Exchange-Traded Funds

There are three Main Asset Classes: Equities (Stock), Fixed Income (Bonds), and Cash Equivalents.

An Asset Class is a grouping of investments that share similar characteristics and structures, typically used to diversify portfolios. However, they have very little correlation with one another. If they did, in a market downturn, many investors will suffer despite diversifying. That’s why an ETF can be broad or narrow, depending on the investor’s risk tolerance.

The three Exposure Types basically decide how the ETF will track an index or benchmark; market segment; or its strategies to succeed.

Reflection

It seems so overwhelming, especially since ETFs can get really narrow, but it’s complication isn’t as crazy as it looks. Best way to understand is that the super specific ETFs are for investors that want that exact ETF.

What a majority of safe or beginning investors want to look at are Passive ETFs, which I’ll explain more of in this blog, rather than Active ETFs. If you’re curious for a much better and further breakdown of the diagram, check out justETF. If you want to read more about Active ETFs, look at this article Fidelity posted on Fidelity Learn. The video by Explanity is also a great way to understand what ETFs are.

Passive ETFs

The primary objective of a Passive ETF is to track or replicate an index. It functions very to an Index Fund, but there are fundamental differences between the two, which will be discussed later on. Like I mentioned earlier, most people choose this option, mainly because you don’t have to constantly keep track of the market in order to get rewarded for it.

There are a lot of differences amongst ETFs and Mutual Funds. It’s a lot to cover, but I want to cover the main differences and further discuss the more complicated aspects of these differences. Below is a comparison table:

ETFs Versus Mutual Funds

Let’s first understand how Mutual Funds work and how investors recognize capital gains. Mutual Funds are managed by a fund manager; when you sell your shares in a Mutual Fund, the manager will give you money available in the fund. Capital gains are only recognized when underlying stocks are sold at a profit, so in this case, if there is enough money at hand in the fund, the fund manager doesn’t need to sell any underlying assets. Let’s take a look at this scenario:

In a market downturn, multiple investors sell their shares of a mutual fund. This amount exceeds the cash available at hand, forcing the fund manager to sell underlying stocks. If the manager sells shares at a profit (Originally bought Apple Stocks for $50, sold today for $100), every investor (even ones that aren’t selling) will recognize capital gains. Even if all the investors are recognizing a total loss, it is still a capital gain. There are workarounds to this, like recognizing capital losses, but overall is more work for investors.

ETFs function very differently. In order for ETFs to form, they must go through a process called creation basket. Authorized Participants (AP), like Goldman Sachs or Morgan Stanley, buy stock shares that match an ETF Portfolio created by a brokerage firm. Once they obtain these shares, they safely put them in a Custodian Bank; this bank holds the ETF’s assets (underlying stock). Brokerage firms then create shares based off of the Custodian Bank’s assets, where they give to APs and are sold to investors (people like us). This is called a creation basket. When investors sell ETFs on the market, it’s not actually selling the underlying stock, even in mass selling scenarios. It’s only selling what the ETF is valued at. Let’s look at the same scenario as above, but with ETFs:

In a market downturn, a lot of investors mass sell their shares of this ETF. This causes the price of the ETF to drop, thereby having a price discrepancy despite its true value (NAV: Net Asset Value) being higher. The AP will take advantage of this and buy the ETFs in the market that are lower than the NAV, where they then redeem the ETF shares in-kind with the ETF issuer (AP swaps their ETF Shares for Underlying Stocks with the ETF issuer). This still isn’t realized as capital gains, only when the AP decides to sell the underlying assets will it finally be recognized as a capital gain.

Conclusion: ETFs avoids capital gains taxing on other investors, besides the one making the sale. Mutual funds cannot recognize this due to the nature of taxing on underlying assets. Although there are ways to offset it in mutual funds, it requires more active management from all the investors.

Let’s examine the Tax Benefits and Capital Gains, as these are the main driving factors in what makes ETFs attractive.

Tax Benefits

Capital Gains & Availability

As mentioned before, an ETF operates very similarly to a stock. During anytime of the day, they can be bought or sold. This is really attractive for investors as you can buy an ETF under the NAV or sell an ETF over the NAV. Although it may not stray far away from the NAV, it helps investors realize a small profit or save some money. Their other main benefit is immediate execution, if you want to sell it now, you can.

On the other hand, a Mutual Fund wouldn’t be able to, as it’s focused on being sold at the end of the day. For many investors, this makes it less attractive, as you can’t see the price changing constantly, nor is it easy to liquidate compared to ETFs. Along with the capital gains taxing downside, they often look worse, but that’s not the case.

Conclusion

It seems like on paper that ETFs are superior compared to Mutual Funds, but would be far from the reality. They’re both equally good and it just boils down to preference. Your risk tolerance or what lifestyle you’re looking for will affect what you really want. People who prefer a more engaging investment lifestyle may choose an Active ETF, while someone who wants to forget about their investment may choose a Passive ETF or an Index Mutual Fund.

Some consensus online is that you should mostly purchase Mutual Funds in a tax-advantaged account, where the capital gains tax issue is absolved. While in your brokerage account, take advantage of ETFs’ flexibility. Regardless, always do more research before, as this is not investment advice, just a blog to help you understand all the investment types.

Sources:

ExplainityChannel. (March 2, 2022). ETF explained (explainity® explainer video). YouTube. https://www.youtube.com/watch?v=YNOgoR9k0i8

Capital.com. (May 23, 2022). ETFs Explained: A beginner's guide. YouTube. https://www.youtube.com/watch?v=DPsUntwGIAg

Fidelity Learn. (January 12, 2022). What is an ETF?. Fidelity. https://www.fidelity.com/learning-center/smart-money/what-are-etfs

Fidelity Learn. (January 12, 2022). Actively Managed ETFs. Fidelity. https://www.fidelity.com/learning-center/investment-products/etf/types-of-etfs-actively-managed

Fidelity Learn. (October 30, 2025). What is an ETF?. Fidelity. https://www.fidelity.com/learning-center/smart-money/what-are-etfs

Chen, J. (December 5, 2025). Exchange-Traded Fund (ETF): What Is It And How To Invest. Investopedia. https://www.investopedia.com/terms/e/etf.asp

(Retrieved March 1st, 2025). ETF Database. https://etfdb.com/etfs/asset-class/

(Retrieved March 3rd, 2025). ETFs vs Mutual Funds. Wikipedia. https://www.bogleheads.org/wiki/ETFs_vs_mutual_funds#Availability_and_portability