10 ETF Myths Debunked

The first modern-day mutual fund was launched in 1924, offering investors an easy way to own a professionally managed portfolio. Until the fairly recent past, these types of funds dominated the landscape for investors looking for instant diversification in a single package. In 1993, the first exchange-traded fund made its appearance, changing how investors can access mutual funds.

As ETFs are much younger than traditional mutual funds, a number of myths have arisen regarding their characteristics and performance. Here are some of the most common, along with the reasons for why they are not true.

Last updated: Aug. 30, 2021

Some investors believe that ETFs are more expensive than mutual funds because some funds charge no commission to buy or sell. However, all mutual funds still have ongoing annual expenses, and in some cases, those costs can be high. Many ETFs, on the other hand, have extremely low ongoing expenses, as reflected in their expense ratios. The Vanguard S&P 500 ETF (VOO), for example, charges just 0.09% per year in expenses.

Exchange-traded funds are used by many investors to focus on specific market sectors with their investments, such as information technology or energy. In fact, sector ETFs can be a great way to diversify your portfolio or to make bets on specific areas of the market. However, the ETF universe has a wide variety of options, and only a few actually focus on specific sectors. 

Individual stocks and bonds can outperform ETFs, but the reverse is also true. In 2020, for example, the info tech ETF XLK returned 43.67%, far outperforming many big-name stocks like Facebook and Salesforce.com, even though those stocks are included in the ETF. It’s actually quite common for an ETF in a hot sector to outperform a large number of individual stocks. In the bond world, price changes aren’t as dramatic, but a well-run ETF can still outperform individual selections.

Some ETFs are nondiversified by design. For example, the technology sector ETF only holds stocks in the technology industry. However, plenty of ETFs are very well diversified. In fact, the largest ETF on the planet is the SPDR S&P 500 ETF Trust (SPY), with $382.5 billion in assets. That ETF holds the 500 largest stocks on the U.S. stock exchange, providing a very diverse portfolio. But some ETFs, like the Vanguard Total Stock Market ETF (VTI), are even more diversified, holding literally thousands of stocks. In reality, it’s quite easy to create a diversified portfolio with a very small number of ETFs — perhaps even just one.

It’s true that some of the most popular and well-known ETFs are passively managed, meaning that managers build a portfolio and change it infrequently. But hundreds of ETFs are indeed actively managed, with portfolios run more like traditional mutual funds. With an actively managed ETF, investors are betting on the stock- or bond-picking ability of the fund managers rather than relying on the static performance of an index.

Since exchange-traded funds are often equated with traditional mutual funds, some investors fear that ETFs make frequent taxable distributions to shareholders that are beyond their control. In reality, ETFs are highly tax-efficient. According to Fidelity Investments, holding an ETF will generally result in lower tax liabilities than owning a traditional mutual fund in a taxable account. Some ETFs make few or no distributions whatsoever, and investors can also choose when to sell an ETF to trigger a capital gain or loss, even in the middle of a trading day. 

Some exchange-traded funds do focus on narrow sectors of the market and only invest in stocks, but many offer a wide range of marketable securities in a single investment envelope. For example, the Vanguard Total Stock Market Index offers every single stock available in the investable U.S. market, from mega-caps down to small caps. A number of other ETFs also include both stocks and bonds in varying allocations.

As their name suggests, exchange-traded funds trade on stock exchanges. This makes them subject to the laws of supply and demand. Popular ETFs, like the SPDR S&P 500 ETF Trust (SPY), trade tens of millions of shares per day. Most other ETFs are similarly liquid, although they may not trade with such heavy volume. There are a small handful of ETFs that trade infrequently and may have large bid-ask spreads, contributing to illiquidity. However, for every illiquid ETF you can find, there’s likely a more liquid — and usually better-performing — ETF with the same investment mandate.

It’s certainly easy to trade in and out of an ETF. Since ETFs trade like stocks, you can literally buy and sell them every second of every day if you are so inclined. But while you can trade ETFs, many investors use them as long-term investments. This is particularly true for the diversified ETFs, such as the S&P 500 index ETFs. Those types of ETFs are what some financial advisors call “core holdings,” meaning they’re actually intended to be held for the long run.

While buying certain ETFs makes it easy to diversify your portfolio, the wide range of available ETFs doesn’t preclude the need for a good financial advisor. In fact, the opposite is actually true. There are so many ETFs to choose from that choosing the ones that match your investment objectives and risk tolerance can actually be difficult. Buying an ETF based solely on its name or top 10 holdings doesn’t give you the full picture of how an ETF will trade or function. That’s why it’s best to use a fiduciary financial advisor when assembling a portfolio of ETFs.