Similar to mutual funds, exchange-traded funds (ETFs) invest in a mix of stocks, bonds and/or other assets. Unlike mutual funds, however, ETFs can be bought and sold on an exchange like stocks throughout the trading day.1 It is important to keep in mind that the price at which an ETF trades is determined by the market as opposed to the value of the assets held by the ETF. Although many ETFs seek to keep the market prices of their shares near the actual value of the ETF’s shares, there is no guarantee that an ETF will not trade at a discount to its shares.
Getting to Know ETFs
Exchange-traded funds are investment products consisting of a basket of securities that may bring diversification to an investment portfolio.
Potential Benefits
ETFs often appeal to those looking for a simplified way to invest, since they can offer exposure to many securities at once through a single fund, often related to a particular sector or slice of the market. ETFs that are diversified may help balance risk since the money you invest in them is spread out across these various securities. Moreover, ETFs may lower the barrier of entry for investors with limited resources.
Index vs. Actively Managed
ETFs typically fall into one of two categories: index or actively managed.
Index ETFs, as their name suggests, attempt to track a particular index (like the S&P 500 ®) with the goal of mimicking its performance over time (before paying fund expenses) rather than beating a benchmark. Many ETFs fall into this category. Generally, index funds can be more tax-efficient than actively managed products due to low portfolio turnover. 2
Rather than track an index, actively managed ETFs adjust the mix of securities they hold, aiming to beat a benchmark using research-backed strategies or other investment analyses. These ETFs tend to carry higher fees, which help compensate the ETF’s adviser for managing the fund. Active management may also lead to portfolio turnover that could potentially lead to the generation of taxable capital gains.
Areas of Focus
ETFs can be made up of different types of investments, depending on their focus. Stock ETFs might provide the basis for growth in a portfolio, while bond ETFs may potentially offer capital preservation and steady income. Some ETFs may invest in specific commodities, while others might provide exposure to international markets.
Considerations Before Adding ETFs to Your Portfolio
When considering an ETF (or any investment, for that matter), know that there are risks involved. While looking at past performance may give you a sense of the fund’s volatility over time, it does not indicate or guarantee future returns.1
You’ll also want to take a close look at fees for sure. Though many ETFs have low expense ratios relative to other types of investments, they still come with fees that cut into any potential gains.
It is important to review an ETF’s prospectus prior to investing, which describe its investment strategy, risks and expenses.
Lastly, keep in mind that investment returns and realized capital gains resulting from portfolio turnover could be taxable. Because of this, you may want to consult with a tax professional before moving forward.
As always, if you need help deciding how ETFs or other investments may fit into your portfolio, a Financial Advisor can be a great resource.
1 U.S. Securities and Exchange Commission, "Mutual Funds and ETFs." Available at https://www.sec.gov/investor/pubs/sec-guide-to-mutual-funds.pdf. Accessed June 22, 2022.
2 Investopedia.com, “Tax Efficiency Differences: ETFs vs. Mutual Funds.” Available at https://www.investopedia.com/articles/investing/090215/comparing-etfs-vs-mutual-funds-tax-efficiency.asp(opens in a new tab). Accessed July 21, 2022
This article has been prepared for informational purposes only. It does not provide individually tailored investment advice and has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The strategies and/or investments discussed in this article may not be appropriate for all investors. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a Financial Advisor. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.
An investment in an exchange-traded fund (ETF) that invests in equity securities involves risks such as market fluctuations caused by such factors as economic and political developments, changes in interest rates and perceived trends in stock prices. Bond ETFs are exchange-traded funds that invest in various fixed-income securities such as corporate bonds or Treasuries. Bond ETFs allow ordinary investors to gain passive exposure to benchmark bond indices in an inexpensive way. Investing in an international ETF also involves certain risks and considerations that include political, currency, economic and market risks. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economics. For specifics and a greater explanation of possible risks with ETFs, please consult a copy of the ETFs prospectus. Investing in sectors may be more volatile than diversifying across many industries. The investment return and principal value of ETF investments will fluctuate, so an investor’s ETF shares, if or when sold, may be worth more or less than the original cost. ETFs are redeemable only in Creation Unit size through an Authorized Participant. ETF investors are exposed to the risk, among others, that the market price of ETF shares will not be equivalent to the net asset value of the ETF. ETFs may trade at a discount or premium to their net asset value. Purchasing an ETF at a premium and/or selling an ETF at a discount can significantly affect the realized return earned by an investor and such realized return can be substantially different than the net asset value of the ETF and, if applicable, the index or benchmark an ETF may seek to track. ETFs generally do not charge sales loads, but investors often pay a brokerage commission on the purchase and sale of ETF shares.
Please consider the investment objectives, risks, charges and expenses of the ETF carefully before investing. The prospectus contains this and other information about the ETF. To obtain a prospectus, contact your financial advisor. Please read the prospectus carefully before investing.
Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.
Morgan Stanley Smith Barney LLC ("Morgan Stanley") and its Financial Advisors and Private Wealth Advisors do not provide any tax/legal advice. Consult your own tax/legal advisor before making any tax or legal-related investment decisions.
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