ETFs: Understanding the Basics

Exchange-traded funds, or ETFs, were a misunderstood, newfangled investment “product” not long ago.

Today, ETFs are hot, and deservedly so. They are stealing the march and assets from traditional mutual funds. ETFs have attracted long-term index investors and day traders (or market timers).

You may have heard of ETFs long before they became so popular and not even known it. The most famous ETFs remain the Dow Jones Industrial Average “diamonds” (ticker: DIA), the S&P 500 “spider” (SPY) and the NASDAQ 100 “cubes” (so named after their ticker symbol: QQQ), which all started trading in the 1990s.

Vanguard was a bit late to the ETF game but has come to dominate the industry alongside BlackRock’s iShares franchise. At the end of March 2024, around $2.5 trillion was invested in Vanguard’s ETFs.

This evergreen article will get you up to speed on ETFs, how they operate and how they compare to mutual funds. I’ll also give you a rundown of Vanguard’s ETF lineup and discuss how to think about using ETFs in a portfolio.

If you want to improve your ETF knowledge, I discuss the nitty-gritty of ETF pricing, returns and tax mechanics in my ETFs 102 article.

What are ETFs?

Mutual funds date back to the 1920s. They are investment vehicles that allow individual investors to pool their money together so a professional can invest those dollars for them. That portfolio manager may actively pick the stocks (or bonds) for the pool in an effort to “beat the market,” or they might try to track an index.

If you have $10,000 to invest, building a diversified portfolio on your own is hard. You’ll also be hard-pressed to find a professional investor willing to oversee an account of that size. But if you can pool your money with others like you, that solves those problems.

I’m a big fan of mutual funds—as you might expect from someone writing a newsletter focused on one of the largest mutual fund companies in the world. While mutual funds (and the industry around them) are not perfect, they have made diversified investing (and hence the opportunity to build wealth by spending time in the market) accessible to many investors.

Exchange-traded funds (ETFs) are mutual funds that you can trade throughout the day like stocks—think of them as mutual funds version 2.0. ETFs were born in the 1990s and improved upon some of the flaws in the mutual fund structure.

Most ETFs aim to track a standard index—like the S&P 500 index or NASDAQ Composite—but thousands of ETFs are available today. An ETF outside of standard indexed fare might aim to provide exposure to niche parts of the market or use leverage. Actively managed ETFs, like those factor ETFs Vanguard introduced in 2018, are a relatively new wrinkle.

The chief difference between mutual funds and ETFs is that ETFs trade throughout the day, like stocks. This means the price you receive depends on when you hit the buy (or sell) button. On the other hand, mutual funds only trade once, at the end of each day. Everyone who buys or sells a mutual fund on the same day receives the same price.

ETFs and mutual funds differ in a few other, more nuanced ways. However, the critical distinction for most investors is the ability to trade them during the day rather than once a day.

ETF Advantages

As I said, ETFs are mutual funds version 2.0. And in many ways, they are a better mousetrap than the original mutual fund. All else equal, ETFs are cheaper, more liquid (you can trade throughout the day, not at the end of the day), more transparent (investors generally know the underlying holdings each day), and more tax-friendly.

These advantages are often overblown—mutual funds are far from obsolete—but ETFs have an edge. However, there is one Vanguard-sized exception to the rule:

Vanguard’s Admiral-class index funds and their ETF siblings are share classes of the same funds. They get the same tax treatment and typically charge the same expenses. As a result, shareholders have earned effectively identical returns (before and after taxes) whether they owned the ETFs or the Admiral shares—and that will continue to be the case. (I'll expand on this topic in next week's article.)

ETF Limitations

ETFs may have advantages, but they are not the right vehicle for all situations—some of the ETF’s advantages are stumbling blocks for active managers.

A big one is transparency. Many stock pickers don’t want to disclose their holdings every day because they don’t want other traders to know what they are buying and selling until they have already built (or exited) a position.

Another issue for active managers is that you can’t close an ETF the same way you can a mutual fund. So, if you want to limit capacity (the amount of assets in your fund), the ETF wrapper doesn’t work for you.

These two concerns for stock pickers explain why ETFs have been mainly an index fund story. They also explain why nearly all actively managed ETFs today are either quantitatively run (like Vanguard’s factor ETFs) or focused on large-cap stocks.

Many in the mutual fund industry are working to bring the tax efficiency of ETFs to actively managed mutual funds—and I would welcome, say, a more tax-efficient PRIMECAP-run fund—but, so far, that’s a nut that hasn’t been cracked.

ETF Disadvantages

The big “con” of ETFs is the added complexity of trading.

If you trade ETFs during the day, you must be aware of the bid-ask spread, discounts and premiums to net asset values (NAVs), limit orders, etc. Mutual funds, by comparison, are operationally simple.

Also, although most ETFs are simply a different type of index fund, not all exchange-traded funds are created equal.

