Often promoted as cheaper and better than mutual funds, an ETF is a financial instrument that offers investors flexibility in trading, cost savings compared to mutual funds, tax efficiency and broad diversification of an investor’s portfolio.

In the United States, these factors have spurred continued expansive growth in the popularity of ETFs since their introduction in 1993.

What is an ETF?

Think of an ETF as a mutual fund that trades like a stock. Just like a mutual fund, an ETF represents a basket of stocks. However and ETF isn’t a mutual fund; it trades just like any other company on a stock exchange. Unlike a mutual fund that has its net-asset value (NAV) calculated at the end of each trading day, an ETF’s price changes throughout the day, fluctuating with supply and demand.

By owning an ETF, you get the diversification of a mutual fund plus the flexibility of a stock. Because ETFs trade like stocks, you can short sell them, buy them on margin and purchase as little as one share. Another advantage is that the expense ratios of most ETFs are lower than that of the average mutual fund. When buying and selling ETFs, you pay your broker the same commission that you’d pay on any regular trade.

Like mutual funds, ETFs hold a portfolio of assets, and each share represents an undivided interest in that pool of assets. Also like mutual funds, new shares of ETFs can be created or redeemed at any time. The vast majority of ETFs are regulated by the SEC under the Investment Company Act of 1940, in essentially the same way as mutual funds.

Mutual Funds Vs. ETFs

An investor considering two investment options, an actively managed mutual fund or a similar ETF, might be well-advised to choose the latter. The primary reason is profitability, which is one of the major contributing factors to the growth of the ETF industry.

If you find the tasks of analyzing and picking stocks a little daunting, ETFs may be right for you.

First of all, in terms of overall returns, most actively managed mutual funds do not outperform most benchmark indexes, even over a substantial period of time.

Second, and perhaps more importantly, ETFs generally have substantially lower expense ratios than mutual funds. An average equity mutual fund charges somewhere between 1 to 1.5% in expenses. An average equity ETF typically charges less than 0.6%.

A lower expense ratio means a higher total return to investors. A difference of 1% in expense ratios, for an investor with $10,000 invested in mutual funds or ETFs, can mean a much larger differential in profitability. Assuming a 5% annual return in a mutual fund or ETF, a 1.5% expense ratio versus a 0.5% ratio, reduces an investor’s net profits by an additional 20%.

ETFs also offer greater flexibility and liquidity than mutual funds since they are traded like stocks throughout the trading day, as opposed to mutual fund shares that can only be bought or sold at their end of day net asset value (NAV). With trading days where the S&P 500 surges or falls by as much as 1 to 2%, having the ability to act early in the day rather than waiting until the end of the day to realign one’s investments is a huge advantage.

While mutual funds are offered through a number of distribution channels, ETFs trade throughout the day on the secondary market just like a stock. Hence the name “exchange traded.” 

ETFs also offer the advantage of easier access to a wider variety of investments. Mutual funds were created solely for the purpose of assembling a diversified portfolio of stocks. ETFs reflect the changing global investment market, offering investors exposure to emerging market economies, commodities, currencies and various derivative investments.

The U.S. Market

In the U.S. market alone, there are more than 1,500 ETFs trading. Deutsche Bank released a report in 2013 stating that global ETF assets had grown by over 28% over just one year. ETF growth has continued to outpace that of mutual funds. Since the year 2000, the percentage increase in assets committed to ETFs has grown by over 2,500%, compared to an increase of only 120% for mutual funds.

However, total investment capital committed to mutual funds still dwarfs, by more than tenfold, the total amount committed to ETFs, suggesting ETFs can continue to experience substantial growth, at 15 to 30% per year, for the next five to 10 years. As of 2015, there were more than 7,000 mutual funds available, compared to less than 2,000 ETFs, indicating the ETF market still has room for massive expansion.

What kinds of ETFs are available?

ETFs follow a wide range of strategies, including equities, fixed-income, and blended strategies. Within these broad categories are a number of subcategories, including geographic restrictions, capitalization ranges, industry sectors, and credit quality, to name a few. ETFs may be broadly diversified or narrowly focused. Some ETFs seek exposure to commodities. Many of these ETFs have a different corporate and regulatory structure, with different tax consequences.

ETFs must also disclose all the fund’s holdings on an ongoing basis daily, meaning there are no surprises about what you own.

Conclusion

A great reason to consider ETFs is that they simplify index and sector investing in a way that is easy to understand.

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