What are Exchange-Traded Funds

Exchange-Traded Funds, commonly known as ETFs, are investment funds that trade on a stock exchange throughout the trading day, much like individual stocks.

An ETF can hold a diversified portfolio of stocks, bonds, commodities, or other investments, allowing investors to gain exposure to an entire market, asset class, investment strategy, sector, or theme through a single security.

ETFs combine several characteristics of traditional investment funds with the flexibility of exchange-traded securities. Depending on the ETF, investors may benefit from diversification, liquidity, transparency, relatively low investment costs, and potential tax efficiencies. Importantly, the ETF marketplace has evolved significantly. While ETFs were historically associated primarily with passive index investing, investors today can choose from both index-based ETFs and actively managed ETFs.

Passive vs. Active ETFs

Index-Based ETFs

Many ETFs are designed to track the performance of a particular market index or benchmark.

For example, an ETF might seek to track a broad U.S. stock market index, an international equity benchmark, a bond index, or a specific market sector.

Rather than selecting individual securities in an effort to outperform the market, an index ETF generally seeks to replicate or closely approximate the performance of its underlying benchmark, before fees and expenses.

Actively Managed ETFs

One of the most significant developments in the ETF industry in recent years has been the rapid growth of actively managed ETFs.

Unlike an index ETF, an actively managed ETF does not simply seek to replicate a benchmark. Instead, a portfolio manager or investment team makes ongoing decisions about which securities to own, how much to allocate to each investment, and when portfolio changes should be made based on the fund’s investment objective and strategy.

Active ETFs can invest across many different areas of the market, including:

• U.S. equities
• International and emerging-market equities
• Investment-grade and high-yield bonds
• Municipal bonds
• Income-producing securities
• Dividend-paying companies
• Options and alternative strategies
• Specific sectors, industries, or investment themes

The growth of actively managed ETFs has provided investors and financial professionals with additional ways to combine professional portfolio management with many of the structural benefits traditionally associated with ETFs.

Whether an active or passive ETF is appropriate depends on the investor’s objectives, risk tolerance, time horizon, tax circumstances, costs, and the role the investment is intended to serve within the overall portfolio.

How Do ETFs Work?

ETF shares trade on exchanges throughout the day at market prices, meaning their value can fluctuate while markets are open.

This differs from traditional mutual funds, which generally transact once per day based on the fund’s net asset value calculated after the market closes.

Behind the scenes, ETFs also utilize a creation and redemption process involving large institutional market participants. This mechanism can help keep an ETF’s market price relatively close to the value of its underlying portfolio and can also contribute to certain potential tax efficiencies.

Because ETF shares trade in the secondary market, investors should understand that the market price of an ETF can at times trade above or below its underlying net asset value.

Potential Benefits of ETFs

Diversification

ETFs can provide exposure to dozens, hundreds, or even thousands of underlying securities through a single investment.

This can make it easier to construct a diversified portfolio across asset classes, industries, geographic regions, company sizes, and investment styles.

Diversification can help reduce the effect that the performance of a single security has on a portfolio, although diversification does not guarantee a profit or protect against investment losses.

Broad Investment Choice

The ETF marketplace has expanded dramatically.

Investors today can access ETFs covering nearly every major asset class and investment category, including domestic and international stocks, bonds, commodities, alternative investments, specific sectors, investment themes, and actively managed strategies.

This flexibility allows ETFs to be used as both core portfolio holdings and more targeted allocations.

Intraday Trading

Unlike mutual funds, ETFs can generally be bought or sold throughout the trading day at prevailing market prices.

This gives investors and portfolio managers greater flexibility when implementing investment decisions or adjusting portfolio allocations.

ETF investors should still consider bid-ask spreads, market liquidity, and potential premiums or discounts to net asset value when trading.

Potentially Lower Costs

Many ETFs have relatively low operating expenses, particularly broad-market index ETFs.

However, ETF costs vary substantially depending on the strategy. Actively managed, specialized, thematic, or alternative ETFs may carry higher expense ratios than traditional index ETFs.

Investors should therefore evaluate a fund’s total cost rather than assume that every ETF is inexpensive simply because it uses the ETF structure.

Transparency

Many ETFs provide frequent information about their underlying portfolio holdings, helping investors and financial professionals better understand what they own and where their portfolio exposures are located.

Disclosure practices can vary by ETF structure and strategy, particularly among certain actively managed ETFs.

Potential Tax Efficiency

ETFs can offer important tax advantages in taxable investment accounts.

Because of the ETF creation and redemption mechanism, securities can often be transferred in-kind rather than sold within the fund. This structure can help reduce the realization and distribution of capital gains compared with certain traditional mutual funds.

As a result, many ETFs historically have generated fewer taxable capital-gain distributions than comparable mutual funds.

However, ETFs are not tax-free. Investors may still owe taxes on dividends, interest, capital-gain distributions, and gains realized when ETF shares are sold.

Tax efficiency can also vary substantially depending on the ETF’s strategy and underlying investments.