Today, over 2,000 different ETFs are available in the U.S., and many of the newer products track narrow market segments, such as indexes tied to a single country, a single market-cap segment (large-cap, small-cap, etc.), or very specific sectors such as the solar energy industry.

Some would argue that more choice is good. However, investing in any narrow slice of the overall market may or may not increase your returns, but it almost certainly will increase your risk.

Investors need to be particularly wary of the ETFs designed to provide traders with a two- or three-times leveraged performance keyed to a particular index. These leveraged ETFs are extremely risky. Don’t use them unless you understand how they work. They are so dangerous that you can no longer buy them through Vanguard, as the firm dropped all leveraged ETFs from its brokerage platform in early 2019.

ETFs at Vanguard

Given their size today, it may surprise you to learn that an indexing shop like Vanguard was late entering the ETF market.

When Vanguard finally took the leap in May 2001, it chose the catchy name of VIPERs, which stood for “Vanguard Index Participation Equity Receipts,” for its take on ETFs. The VIPER name lasted for just over five years until early July 2006, when Vanguard shed it in favor of the “ETF Shares” label.

From their very start, Vanguard’s ETF offerings were structured as share classes of existing open-end index mutual funds—a unique take on the ETF structure. However, the fund’s newer (actively managed) ETFs do not follow this dual share class structure.

As of the end of March 2023, Vanguard had 87 ETFs in its roster—although most of them are of dubious worth to all but a handful of traders. Vanguard’s ETFs cover the various broad market capitalizations, from small to mega, including almost all of the growth and value offshoots, as well as more specific industry sector ETFs.

In addition to the “traditional” market-cap-weighted indexes, Vanguard runs ETFs focusing on dividends and offers three ETFs tracking socially conscious (or ESG) indexes. Vanguard has managed five active factor ETFs since 2018 and runs three active bond ETFs.

Vanguard's ETF Lineup

What could be next for Vanguard?

A junk bond ETF and LifeStrategy ETFs are noticeably absent from Vanguard’s ETF lineup. It’d be fairly easy for Vanguard to fill those gaps.

Also, Vanguard has said N-O to all bitcoin or cryptocurrency ETFs—not only is Vanguard not going to launch its own bitcoin ETF, but it has blocked purchases of any cryptocurrency-related ETFs on its platform. 

Putting cryptocurrencies aside, Vanguard's real “missing puzzle piece” is actively managed ETFs. Vanguard offers some active bond ETFs and has the factor ETFs, but it has not stepped into the active ETF waters with any of its most popular active stock funds. 

Adding the ETF Advantage to Your Portfolio

ETFs generally have advantages over the traditional index mutual fund—those advantages are often overblown, but they exist. And, as I said, a Vanguard ETF and its Vanguard Admiral share mutual fund sibling are on even footing.

So, how do you choose between them? Well, there are only three reasons to pick a Vanguard ETF over a Vanguard index mutual fund:

First, in some cases, like with the S&P mid-cap index-based funds, Vanguard doesn’t have an Admiral share option—it only offers ETF and Institutional shares. In those situations, unless you are willing to go with a different index provider in that space, ETFs are the only route into that slice of the market.

Second, if you can’t meet the $3,000 minimum investment hurdle required by the Admiral shares, the ETF has a lower bar—the cost of one share.

Finally, if you value the flexibility and added liquidity of trading throughout the day with an ETF, that’s an obvious choice. Those benefits come at a cost—bid-ask spreads, the risk of trading above or below NAV, and uncertainty around pricing and returns. In other words, they are more complex.

Unless you fall into one of those camps, I see no compelling reason to buy a Vanguard ETF over a Vanguard index mutual fund.

To that end, traditional mutual funds (both active and indexed) and ETFs can all be parts of a well-diversified investment portfolio.

History shows that most actively managed funds fail to beat their benchmarks over the long term. That’s not to say that all managed funds are underperformers, however. And since costs are the main reason indexes outperform most active funds, and Vanguard’s active funds have some of the lowest costs in the fund marketplace, the argument that one should “give up” and index carries much less weight if you’re a Vanguard investor.

I provide an ETF-only Portfolio, Aggressive ETF, because you (IVA readers) asked for it. I do not mean to imply that using ETFs exclusively is wrong, but my preferred approach is using ETFs to complement actively managed funds and index mutual funds.

I try to be a disciplined but not dogmatic investor. I want to find the right fund (active or passive) and the right vehicle (mutual fund or ETF) for my portfolio.

That’s led me to incorporate ETFs in my Portfolios when I’ve felt they were the best option. By mixing ETFs with actively managed funds, I can keep costs low while still having the potential to earn index-beating returns.

Class Dismissed

If you’ve made it this far, congrats! You should now have a better understanding of ETFs than many other investors. However, if you want to take your ETF knowledge up a level, in the next lesson, I discuss the nitty-gritty of ETF pricing, returns and tax mechanics.