ETFs
What is the Excitement with ETFs?
What is a stock? It might seem like a simple question, but definitions vary, and for many, the term recalls a mix of good and bad experiences—years of strong returns or painful recessions. For me, it takes me back to a freshman-year midterm at Saint Vincent College, when I incorrectly defined stocks as growth-oriented investments tied to a company’s performance. My professor quickly corrected me: a stock is an ownership stake in a company. When you buy stock, you own part of the company. A subtle distinction, but an important one.
Exchange Traded Funds (ETFs) are all the rage in markets today. These investment funds have been around since 1993 with the launch of the SPY, a fund created to track the S&P 500 Index, however as you can see from this chart the security has really begun to surge since 2014.
Figure 1. US ETF Total Net Assets, 2014–2024 (Source: ICI Fact Book 2024 & 2025)
Going from just over $2 trillion, to $10.3 trillion in AUM is 10-year annualized growth of 17.86% but what’s driving this explosive growth?
What are ETFs?
An ETF is a pooled investment vehicle that holds a basket of assets—stocks, bonds, or commodities—and trades on an exchange like a stock. Investors gain broad exposure to markets or sectors at relatively low cost, along with intraday liquidity, unlike mutual funds, which price only once per day.
ETFs are generally more tax-efficient than mutual funds due to their unique in-kind redemption process, which helps minimize capital gains distributions to investors. The table below compares the tax treatment of ETFs and mutual funds across several key dimensions.
Topic | ETFs | Mutual Funds |
Capital gains during holding period | Rare for broad ETFs due to in-kind redemptions; distributions typically minimal. | Common when managers sell appreciated positions; gains pass through annually. |
Realization mechanics | In-kind creations/redemptions with APs minimize realized gains. | Cash redemptions can trigger realized gains distributed to shareholders. |
When investor is taxed | Primarily when selling shares or receiving minimal distributions. | Annually on capital gains distributions + when selling shares. |
Turnover impact | Index ETFs typically have low turnover, reducing taxable events. | Active funds often have higher turnover, causing more taxable events. |
Cost basis control | Investor controls timing by choosing when to sell. | Less control due to pass-through gains from fund-level activity. |
What’s the Appeal?
ETFs combine the accessibility of mutual funds with lower costs, broader fund options, and greater tax efficiency. From simple index ETFs mirroring benchmarks like the S&P 500 to leveraged and inverse ETFs offering amplified exposure, there’s something for nearly every investor.
The Misconception
It all sounds very exotic, in fact ETFs might as well stand for Exotic Tradeable Funds. This is where we must pause though and ask if it is worth getting excited about. The answer for us at Covington is a reserved no. While ETF’s sound great on paper, most investors are generally unaware of what they own, you don’t directly own the underlying securities—you own a claim on the fund’s holdings, similar to mutual funds.
This distinction matters as it contributes to greater liquidity risk, meaning that in a severe downturn, mass redemptions could trigger liquidity crunches. This event may leave you with a considerable loss to your principal investment.
Additionally, owners of ETFs and mutual funds do not have direct say in company decisions, unlike individual shareholders, meaning that their ownership has no influence on the company’s performance.
These deficiencies are often overlooked during bull markets, but history tells us market corrections are inevitable. The last major recession was in 2008, and history tells us that we can generally expect a recession about every 10 years, we are overdue.
Conclusion
Despite this, ETFs still have a valuable role, particularly for investors who can’t afford diversified portfolios of individual stocks. They provide instant diversification at a low cost. Funds like SPY, which track the S&P 500 Index, have historically delivered strong results, averaging a total return of 10.53% of annual returns since its 1993 inception.
The key point that our readers should take from this is that while ETFs seem attractive, they should not be investors’ first choice. If you can afford an actively managed portfolio of high-quality individual securities, that is preferrable. If you rely on ETFs, don’t abandon them, but be selective and informed. Above all, if a fund’s strategy or description is confusing, it’s probably not a good place to park your money.
As always if you have any questions about this subject, we encourage you to reach out to us at our office.
Best Regards,
Jacob
Sources: Investment Company Institute (ICI), 2024 Fact Book — Chapter 4: US Exchange-Traded Funds
Investment Company Institute (ICI), 2025 Fact Book — US ETF Market Briefs
Commentary Disclosures: Covington Investment Advisors, Inc. prepared this material for informational purposes only and is not an offer or solicitation to buy or sell. The information provided is for general guidance and is not a personal recommendation for any particular investor or client and does not take into account the financial, investment or other objectives or needs of a particular investor or client. Clients and investors should consider other factors in making their investment decision while taking into account the current market environment.