An exchange-traded fund (ETF) is a basket of securities that trades on an exchange like a stock. In the event you don’t know how the stock market works, shares of public companies trade at various prices based on demand. The distinguishing factor with an ETF is that, rather than representing ownership in a single company, it tracks an index such as the S&P 500 or Dow Jones Industrial Average. The price of an ETF, similar to a basket of stocks in a mutual fund, will vary based on the performance of its underlying holdings. If an ETF represents an index with thirty different companies and all of them are trading up on a given day, the offering price of the ETF will move up accordingly.*
A good starting point for better understanding this important and relatively new investment product is to view their advantages against investments which could be utilized by a similar audience. Mutual funds are the investment product most analogous to exchange-traded funds which can be used as a benchmark for comparison. Let’s analyze some of the criticism given to mutual funds and then see how exchange-traded funds stack up.
• Mutual funds tend to be expensive.
• Mutual fund prices are only figured once daily- after the close of the market. If you put in an order for a mutual fund at 9:45 in the morning, you’ll get the 4 pm price.
• An investor cannot short sell or buy options on mutual funds.
• Mutual funds often have steep sales charges.
• Most mutual funds are actively managed.
Keep in mind that, while mutual funds may have certain disadvantages, they are still an extremely popular and important investment vehicle. Part of the value which can be extracted from the earlier chapter on selecting mutual funds is based on both the staggering amount of assets invested in mutual funds in the United States as well as the fact that many retirement plans, such as the 401k, require the use of mutual funds by plan participants. I’m highlighting their criticisms for the purpose of making my ETF discussion as clear as possible. That being said, let’s talk about how exchange-traded funds are different from mutual funds.
Exchange-traded funds are relatively inexpensive. Because ETFs track indexes, the expenses are usually lower than mutual funds. There are several reasons for this. First, they avoid costs associated with hiring portfolio managers and research analysts to help pick securities. Second, transaction costs are typically lower as well. Unlike mutual funds, ETF sponsors do not sell shares directly to the public. They exchange large blocks of shares, known as creation units, for the securities of the companies that comprise their underlying index. In a sense, it is the predictability of the creation units which differs from mutual funds and causes fewer transactions. With a mutual fund, it is near impossible to anticipate who will buy shares and who will redeem shares from day to day. This operational difference also lends itself to certain tax advantages, such as lower rates of capital gain distributions getting transferred to investors.
Exchange-traded funds can be bought or sold throughout the day. Imagine if the market was rapidly declining because of a terrorist threat. An investor could sell his ETF shares early in the morning whereas mutual fund shares could not be liquidated until the end of the day. This advantage is referred to as liquidity.
Some people actually claim this as a disadvantage because it encourages a higher volume of trading in funds that are often intended to be purchased as long-term investments. I don’t think of this as a specific disadvantage of exchange-traded funds- rather a commentary on the impulsive and often emotional nature of many investors. Having a smart financial advisor and self-discipline should help overcome the desires to trade your core portfolio holdings.
The ability to short-sell or trade options on exchange-traded funds. If you’re looking for a potentially inexpensive way to hedge yourself after a recent climb in the markets, short-selling an ETF may provide that possibility. This practice is not possible with open-end mutual funds as they are not securities which can be bought or sold on an exchange. One can also buy or sell options on an ETF the same way they could with a stock. For example, buying a “put” on an ETF which tracks the S&P 500 index might provide some protection against a decline in the overall markets.** Similarly, if it were your belief that the broad market averages were going to perform well in the near future, you could buy a “call” on an ETF which corresponds to the market index which you’d like increased exposure to. To learn more about options strategies and how they may pertain to your portfolio, visit www.cboe.com.
Exchange-traded funds don’t have steep sales charges.*** This advantage depends in many ways on your current compensation arrangement with your broker or advisor. Technically, an ETF is purchased like a stock. An investor pays a commission to a broker for executing the trade. The size of that commission obviously is something which you work out with your broker or advisor, but it’s quite possible that the commission would be lower than an up-front commission on a load mutual fund. For example, a $10,000 purchase of an ETF, similar to a stock, might cost you around 1% ($100) to purchase. This number could be even less if you choose to utilize the services of a discount brokerage firm. Compare that with a standard up-front commission on an equity mutual fund which could run you in the ballpark of 5%, or $500.
