Debunking common ETF myths and misconceptions

With so many ETFs available, distinguishing between them can be a challenge. Approaches vary widely, and characteristics differ across multiple dimensions. Applying a simple checklist can help identify those best suited to portfolio objectives.

Since State Street Investment Management launched the first US-listed exchange traded fund (ETF) in 1993, ETFs have grown to become an extremely popular investment vehicle for a range of investors. Having said this, there is still a great deal of myth and misunderstanding about how they work, and what they offer in an investment portfolio.

We look at some of the myths that have arisen about ETFs and why things are not always as they seem.

Myth: ETFs are the same as individual shares.

Fact: They trade in the same way, but generally ETFs are shares in a diversified investment, while stocks provide exposure to individual companies.

A stock, or share, is a security that represents ownership in a company and a claim on its assets and earnings. It can be traded on major stock exchanges throughout the day, with its price driven by supply and demand in the market.

An ETF, by contrast, is typically a fund that invests in a diversified basket of assets. In most cases, these portfolios are designed to give exposure to a broad market or a segment of the market, allowing investors to gain diversified exposure through a single investment.

Myth: All ETFs fully replicate their underlying indexes.

Fact: Not all ETFs hold a portfolio that exactly mirrors their benchmark.

While many seek to track an index by holding a portfolio that closely matches it, others are actively managed and do not aim to replicate a benchmark at all. For those that do track an index, three primary replication methods are typically used:

• Full replication: The ETF holds all the securities in the index in the same weights. This usually delivers very tight tracking.
• Optimisation: The ETF holds a representative subset of securities to mimic the index. It can be more cost-efficient but may lead to greater tracking differences.
• Stratified sampling: A type of optimisation approach that builds a representative portfolio by matching the key risk factors (such as duration, sector, credit quality, and issuer) of the index. Instead of replicating each security, it ensures the ETF reflects the index across its main risk dimensions to track performance efficiently.
• Synthetic replication: The ETF uses derivatives (like swaps) to replicate index returns instead of holding the actual assets. This can help access hard-to-trade markets but introduces counterparty risk.

Myth: Individual stocks, bonds and managed funds generally outperform ETFs.

Fact: No asset class or investment category consistently outperforms over time. Markets are influenced by many factors — including economic conditions, interest rates, and sector-specific dynamics — and past performance is not a reliable guide to future returns.

Stocks and bonds are driven by different fundamentals, such as earnings and valuations for equities, or interest rates, inflation, and credit quality for bonds.

ETFs help address this uncertainty by providing diversified exposure to a broad range of securities. This diversification can reduce overall portfolio risk, as gains in some investments may offset losses in others.

Managed funds do not consistently outperform ETFs, and may be more likely to underperform over time if they incur higher fees and/or transaction costs, which can erode returns.

Myth: ETFs are riskier investments than managed funds.

Fact: There is no clear evidence that ETFs are inherently riskier than managed funds.

More broadly, the risk of any pooled investment — whether an ETF or managed fund — depends on factors such as the assets it holds, the markets it invests in, and the investment approach used. For actively managed managed funds and ETFs, outcomes also depend on the manager’s ability to successfully select securities and manage risk in the portfolio to provide attractive risk-adjusted returns.

Myth: ETFs may have lower expenses, but they cost more to own because investors must pay a brokerage commission when trading.

Fact: Advances in technology and increased competition have significantly reduced brokerage costs, making them less of a barrier than in the past across all traded assets.

Having said this, frequent trading can erode returns through transaction costs, so for investors looking to minimise costs, ETFs are often best held over longer period, where the impact of trading becomes less significant.

In contrast, while managed fund investors do not pay brokerage on entry or exit, they may incur other costs such as upfront sales charges, redemption fees, and ongoing management and servicing expenses. In many cases, these costs can exceed the total trading and holding costs of an ETF with a similar strategy. Additionally, turnover in managed funds can lead to greater tax impacts, whereas many ETFs tend to be more tax-efficient.

When comparing investment options, it is important to consider the full cost of ownership — including trading costs, management fees, and tax implications — rather than focusing on any single fee in isolation.

Myth: ETFs carry unreasonable bid/ask spreads.

Fact: ETFs often have tight bid/ask spreads, supported by trading activity and market makers providing continuous pricing.

The bid is the price a buyer is willing to pay, while the ask is the price a seller is willing to accept. The difference between the two is the spread, which represents a trading cost in addition to any brokerage fees.

Spreads are influenced by factors such as supply and demand, availability of information, and market conditions. Larger and more liquid ETFs typically have tighter spreads, while those investing in less liquid or harder-to-access markets may have wider spreads — particularly when underlying markets are closed. Smaller ETFs can still have tight spreads if the assets they hold are easy to trade, as market makers can price them efficiently.

As trading volume increases, competition among market participants tends to compress spreads, improving trading efficiency. While spreads are a consideration, they are generally less significant for long-term investors. For those trading more actively or during volatile periods, using limit orders can help manage execution costs.

Myth: ETFs are only for day traders and short-term investors.

Fact: While ETFs may be used by traders, they are equally effective for long-term investors seeking a diversified, cost-efficient exposure to markets. Their structure allows them to support a wide range of strategies — from short-term trading to long-term portfolio building, and they usually come with a competitive fee.

Myth: ETFs encourage excessive trading.

Fact: Excessive trading is not unique to ETFs — it occurs across all traded assets, driven by factors such as market activity, algorithmic trading, hedging, and speculation.

ETFs simply provide a flexible and efficient way to implement investment strategies across a wide range of asset classes and sectors. Investors were engaging in short-term trading well before ETFs existed, and ETF trading still represents only a fraction of overall market activity.

Myth: Actively managed funds seek to deliver better performance over index ETFs.

Fact: While active managers aim to outperform, there is no consistent evidence that any investment style — active or index — will outperform over time, and outcomes remain unpredictable.

If the last decade has proven anything about investing, it’s that the only thing you can predict about the market is that it will be unpredictable. Any given asset class, investment style, active or passive vehicle may outperform any other during a given time frame. Moreover, past performance is no guarantee of future results. In any case, past performance alone should never be the sole criteria for determining whether an active mutual fund or passively managed ETF is an appropriate choice for you. A range of other factors should be considered:

• Manager discretion: Active managers have flexibility to deviate from benchmarks, which may create opportunities for higher returns but can also introduce greater risk.
• Alpha generation: Active decisions can enhance returns or reduce losses, but can just as easily lead to underperformance and higher volatility.
• Costs: Active management typically involves higher fees and trading costs, which can reduce net returns over time.

Ultimately, both active and passive strategies may have a role in the portfolio, and investors should focus on how each fits their overall portfolio objectives.

Over time, ETFs have evolved into a flexible and efficient investment vehicle, supporting both short- and long-term portfolio strategies. By cutting through common misconceptions, investors can better understand what truly drives outcomes — cost, diversification vs. concentration, transparency, and portfolio construction discipline. Ultimately, the choice between ETFs, managed funds, or other vehicles should be driven by how well each option aligns with portfolio objectives, risk tolerance, and investment horizons.