Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton. New exchange-traded funds are sprouting up quickly. In 2025, more than 1,000 ETFs launched, and the crop included promising funds as well as those taking on unnecessary risks. The field could expand soon to include hundreds of riskier ETFs. As investment choices evolve, how can everyday investors spot what’s a good fit for their portfolio? Dan Sotiroff is the associate director of US passive strategies research for Morningstar.
Thanks for joining me, Dan.
Dan Sotiroff: Thanks for having me.
Hampton: Give me a sense of how ETFs have evolved since State Street SPDR S&P 500 ETF Trust debuted back in the ’90s.
Sotiroff: Sure. I think it’s fair to say they’ve evolved a lot, and that might be the understatement of the century. Like you referenced, the earliest ETFs—the first one actually from State Street was built around the S&P 500—but a lot of the early ETFs we saw were built around broad indexes. You had State Street come out with their S&P 400 Midcap ETF MDY: that’s still around today. They got into the Select SPDR ETFs, and we eventually saw Vanguard and iShares get into the same game, playing around with broad-market index ETFs, really. What we’ve seen over the years is we’ve started to see an evolution away from just equity. So, we started to see fixed-income ETFs come into the fold eventually in the 2000s. But the bigger thing we’ve seen since probably around the mid-2000s is that the underlying portfolios themselves have gotten narrower and narrower over time.
Even when you look at just stock ETFs, we went from, let’s say, around 98, 99 having on average about 500 stocks in an ETF to now we’re looking more at maybe 100 to 120 stocks in an ETF portfolio among a lot of the ETFs that are out there. So, the exposure, the diversification, whatever you want to call it, has come down over time. That obviously changes the risk/reward profile a little bit, but at a high level, that’s kind of how they’ve developed in the decades since SPDR S&P 500 came out.
Hampton: Let’s fast-forward to today. What trends are emerging from current launches, and what do you think of them?
Sotiroff: I would put this in more of maybe the last seven to 10 years. What we’ve seen is that the complexity has really gone up through the roof. What I mean by that is a lot of newer ETFs are using derivatives in order to sort of alter the risk/reward of those stocks and bond ETFs that we had back in the ’90s and the 2000s. Some of that’s for good reasons; some of it for not-so-good reasons. In some cases, they may be writing covered calls to generate additional income beyond what a stock or bond portfolio can provide. In other cases, they may be using derivatives to provide some downside protection. Think of the buffer ETFs that have come out over the last couple of years. And then there’re others that are just levered and inverse exposures to an index or increasingly single stocks. Those also are using derivatives to gain that leverage or inverse exposure to them.
There are really two big concerns you run into with that additional complexity. They’re very risky on their own, so they’re amping up the risk and return in the case of levered and inverse ETFs. The other thing you’ve got to be very aware of here is that the use case; how to use them and when to apply them is very difficult to understand. In some cases, the risk/reward profile is a little bit trickier to understand. You think of the buffer ETFs or the covered-call ETFs. They have their place in the right setting for the right clients at the appropriate time, but you really have to know how to use them, and you have to be aware of the risk and rewards. What are you giving up to get what this ETF is providing you with in the case of a covered call? You’re foregoing some capital appreciation for income today, as an example.
And so that isn’t always obvious when you’re looking at these ETFs, you kind of just see the headline figure, and you think you buy it now, and that isn’t always the case. They should have some very specific guidelines on how to use them. And you need to be careful about how you use them and when you implement them.
Hampton: You have to dig deeper.
Sotiroff: You have to dig a little deeper. That’s a good way of putting it.
Hampton: Some of the biggest ETFs track broad indexes, charge cheap fees, and that can make it tough for new ETFs to compete. What areas are ETF providers targeting to attract these investors?
Sotiroff: Well, a reason a lot of these more complex ETFs are coming out, and it kind of gets down to the business case for a lot of these asset managers. You mentioned those really big index tracking ETFs, predominantly from Vanguard, iShares, State Street, to a lesser extent Charles Schwab, and a few others. You can’t really compete with them because they’ve sort of taken up the opportunity set already. They already have sort of a pretty good foothold on that stuff. They’ve built trust with clients over decades. They’re more or less winning the game, and the fees are already more or less zero at this point. So, you can’t really go in and compete by trying to offer something at a cheaper cost. It’s really, really difficult, if not impossible to compete with them.
