Morningstar's Guide to ETF Investing (2024)

Exchange-traded funds are still relatively new, but they’ve quickly surged in popularity.

ETFs trade on stock exchanges such as the New York Stock Exchange, in the same way that stocks do. This is different from mutual funds, for which trades are conducted through brokers or with the investment companies themselves, and for which orders are only processed once a day.

Since ETFs debuted in 1993, investors have flocked to them because they’re typically cheaper, usually more tax-efficient, and simple to buy and sell. However, their attractiveness can vary substantially depending on the specific fund, so it’s still essential to evaluate each option carefully.

This guide answers some common questions about the inner workings of ETFs, the associated costs, and how to get started investing in them.

IN THIS ARTICLE

• What are the types of ETFs?
• Are all ETFs passive?
• How are ETFs taxed?
• What is a good expense ratio for an ETF?
• How many ETFs should I own?
• How to choose an ETF
• 3 Noteworthy Equity ETFs
• 3 Noteworthy Bond ETFs

What are the types of ETFs?

There are 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. Stock ETFs invest in a basket of stocks from U.S. and/or international companies. Depending on the stocks they’re primarily exposed to, they may be better suited to be either portfolio anchors or tools for diversification.
• Bond ETFs. Bond ETFs can invest in fixed-income securities issued by governments, municipalities, or corporations. These can be a good fit for investors with mid-range goals, or investors who aren’t comfortable with a completely equity-focused portfolio.
• Thematic ETFs. Thematic ETFs focus on investments within a particular sector or theme, such as ESG investing or cryptocurrency. Investors often use these ETFs to tap into a particular theme without having to manually buy multiple individual stocks.

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

Are all ETFs passive?

Many are, but not all.

Passive investing aims to replicate the performance of an index, such as the S&P 500. And the fact that many ETFs take this approach to investing has been a key reason for their appeal, because it means:

• More transparent performance. Whether an ETF does or doesn’t do well, that outcome can clearly be traced to the performance of the index.
• The ETF relies less on a particular manager. If the fund manager of an ETF leaves, another individual can more easily take over the job of tracking the index.

That said, though actively managed ETFs are still a small portion of the ETF universe, they have become more mainstream in recent years, as the largest holdouts of mutual fund providers have ventured into the space.

One reason for this growth is that fund managers have become more comfortable with ETFs’ transparency: ETFs report their holdings every day, unlike mutual funds, which typically report holdings on a quarterly basis.

Furthermore, combining the skill of a strong manager with the cost and tax benefits of the ETF structure can deliver substantial benefits.

Still, there are limitations to active ETFs—one of the biggest being capacity concerns. Like the portfolio managers of active mutual funds, the managers of active ETFs must invest all incoming money, regardless of whether they have a particularly good idea for how to do so.

There are also smart-beta (also known as strategic-beta) funds, or index-tracking funds that make active bets.

How are ETFs taxed?

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

• Investors sell shares on an exchange against 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 traded 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.

The tax efficiency that ETFs offer 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 asset class. For example, these tax advantages aren’t as good for bonds as they are for stocks.

What is a good expense ratio for an ETF?

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

The average expense ratio has been falling for two decades: As of 2022 (the latest year for which data is available), the average expense ratio for both ETFs and mutual funds was 0.37%—less than half what investors paid in 2002.

But rather than breaking down costs for mutual funds versus ETFs, investors should look to a fund’s strategy to assess a “good” expense ratio.

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.

Across the board, investors can bear in mind a couple of general rules: The more niche the strategy, the higher the fee; and the average active fund charges substantially higher fees than a passive one.

Finally, 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 owning an ETF.

How many ETFs should I own?

Short answer: There's no magic number.

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 if you should consider equities, bonds, or other options.

For some, one ETF can be enough if it’s sufficiently diversified. Take, for instance, Vanguard Total World Stock ETF VT, which includes stocks from around the world. This approach can be a good fit for passive stock investors who prefer the set-it-and-forget-it approach.

On the other hand, investors who prefer to be more hands-on may want to set their own asset allocations and therefore invest in multiple ETFs. It all comes down to personal preference—to an extent.

