Since their
inception in 1993, Exchange Traded Funds (ETF’s) have increased exponentially in popularity with institutional and
retail investors. The advent of ETF’s to the investment landscape is analogous
to the introduction of flat-screen TV’s to the home entertainment arena. In
other words, in the investment product space ETF’s function like the sleek,
flat-screen High Definition TV’s, while their predecessor, the mutual fund, is big
and clunky just like an old TV set. Accordingly, record assets have been invested
in these products with hardly a sign of slowing down. This relentless demand is
being fueled for a few reasons.
First, ETF’s
cost less than their primitive counterparts, the index fund and mutual fund.
The costs to run a fund are ultimately passed onto the investor in the form of
an expense ratio and, with mutual funds, additional sales and load fees. Since
ETF’s offer a comparable investment strategy to an index fund (that is, both
products are built to mirror an index such as the S&P 500), utilizing ETF’s with
lower costs is the wise choice for investors. Since ETF’s rebalance only a few
times a year that means there are less commissions being passed onto the
investor, whereas an actively-managed mutual fund could turnover its entire
book two to three times a year. With the higher expense ratios and fees embedded into mutual funds these products are viewed as a more complicated investment further deterring investors. Costs are going to be a primary driver as a
percentage of your total return. Throughout recent years investors are recognizing this and it
is propelling a large move to low-cost investing.
Second,
ETF’s provide diversification. Under the precepts of Modern Portfolio Theory, diversification is a useful tool in
mitigating an investor’s risk. That is, having some of your investments exposed
to stocks, bonds, currencies, commodities, and real estate in varying amounts
throughout a full market cycle will allow for you to experience a smoother
ride. The proportions in each asset class are referred to as your asset
allocation and it is constructed in a way that optimizes your performance based
on your risk tolerance.
With ETF’s,
a portfolio could easily be built with only five funds, each of which is
indexed thereby offering even more diversification. For example, instead of
owning one stock or a mutual fund with 50-60 stocks an ETF will invest your
assets across all the stocks within the benchmark index (e.g. Russell 2000
Index). Also, there are commonly used commodity and real estate indexes which an
ETF will mirror and invest in a variety of commodities (e.g. energy,
agriculture, or metals) and types of real estate (e.g. commercial and
residential), respectively.
Additionally,
ETF’s can reduce other forms of risk. Since an equity-focused ETF mimics an
index or sector of the economy no one stock has too much weight in the fund.
Instead of holding a few of your favorite stocks or your employer’s stock in
your portfolio and being subject to potentially large, adverse price moves, the
ETF will typically have a maximum weighting in any one stock of around 2%. So
even if a company went bankrupt, the most you could lose on that holding is 2%.
However, when Standard and Poors or Russell Investments rebalances an index,
the losing companies will be sold and new companies with a growing market share
will replace them. So, it is unlikely that any one position in an ETF will have
too much effect on its performance, just as no single company can have too
great an impact on the actual index.
Too, since
ETF’s are passively-managed (i.e. ETF’s track an index) there is no
active-management risk incurred by you as the investor. Having a fund manager
select the investments for a mutual fund based on proprietary but subjective
criteria can open the door for behavioral biases and multitude of other
investment errors. In fact, so few active managers outperform an index yet
charge higher fees for their active management resulting in mutual funds becoming
an expensive mistake for most investors. However, investors have realized that the
odds are in their favor to underperform an index and incur greater costs with a mutual
fund which has helped drive the shift to ETF’s that on average outperform most
mutual funds throughout a full market cycle and cost far less to do so.
Third, ETF’s
offer investors the ability to trade during the day. Since ETF’s trade like a
stock, which is also listed on an exchange, this has opened the door for
institutions and speculative investors to use the product. Accordingly, many
niche ETF’s have emerged to meet the demands of these investor demographics. However,
for most a basic index ETF with low costs will suffice.
Conversely,
mutual funds can only be bought and sold (i.e. subscribed and redeemed,
respectively) once a day. As a result, these products have only one price a day
(i.e. the Net Asset Value or NAV) and trade based on dollar amounts not share
price. For example, if you wanted to buy a particular fund an order could be
placed through your broker for a pre-determined dollar amount but you would not
know how many shares you would own until after the market closed and all the underlying
holdings were priced for the fund’s NAV. On the other hand, with an ETF the
price is determined by the market intraday and any inefficiencies or spreads
between the price of the ETF and its NAV are negated through arbitrage between
large institutional players and market makers. In effect, you have a more
transparent playing field and are able to buy or sell a position at the price
you want, not just the closing value.
Finally,
ETF’s have unique tax benefits. First, ETF’s exhibit low turnover (i.e. low
trading activity) thereby lowering the amount of potential capital gains to be
passed onto you as an investor. Furthermore, you can select ETF’s that have
investment policies that state to minimize capital gains distributions, making
them an attractive product for taxable accounts. Likewise, if tax management is
a concern there are ETF’s with low to no dividend yield which will minimize any
taxes on dividends. As with other costs, minimizing taxes will allow for your
investment to grow at a faster compounded rate, thereby creating more wealth.
Hopefully
these insights will help you understand how ETF’s have become so popular given
the multitude of benefits as well as how they can help you become a better investor.
Whether your goals are to cut costs, minimize taxes, or be broadly diversified
ETF’s are a great investment tool that should be included in your portfolio.
As always,
if you have questions or comments, feel free to send me a message. Thanks for
reading.
JD
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