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What You Should Know About ETF's

What is an ETF? How is it used? What are its benefits? These are a few of many questions that will need to be explored to adequately understand this popular investment product.

ETF is an acronym for Exchange Traded Fund which is an investment product that works similarly to a mutual fund.  However, there are several key differences between these products which ultimately give ETF’s an advantage. As the name implies, ETF’s are listed on an exchange and traded during market hours. This provides instant liquidity and exposure for market participants without having to wait to buy or sell funds based on closing values (i.e. Net Asset Value or NAV) as you would have to do with a mutual fund.  ETF’s also provide an alternative to equity index futures for money managers who desire timely market exposure or hedging ability. ETF’s can offer this exposure since most are “indexed” or created to mirror an existing basket of securities (e.g. S&P 500 Index). In other words, an ETF is structured like a mutual fund but trades like a stock.

In addition to the favorable trading features of ETF’s, the product is also generally much less expensive than a mutual fund. Mutual funds can have several different types of sales fees embedded in them usually associated with opening or closing a position in a fund (i.e. subscribing and redeeming, respectively) in addition to the fund’s annual expenses. Conversely, most ETF’s charge only an annual expense fee which is considerably low (e.g. 0.1-0.5% of fund equity per annum). 
Conceptually, the lower fees are possible on ETF’s since the products are generally considered “passive” investments whereas most mutual funds are actively managed pools of money. A passively managed product needs only to be rebalanced quarterly or annually in accordance with the index it tracks, thereby allowing fewer management costs to be passed on to you as the investor. ETF’s and mutual funds can be further delineated as beta and alpha products, respectively, although much research will argue against the efficacy of mutual funds in providing excess returns from a benchmark (i.e. alpha).

When investing in an ETF, you as the investor need to realize that you are not attempting to outperform a benchmark index, rather your desire is to mimic the returns of the index in the most cost-effective manner. In doing so, when combined with an effective asset class rebalancing strategy you should be able to accumulate a reasonable amount of wealth in the markets over many full market cycles.

As always, please do not hesitate to ask any questions. Thanks for reading.


JD
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