As Morningstar director of manager selection Josh Charlson notes, “In choosing funds beyond the core categories, it’s important to assess whether those asset classes provide true diversification over existing holdings... and whether those asset classes serve a specific investment need that the existing portfolio lacks.”

How to choose an ETF

Once you’ve determined whether you want to pursue an active or passive strategy, we recommend starting your selection process by reviewing a fund’s Morningstar Medalist Rating. This forward-looking, qualitative rating helps investors find funds that are likely to outperform their peers over a full market cycle.

The rating of Gold, Silver, Bronze, Neutral, or Negative is based on an assessment of the fund managers’ approach to their investment strategy (Process), the individuals who manage the fund (People), and the asset manager that offers the fund (Parent).

Check out the ETFsthat presently hold a rating of Gold.

3 Noteworthy Equity ETFs

There are currently 19 U.S. large company stock ETFs, 11 U.S. mid- and small-cap company stock ETFs, and 10 international stock ETFs that hold a Morningstar Medalist Rating of Gold.

Here, we zoom in on a few options from this group that represent various fund companies.

Dimensional US Core Equity Market ETF DFAU

Dimensional US Core Equity Market ETF is a well-diversified strategy with some mild factor tilts that should serve investors well in the long term.

The fund offers broad exposure to stocks of all sizes listed in the U.S., and it tilts toward those with lower valuations, higher profitability, and smaller market capitalizations.

To do this, the managers assign weights based on a stock’s market cap and a market-cap multiplier. They apply larger multipliers to stocks with smaller market capitalizations, lower valuations, and higher profitability and smaller ones to stocks with opposite characteristics. This technique has two advantages: It tilts toward factors that have historically been associated with superior long-term returns, and it cuts back on turnover and trading costs.

The portfolio’s value and small-cap orientations have aided its performance. It led the Russell 1000 index by 2 percentage points annualized from its launch in November 2020 through March 2023.

DFA charges 0.12% for this portfolio, which lands it in the cheapest decile of the category and should provide a long-lasting advantage.

Vanguard Small-Cap Value ETF VBR

Vanguard Small Cap Value Index provides a market-cap-weighted portfolio of the cheapest companies in the small-cap market. Its broad diversification and razor-thin expense ratio make it one of the best small-cap value funds available.

The fund tracks the CRSP U.S. Small Cap Value Index, which captures the cheaper side of the small-cap market, and performance has been strong since it started doing so in April 2013.

It has outperformed its average category peer by more than 1.6 percentage points annually. Volatility has also been muted relative to the category, allowing the fund to post an even wider risk-adjusted-return advantage. Market-cap-weighting pushes the portfolio up the market-cap ladder, contributing to more consistent category-relative performance.

Market-cap weighting is an efficient way to weight holdings because it harnesses the market’s consensus opinion on the relative value of each stock. Stocks that grow in size take up a larger share of the portfolio, while smaller companies that may be struggling will have less importance. Generous buffers around the fund’s size and style constraints improve the breadth of the portfolio and help tame turnover.

iShares Core MSCI Total International Stock ETF IXUS

IShares Core MSCI Total International Stock ETF captures nearly all of the international stock market for a low fee.

The fund tracks the MSCI ACWI ex USA Investable Market Index. It targets small-, mid-, and large-cap stocks from most overseas markets, pulling in around 4,300 names. The final portfolio weights its holdings by market cap, which harnesses the market’s collective wisdom of each stock’s intrinsic value. This approach also helps mitigate turnover and the associated trading costs.

Diversification is a strength of this portfolio, owing to the expanded scope of its target index. Its 10 largest holdings account for just 10% of its assets, with no single position weighing in at more than 2%, which should be a boon to its long-term performance.

3 Noteworthy Bond ETFs

There are currently eight intermediate- and long-term bond ETFs and 10 short-term and inflation-protected bond ETFsthat hold a Morningstar Medalist Rating of Gold.

Learn more about a few options from this group that represent various fund companies.

