Morningstar′s Guide to ETF Investing

For investors who want a diversified portfolio, exchange-traded funds have a lot of appeal, as they are typically cheaper, usually more tax-efficient, and simple to buy and sell. However, their attractiveness can vary greatly from fund to fund, so it’s essential to evaluate each option carefully.

This guide highlights our latest research on ETFs, insights on how the ETF landscape operates, and ideas for ETFs that could work in your portfolio.

ETF Insights From Morningstar Analysts

The popularity of ETF investing over mutual funds is a continuing trend that has not lost steam this year.

ETFs now represent roughly 39% of the combined ETF and mutual fund market, according to Morningstar’s fund flows data. “This is almost twice the market share ETFs held in 2020,” says Brian Paoli, associate manager research analyst at Morningstar.

Understanding the ETF Landscape: What Should Investors Know?

ETFs trade on stock exchanges such as the New York Stock Exchange in the same way that stocks do. In contrast, mutual fund trades are conducted through brokers or with the investment companies themselves, and orders are processed only once a day.

What Are the Types of ETFs?

Investors can choose from a wide range of ETFs that invest in a variety of asset classes and subasset classes. A few common types of ETFs include:

• Stock ETFs invest in a basket of stocks from US and/or international companies.
• Bond ETFs can invest in fixed-income securities issued by governments, municipalities, or corporations.
• Thematic ETFs focus on investments within a particular sector or theme, such as ESG investing or cryptocurrency.

ETFs can also focus on commodities, factors, and just about every asset class.

How to Evaluate ETFs for Your Portfolio

How Many ETFs Should I Own?

Asset allocation is the first factor to help determine the appropriate investment options for you. How close are you to your goal? How much risk can you afford to take? The answers to these questions can determine whether you should consider equities, bonds, or other options.

For some people, one ETF can be enough if it’s sufficiently diversified. Investors who prefer to be more hands-on may want to set their own asset allocations and invest in multiple ETFs.

How Are ETFs Taxed?

ETFs are often lauded for being more tax-efficient than mutual funds, for several reasons:

• Investors sell shares on an exchange to other market participants using outstanding shares. So, the ETF sponsor is unaffected by the transaction, and the shares outstanding for the ETF are unchanged.
• Authorized participants (specific firms that have signed agreements with fund distributors) can conduct “in-kind transactions,” in which securities are exchanged directly for ETF shares. Because the trade doesn’t result in a security being sold for cash, it doesn’t trigger capital gains.
• Many ETFs are index funds that don’t turn over the securities within their portfolio very often, so there are fewer opportunities to realize gains from selling a security.

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The tax efficiency of ETFs is a clear advantage, but it’s worth remembering a couple of things:

• Tax-efficient doesn’t mean tax-free. You’ll still pay taxes on regular distributions of income.
• This tax efficiency varies depending on the asset class. For example, bond ETFs don’t benefit from these tax advantages as much as stock ETFs do.

What Is a Good Expense Ratio for an ETF?

A fund’s

is the percentage of assets deducted from its returns each fiscal year to cover costs, such as administrative fees and operating expenses.

Broad-market index ETFs that track the S&P 500, for example, often charge less than 0.05%. And investors can typically find solid strategies charging 0.25% or less in most fund categories. In general, the more niche the strategy, the higher the fee. The average active fund charges substantially higher fees than a passive one.

Though expense ratios have historically been considered the key data point, investors should also assess individual transaction costs and holding costs for a better sense of the total cost of ETF ownership.