Types of ETFs

Broad-Market Equity ETFs

These ETFs provide exposure to large portions of the stock market and may invest across hundreds or thousands of companies.

They can be used as core holdings within a long-term portfolio.

International and Emerging-Market ETFs

International ETFs provide access to companies outside the United States, including developed and emerging markets.

International exposure can help diversify a portfolio geographically and provide access to economic opportunities that may differ from those available in the U.S. market.

Bond ETFs

Bond ETFs invest in fixed-income securities such as U.S. Treasury bonds, municipal bonds, investment-grade corporate bonds, high-yield bonds, mortgages, or other debt instruments.

Bond ETFs can be used for income, diversification, or managing overall portfolio risk, but they remain subject to risks including interest-rate risk, credit risk, and market-price fluctuations.

Sector and Industry ETFs

Sector ETFs target specific parts of the economy, such as technology, healthcare, financial services, utilities, energy, or industrial companies.

These ETFs can be useful for making targeted allocations, but can also expose investors to greater concentration risk.

Thematic ETFs

Thematic ETFs invest in longer-term trends or investment themes.

Examples may include artificial intelligence, cybersecurity, infrastructure, robotics, defense, biotechnology, clean energy, or other evolving areas of the economy.

Because thematic ETFs can be narrowly focused, investors should understand how much overlap or concentration they may introduce into an existing portfolio.

Income-Oriented ETFs

Income-focused ETFs may invest in dividend-paying stocks, preferred securities, bonds, covered-call strategies, senior loans, or other income-producing investments.

They may be appropriate for investors seeking portfolio income, but higher yields can sometimes involve higher credit, equity, option, or market risk.

Actively Managed ETFs

Active ETFs give portfolio managers the ability to make ongoing investment decisions rather than mechanically following an index.

Managers may alter security selection, sector exposure, credit quality, duration, geographic positioning, or other portfolio characteristics as opportunities and risks change.

This can make active ETFs particularly useful when an investor wants both the ETF structure and professional investment management.

Commodity and Alternative ETFs

Certain ETFs provide exposure to commodities such as gold or other alternative asset classes.

These investments may behave differently from traditional stocks and bonds and can sometimes provide diversification benefits, although they may also involve specialized risks and tax considerations.

Leveraged and Inverse ETFs

Leveraged and inverse ETFs seek magnified or opposite exposure to an underlying benchmark, generally over a specified daily period.

Because of their structure, compounding effects, and potentially significant volatility, these products can behave very differently from traditional ETFs and may not be appropriate for long-term investors.

ETFs vs. Mutual Funds

ETFs and mutual funds can both provide diversification and professional investment management, but there are important structural differences.

ETFs generally:

• Trade throughout the day
• May provide greater trading flexibility
• Often provide frequent portfolio transparency
• Can have relatively low operating costs
• May generate fewer taxable capital-gain distributions
• Are available in both passive and actively managed strategies

Mutual funds generally transact once per day at their calculated net asset value and may have different expense-, tax-, distribution-, and trading characteristics.

Neither structure is automatically superior.

The more important question is whether the underlying investment strategy is appropriate for the investor and whether it is being used effectively within the broader portfolio.

More Than Simply Buying an ETF

The rapid growth of the ETF marketplace has created tremendous choice for investors—but more choices do not necessarily make portfolio construction easier.

Two ETFs with similar names may have very different underlying holdings, methodologies, risks, expenses, tax characteristics, and performance patterns.

Investors should consider questions such as:

• What does the ETF actually own?
• Is the strategy actively managed or index-based?
• How concentrated is the portfolio?
• Does it overlap with investments already owned?
• What risks drive its performance?
• What does it cost?
• How liquid is it?
• How has it behaved during different market environments?
• Is the ETF appropriate for a taxable or retirement account?
• What role is it intended to serve within the overall portfolio?

Selecting an ETF should therefore involve more than simply choosing the fund with the lowest expense ratio or strongest recent performance.

How Hennion & Walsh Uses ETFs

At Hennion & Walsh, we believe ETFs can be powerful building blocks for professionally managed portfolios.

The breadth of today’s ETF marketplace allows investment managers to access a wide range of asset classes, market segments, investment styles, geographic regions, income strategies, and specialized opportunities.

Our focus is not simply on selecting individual ETFs. It is determining which investments should be owned, how they should be combined, and when portfolio allocations should change as market conditions and client needs evolve.

Both passive and actively managed ETFs can play a role depending on the investment objective. By evaluating factors such as diversification, risk, valuation, income potential, underlying holdings, costs, liquidity, tax efficiency, and portfolio overlap, ETFs can be incorporated into a broader investment strategy designed around an investor’s specific goals.

All investments involve risk, including loss of principal. Past performance does not guarantee future returns. Diversification and asset allocation do not ensure a profit or protect against loss. ETFs are subject to market fluctuations and the risks of their underlying investments. ETF shares may trade at a premium or discount to net asset value. Past performance does not guarantee future results. Investors should carefully consider an ETF’s investment objectives, risks, charges, and expenses before investing.