Fidelity Total Bond ETF FBND

Deep experience, solid resources, and thoughtful execution at a low cost earn Fidelity Total Bond ETF a Gold rating.

Besides investing in the typical investment-grade corporate credit, mortgages, and U.S. Treasuries that constitute the strategy’s Bloomberg US Aggregate Bond Index benchmark, co-lead portfolio managers Ford O’Neil and Celso Munoz and their co-managers may allocate up to 20% in non-investment-grade bonds, including high-yield and emerging-markets debt, when market valuations are compelling.

Keeping its duration near the index has helped the strategy weather interest-rate volatility. As U.S. Treasury rates spiked over 2022, the fund’s 12.8% loss, while painful, edged out its typical peer’s 13.5% loss given its moderately shorter duration.

Since O'Neil took the helm in December 2004 through July 2023, the strategy generated a 3.7% annualized return. This beats the 3% return of its index and the 3.4% median gain of a group of distinct peers, all while exhibiting a much lower volatility than its typical peer.

Pimco Enhanced Short Maturity Active ESG ETF EMNT

Pimco Enhanced Short Maturity Active ESG ETF benefits from the same seasoned, liquidity-focused leaders as its non-ESG focused sibling, Pimco Enhanced short Maturity Active ETF MINT, making it a top responsible option among its peers.

This ETF's mandate is more constrained than its other sibling Pimco Short-Term PTSHX but reflects the same broad themes as MINT. Itshould appeal to investors looking for a strategy that provides capital preservation and liquidity, and also supports favorable environmental, social, and governance outcomes. The team applies an extra layer of scrutiny to its bottom-up security selection: It emphasizes issuers with improving-to-exemplary ESG practices and avoids those with deteriorating-to-harmful ESG traits.

Liquidity and capital preservation guide an approach that takes cues from its investment committee’s macro forecasts to form interest-rate, yield-curve, currency, country, and sector decisions. The team draws on large credit and structured products research teams to form its bottom-up decisions, with investment grade credit and securitized debt making up the lion’s share and contributing to its yieldedge over rivals.

The portfolio’s ESG considerations have led to some differences versus MINT. Most notably, its corporate stake tends to favor higher-quality companies. Its ESG themes can be seen in its exposure to climate-sensitive issuers such as green bonds, which are designed to support specific climate-related or environmental projects.

Schwab U.S. TIPS ETF SCHP

Schwab U.S. TIPS ETF provides investors with exposure to the full spectrum of Treasury Inflation-Protected Securities at a low fee.

The fund tracks the Bloomberg US Treasury Inflation-Linked Bond Index (Series-L), which includes U.S. TIPS with at least one year until maturity. The index weights holdings by their market value (excluding amounts held by the Federal Reserve), which mitigates transaction costs. But it also means that issuing activity can change the fund’s interest-rate risk, which is the main risk in this portfolio.

TIPS offer a direct hedge against inflation because their principal is linked to the Consumer Price Index, which tracks the prices paid by U.S. consumers in urban areas. The value of the TIPS’ principal is adjusted upward when the CPI rises, resulting in higher coupon payments.

Given that TIPS are a narrow and hom*ogenous sector of the bond market that is free from credit risk, there is limited potential to outperform or underperform. Therefore, fees are an important factor for investors to consider. The fund’s active peers often take on more risk away from the TIPS market to recoup their fee, making it difficult for them to outperform this portfolio. The fund’s low expense ratio should aid the fund in providing sound category-relative performance.

ABOUT THE AUTHORS

Emelia Fredlick is a senior editor for Morningstar.
Bryan Armour is a director of passive strategies research for Morningstar.

CONTRIBUTORS

Research contributor: Ryan Jackson
Designer: Nura Husseini-Yoon, Zhan Su
Editors: Susan Dziubinski, Margaret Giles

These research authors and research contributors are employees of Morningstar Research Services LLC.

This content is not intended to be individualized investment advice, but rather to illustrate possible factors that can impact financial decisions. Investors should consider this information in the full context of their own financial decisions.

Read our editorial policy to learn more about our process.