So, what you’re seeing is asset managers are getting a little bit more creative. One way they’re doing that is you’re seeing a lot more active managers get into ETFs. They’re bringing their actively managed strategies that were largely parked in just mutual funds up until the last few years, and they’re introducing those to ETFs. So, now the clients that were maybe holding the mutual fund can get a more tax-efficient experience through the ETF. The other thing, and we’ve talked about this several times, is we’re seeing a lot more bond ETFs come out right now. Bonds were an area that were just not very well picked over in the ETF world. So, we’re seeing a lot more bond ETFs come out, particularly a lot of actively managed bond ETFs. That’s another area that’s sort of evolving and where you see a lot of innovation taking place.
The other things are sort of things I’ve kind of hinted at already. You’re seeing things like covered-call ETFs, where maybe you have a client who really needs income or really wants income, and they’re willing to give up some of that upside capital appreciation to get that. You can use a reasonably built covered-call ETF to kind of complement your portfolio and get some additional income. But then there’s other stuff I was alluding to too, like the levered and inverse ETFs. Those should really just be avoided by a lot of people. I think pretty much everybody; there really isn’t a great reason to hold them. There’s no good way to use them. They have a lot of problems with them, and it’s that sort of stuff. So, there’s this weird spectrum of like, yes, I can see the use case for some of this stuff in the right situation. And then there’s other stuff I think that people should just largely avoid.
Hampton: You brought it up, so we’re going to go a bit deeper into it.
Sotiroff: Sure, let’s do that.
Hampton: Why do you think folks should proceed with caution when it comes to leverage and inverse single-stock ETFs?
Sotiroff: The way I think about it is there’s just really no good holding period for these. The stated leverage on a lot of these only applies over the course of a day, and then it resets the following day. So, if you’re using it for that one-day period, you’re going to get the exposure more or less that is on the wrapper. The problem is you’re betting on one-day price moves, in which case anything can happen. In some cases, a lot of unexpected things can happen, and it can go the wrong way for you. If you’re holding them for longer periods, longer than a day, they have another problem that you run into, and we kind of refer to that as volatility decay. The basic way to describe that is that the nature of these ETFs applies to their downside as well as their upside. So, yes, you get the levered upside exposure, but the downside is also levered.
And what happens over time is if the bet goes against you enough times, you end up digging yourself into a really deep hole, and the upside isn’t going to be big enough to overcome the hole that you’ve kind of dug yourself into. And so we see that play out on a lot of the levered and inverse ETFs. If you look at their growth over a long enough period of time, they almost always kind of just slowly decline to zero over time. And so that’s a problem that a lot of them run into. They’re definitely not long-term investments. You’re not going to get that leverage that you think you’re going to get over longer horizons. And then over that one-day period that the leverage applies, it’s very, very speculative, and a lot of things can happen. And odds are it’s probably going to go against you.
Hampton: Oh, wow. Well, there’s another layer of costs that can shrink returns than just the expense ratio. Can you explain?
Sotiroff: A lot of these ETFs—think of the levered and inverse stuff—but it applies to some other of these complex ETFs, is they’re using derivatives to ultimately get the exposure or tweak the exposure to stocks and bonds to produce the outcome that they want to produce. There are costs to those derivatives that aren’t always apparent. And particularly with some of the levered and inverse stuff, you’re using a swap contract to get that levered or inverse exposure. And there are additional costs to get that swap contract. And they’re not trivial costs. The costs vary based on the asset that you’re targeting, the specific terms of the agreement with the counterparty, and then interest rates and a few other factors. But there are additional costs there that are going to eat your return at the end of the day. Some of that stuff, it is disclosed, but you kind of have to dig through the documents. It’s not going to be upfront and obvious to anybody that’s buying these things.
Hampton: Hundreds of these riskier types of ETFs are waiting in line for SEC approval. Any hints from the agency on how they’re likely to proceed?
