In other words, unlike most ETFs, nontransparent ETFs don’t have to disclose detailed portfolio holdings every day. Instead, full reports are made quarterly. “Having to disclose portfolio holdings daily was preventing active managers from offering ETFs to investors because they had to share too much of their stock-selection process,” says Rosenbluth.

Now a number of well-known mutual fund firms have launched active ETFs, both transparent and nontransparent. Fidelity has launched 11 new active ETFs over the past 18 months. Three are clones of well-known mutual funds, including Fidelity Blue Chip Growth ETF (symbol FBCG), whose similarl named mutual fund sibling (FBGRX) is a member of the Kiplinger 25, the list of our favorite no-load funds). T. Rowe Price launched new ETF versions of its mutual funds Blue Chip Growth, Dividend Growth (another Kiplinger 25 fund), Equity Income and Growth Stock late last summer. Putnam and American Century also recently launched active, nontransparent ETFs. “The growing supply of active ETFs has made it easier for investors who believe in active management to have strong choices to consider,” says Rosenbluth.

They’re tax efficient. Tax efficiency has always been a draw for investors to ETFs. Some of that efficiency is due to low portfolio turnover, at least for many index ETFs. But it also has to do with the way ETF shares are created and redeemed. Mutual funds must sometimes sell underlying securities to meet shareholder redemptions. This can trigger a capital gains distribution, which is shared by all fund shareholders. But ETF sponsors don’t actually buy and sell the underlying securities in their portfolios. Third parties—institutional investors and market makers called authorized participants—do that for them, making money on the transactions they complete.

This process is called an in-kind transaction because no cash changes hands between the ETF and the authorized participants. Instead, the ETFs hand over baskets of securities to the authorized participants for redemptions (or the funds receive baskets of securities when new shares are created). Because the ETF itself doesn’t make any cash transactions, it isn’t as likely as a mutual fund to make a capital gains distribution. (You’re still liable for capital gains taxes when you sell shares.)

The SEC now allows portfolio managers to customize the baskets of securities they give to the authorized participants, choosing which share lots of certain securities in their portfolio the authorized participants will sell. “This gives them a chance to dramatically improve tax efficiency,” says Johnson.

Other exchange-traded products

Exchange-traded investment products come in a few different flavors, with important differences. For example, ETFs, shorthand for exchange-traded funds, and ETNs, the acronym for exchange-traded notes, sure sound a lot alike. But they’re very different products.

ETFs invest in a basket of securities and trade on an exchange like a stock. Your main risk is the assets in the ETF declining in value. But ETFs are structured in a way that keeps your investment safe even if the company behind the ETF runs into financial trouble.

ETNs don’t offer that protection. An ETN is a bond, or unsecured debt, issued by a bank or financial firm. Unlike traditional bonds, ETNs don’t pay interest, nor do they invest in the underlying securities of the indexes they track. The bank promises to pay the ETN holder the return on a market index, minus fees.

That promise comes with risk. The issuer’s creditworthiness is key. If the bank goes bankrupt (a rarity) or breaks its promise to pay in full, you could be stuck with a worthless investment, or one worth a lot less. The ETN’s value could fall if the issuer’s credit rating is downgraded. ETNs may also be thinly traded, which can make it harder to get favorable pricing when you buy or sell. And if the ETN is closed before its maturity date, you could end up receiving the current market price, which could be less than your purchase price. Closures have been on the rise: 98 ETNs shuttered last year, according to CFRA Research.

On the plus side, many ETN issuers are financially strong—such as JPMorgan and Barclays, to name a couple—and run ETNs that have been around a dozen years or more. And ETNs offer the ability to invest in niche asset classes, such as commodities or currencies, and deliver a tax break (because ETNs don’t distribute dividend or interest income).

A name you can trust? You might also wonder about ETFs that have “trust” in their names, such as SPDR S&P 500 ETF Trust, the largest diversified U.S. stock fund in the country. They’re among the earliest ETFs and are structured as unit investment trusts (as opposed to today’s more common registered investment company structure), says Matthew Bartolini, head of SPDR Americas Research at State Street Global Advisors. “There’s a different set of rules, but the differences are minor, and performance variations are minimal,” he says. UITs have less flexibility than RICs, as they are bound to hold every security in an index, they can’t lend out shares to short sellers, and they can’t reinvest dividends paid out by the underlying companies, to name a few examples.

Tips on buying and selling ETFs

Exchange-traded funds trade commission-free at most online brokers these days. But placing actual trades takes some care. Here are a few tips.

Use limit orders. Limit orders allow you to specify the price at which you are willing to buy or sell shares. It doesn’t guarantee instant execution, but it ensures that your order will be filled at the price you designate or better, an important protection during periods of unexpected price volatility. A buy limit order will only be executed at the limit price that you set or lower. For example, if iShares Core S&P 500 has a current market price of $425, set your limit price at $425. On the flip side, when you set a limit order to sell shares, the order will only be executed at the limit price or higher. Market orders are filled at the next available price—whatever it is.

Be mindful of the fund’s premium/discount, especially when you’re deciding to buy or sell. ETFs have two prices—the market price per share and the net asset value (or NAV) per share, which is the value of the underlying securities in the fund. These prices can diverge. If the share price is above the NAV, the ETF trades at a premium. If the price is below the NAV, it trades at a discount. The premium/discount can shift, especially when market volatility is high. The iShares Core S&P 500 ETF had a typical premium/discount of 0.02% recently, but during the early 2020 sell-off, it rose to 0.43%. Foreign-stock ETFs are vulnerable to a high premium/discount because the underlying securities trade on exchanges in different time zones. So, too, are active ETFs that don’t disclose holdings on a daily basis.

Time your trades well. Don’t trade on volatile days. “Waiting until the chaos ends will be worth it,” says CFRA’s Todd Rosenbluth. Also avoid trading within the first or last half-hour of the trading day because volatility tends to be higher then. And never buy or sell when the market is closed. That may be okay to do with a mutual fund, which settles at the end of every trading day, but opening prices might catch you off guard if you do that with an ETF.