ETFs: Begin with the Basics

By Sandra Testani - October 19, 2018

Whether you're planning a trip to a far-away country, trying a new sport or learning a new musical instrument, you probably tried to learn something about it before starting on your endeavor.

ETFs are no different. Although you may have a vague idea of what they are or how they work, the market has grown and changed significantly since the introduction of the first ETF in 1993. That's why we think it makes sense to learn about what ETFs offer—to help you make better-informed decisions about how and when to use them in portfolios.

Why have investors embraced ETFs? Probably because they feature some attractive attributes:

  • Trading flexibility: Unlike mutual funds, which are priced at the end of each trading day, ETFs are priced continually throughout the day and can be bought and sold relatively quickly.
  • Transparency: Most ETFs must list their full holdings daily pursuant to SEC regulations, so investors know what they own.
  • Tax efficiency: ETFs are often sold from one investor to another in transactions that don't require the sale of underlying securities. This direct trading, along with the mechanics of how ETF shares are issued and redeemed, enable fewer capital gains.
  • Lower costs: Processing and management costs are typically reduced with the ETF vehicle, though commissions and other brokerage costs remain.

A Growing Menu

The first ETF tracked the S&P 500® Index. Since then, the number and variety of ETFs has ballooned, with more than 2,100 covering equity and fixed income markets around the world. The amount of investor assets has also grown substantially, from less than $500 billion in 2005 to more than $5 trillion as of July 2018.* Early ETFs—which still claim most ETF assets—tracked market-weighted equity indices such as the S&P 500 Index and the Russell 1000® Index.

As investors embrace ETFs, asset managers respond by expanding their menus. Today, ETFs span many different asset classes and investment styles. They can also be used in multiple ways and combined with mutual funds and individual securities to build diversified portfolios. Types of ETFs include:

  • Passive, indexed ETFs: These ETFs seek to mirror the performance of a recognized, measurable benchmark such as a broad market (e.g. the S&P 500 Index), or a group of companies (sectors or industries), fixed income instruments, currencies or commodities—among other types of securities.
  • Strategic beta or alternatively weighted ETFs: These index-tracking ETFs seek enhanced returns by selecting and weighting securities based on criteria other than market cap.
  • Active ETFs: Actively managed ETFs apply the same fundamental expertise as many mutual funds, combining active management with the ETF structure.

ETFs and Mutual Funds: The Differences

How do ETFs stack up against mutual funds? Like mutual funds, ETFs are baskets or pools of individual securities, such as stocks or bonds. And like mutual funds, ETFs are structured as open-end investment companies. Both ETFs and mutual funds post net asset values (NAVs) of their underlying securities at the end of each trading day.

However, there are key differences between the two vehicles.

  Mutual Funds ETFS
Purchases and Sales Buyer purchases directly from the fund company or through a brokerage firm Transact on an exchange and clear through a brokerage firm
Pricing Priced once per day at the end of the day based on NAV of fund’s holdings Priced continuously throughout the day while financial markets are open and may be priced at a premium or discount to NAV
Capital Gains Taxes May require manager to buy or sell underlying holdings to accommodate inflows and outflows, or to reallocate assets, which creates potential capital gains liabilities Shares of individual securities exchanged in-kind for ETF shares to accommodate inflows and outflows generally does not create taxable capital gains
Transaction Costs No transaction costs for no-load funds (fees may apply when buying or selling through a brokerage platform) Brokerage commission and bid/ask spread applies on each purchase or sale

Learn More in Our Latest Publication

Our recent publication, "A Guide to Getting Started with ETFs," covers:

  • The full range of exchange-traded portfolios
  • The mechanics of how ETF shares are issued and redeemed
  • Ways to consider using ETFs in portfolios
  • Questions to consider before selecting ETFs for your portfolio

Getting Started with ETFs

Introduce the basics of ETFs to your clients: their history, how they work, how they compare with mutual funds, and more.

Learn More

American Century® Exchange Traded Funds (ETFs)

Explore our offering of Intelligent Beta and Actively Managed ETFs.

Explore ETFs
  • Related Articles
  • More From Author

Managing Taxes With Loss Harvesting

Tax-loss harvesting may help ease the sting of hefty tax bills when used in concert with an overall investment plan.

ETF Industry Update Series

Our ETF experts provide timely market updates in the ETF Industry Update Series.

Exploring ETFs Monthly Call Series

Our experts share ETF best practices, product knowledge and investing insights in our Exploring ETFs Monthly Call Series.

    Considerations for Allocating to Alternatives

    When adding alternatives to a portfolio, the allocation source matters. These tips can help you determine where to reduce other allocations in favor of liquid alternatives.

    Addressing the Taxman with the Tax Efficient Structure of ETFs

    ETFs have two features that reduce their exposure to events that trigger capital gains, enabling ETFs to generate less tax liability.

    Finding Quality Growth: It's More Than Momentum

    Learn why we believe systematic quality and fundamentally focused growth strategies achieve better exposure to growth.

      * Source: Strategic Insight (SIMFUND)

      ETF shares may be bought or sold throughout the day at their market price, not their Net Asset Value (NAV), on the exchange on which they are listed. Shares of ETFs are tradable on secondary markets and may trade either at a premium or a discount to their NAV on the secondary market.

      ETFs trade like stocks, fluctuate in market value and may trade at prices above or below the ETF's net asset value. Brokerage commissions and ETF expenses will reduce returns.

      Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

      The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.