Sotiroff: Not yet. We’re still kind of in a little bit of a holding period right now. I think what you’re kind of hinting at here is that the SEC was asking for some comments about the introduction and approval process for a lot of the newer ETFs that have been coming out over, say, the last couple of months to a year or something like that. So, there’s obviously been a ton of ETFs that have been filed. I think we’re somewhere around a thousand, like seven months through the year or something like that. We had over a thousand last year. It’s gotten pretty wild, and I think that’s why they’re taking a step back, and they’re looking for some comments on how can we improve things and make things better. So, we’re kind of in a waiting period right now. We’re going to wait and see ultimately what they come out with hopefully in the next few weeks or so.
Hampton: Among the recent launches, you consider a few of them to be bright spots. What are they and why are they worth the look?
Sotiroff: The big ones, I think, are going back to active management. I think you’re seeing some legitimately good active managers start to get into the ETF space. And ultimately what your clients are getting there is more tax-efficient experience at the end of the day, provided that it’s being managed correctly within the ETF framework. Again, there’s a lot of new bond ETFs that have come out. That’s a big area where we’ve seen a lot of development and a lot of improvement. I think pretty much every asset manager, at least most of the big asset managers, now have an actively managed core bond ETF and an actively managed short or ultrashort bond ETF. Think of it as a cashlike substitute, if you want. Those have been some great areas, and obviously it’s become a lot more crowded. So, it’s a little bit more competitive than it was maybe five years ago.
But those are great developments. A lot of cases, those are low-cost. They’re reasonably managed by some pretty big, prominent asset managers. So in a lot of cases—you obviously have to do your own due diligence and look through and make sure you know what you’re buying—but a lot of those I think can be good in the long run. Those are probably the big bright spots, I would say, when we see active management and then some of the fixed-income stuff we’ve seen come out over the last couple of years.
Hampton: Is there anything investors should watch out for when it comes to actively managed ETFs?
Sotiroff: You have to remember the ETF is just a vehicle, right? It’s just a way to get access to an investment at the end of the day. It’s a little more tax-efficient than a mutual fund, so it’s got that going for it. But a lot of the due diligence process and understanding the managers and the process and all that type of stuff, that still applies. You’re not off the hook just because you’re in an ETF. You still need to make sure you understand that. You still need to make sure the manager is following a sensible, repeatable, cost-effective process at the end of the day. It’s kind of the way I think about what we do in manager research. And that is going to hold up over the long run because it has those traits.
So, none of that really changes all that much. You’re just getting a more tax-efficient vehicle. And in some cases, a little bit cheaper investment because the ETF generally has a little bit of a cost benefit over mutual funds, too.
Hampton: What’s the takeaway for investors considering whether they should add new ETFs to their portfolio?
Sotiroff: I would just be extremely cautious around a lot of the new stuff, particularly the stuff that’s based on derivatives. Make sure you really understand what’s going on there, you really understand the risk/reward profile you’re getting into, because you don’t want to end up with a bad experience at the end of the day. And I think the user experience of these things, in some cases, is very complicated. Like I was hinting at before, you really have to know what you’re doing. And if you don’t, just stay away.
Again, it just goes back to basic building blocks. Stick to the low-cost, tried-and-true stock or bond ETFs, whether that’s active or passive. You really can’t go wrong with those at the end of the day. That has the economic underpinnings of what makes great long-term investments is sort of that capital growth and capital appreciation. Stocks and bonds do that great. You don’t really need to look beyond that. You can build a great portfolio with that type of stuff. So, stick to that and then branch out from there if you want to start looking at some newer stuff.
Hampton: Well, Dan, as always, thank you for coming to the table.
Sotiroff: You’re very welcome. Thank you.
Hampton: That wraps up this week’s episode. Thanks for making this show part of your day. A couple of reminders: Give Investing Insights five stars on Apple Podcasts to help others find the work we’re producing for you, and subscribe to Morningstar’s YouTube channel to watch new videos from our team. Thanks to senior video producer Jake VanKersen and associate multimedia editor Jess Bebel. I’m Ivanna Hampton, editorial multimedia manager at Morningstar. Take care.
Leave a comment