Mutual funds are actively managed. The fact that exchange-traded funds try to duplicate an index rather than outperform it could be perceived as either an advantage or disadvantage. The answer reverts back to the popular argument of whether actively managed funds are worth their higher level of expenses. Certain managers are famous for consistently outperforming their peers. If we knew which managers would beat their benchmarks each year, most people wouldn’t bother reading articles about exchange-traded funds. However, statistics show that, over the long run, mutual fund managers usually don’t beat the index which they compare their returns to.**** I consider this an advantage insofar as you’re still getting broad market exposure but potentially paying much less for it.
Why Else Might I Buy an Exchange-Traded Fund?
Another popular use for exchange-traded funds is to gain exposure to specific market sectors. One may do this because of familiarity with a certain slice of the market, or simply to speculate on events which might cause one sector of the market to perform better than others. Just remember when overweighting a specific sector of the market that it could disrupt a mapped out asset allocation.
Because exchange-traded funds have seen such a dramatic increase in fund flows over the past several years, they have started to evolve into quite the trendy product. Originally, ETFs tracked primarily the major market indexes such as the Dow Jones, or Wilshire 5000, and major sectors such as financials, healthcare, and technology. Now, besides the more traditional indexes, ETFs exist for various unique and alternative indexes. There is a clean energy ETF for people looking for a cheap way to gain exposure to the alternative energy market. There is also a currency ETF, leisure ETF, and even one which tracks IPOs (stocks which recently started trading publicly). Granted, it sometimes feels like too many ETFs have been released into the marketplace, but it’s doubtful investors will complain about this as it gives them a wider variety of investment options.
I find the popular reception of ETFs as trading tools to be an intriguing concept. When I first learned about this product, I immediately thought of it as a substitute for mutual funds, as discussed above. With all the people in the world who criticize actively managed mutual funds and advocate the low-cost environment associated with index funds, you’d think ETFs, which are potentially cheaper than index mutual funds, would attract a heavy flow of funds away from mutual funds. Now, this has happened to some extent, but not with the sense of urgency I would have expected. Mutual fund assets in the US currently stand at over $10 trillion, while ETFs are still hovering around $400 billion.
I believe one explanation for this could be how they are marketed–both by the ETF companies and by financial advisors. Many ETFs are based on indexes which are speculative and attract investors with a high tolerance for risk. These are often the same people who enjoy trading stocks. It’s questionable how many of these people are focusing on the costs of their long term investment holdings. If they are, why haven’t they embraced ETFs for that purpose as well?
Also, financial advisors who work on commission tend to make less money selling exchange-traded funds as long-term holdings than they do from selling load mutual funds. Considering the fact that many individual investors learn about new investment products through their advisors, this could certainly slow the passage of information. As we mentioned, those who are actively seeking newer investment products tend to be the investors who focus on short term trading. So basically, we lack a medium through which ordinary investors can learn about the potential cost savings associated with exchange-traded funds. This is one way the blogosphere can really come in handy. It’s a source of free information which can potentially improve your decision-making and make you a better investor.
Questions? Comments? E-mail me
Premier Financial Advisors, Inc
14 E 60th Street, #402
New York, NY 10022
P: 212-752-4343 *31
Securities and certain investment advisory services offered through: First Allied Securities, Inc., a registered Broker/Dealer. Member: FINRA/SIPC. Premier Financial Advisors, Inc. is a Registered Investment Advisor. First Allied Securities & Premier Financial Advisors are not affiliated entities.
* Equity-based ETFs are subject to risks similar to those of stocks; fixed income ETFs are subject to risks similar to those of bonds. Investment returns will fluctuate and are subject to market volatility. Shares may be worth more or less than their original cost when sold. Foreign investments have unique risks, and greater risks than domestic investments. Past performance is no guarantee of future results.
** ETFs can be constructed to represent the holdings found within an index; however, the trusts may not be able to exactly replicate the performance of the indexes because of trust expenses and other factors. Investors cannot invest directly in an index. Options involve risk and are not suitable for all investors. Carefully consider whether options are appropriate for you in light of your experience, objectives, and other financial circumstances.
*** Depending on the number of trades executed, the cost of the associated commissions may outweight the low expense ratio associated with ETFs compared to mutual funds. As such, in some instances, costs of ETFs may be greater than that of mutual funds.
**** William Sharpe, “The Arithmetic of Active Management,” Financial Analysts Journal 47, no. 1 (January/February 1991):7-9