Every industry has its fair share of lingo, and the investment world is no exception. Opening the business section of the Wall Street Journal can feel like trying to decipher Latin. The readers find themselves wading through an alphabet soup of confusing acronyms and industry jargon.
One financial term in particular has made its way into everyday conversation, although few completely understand what it means. It comes up in the news, conversations with friends, and on the internet. You may even own a few in your portfolio. The term is ETF, or Exchange Traded Fund. What are ETFs, and why are they so popular?
What is an ETF?
An ETF is a diversified basket of securities, such as stocks or bonds. By investing in an ETF, you gain exposure to a broad selection of positions. In this way, an ETF is like a mutual fund. The similarity, however, ends here. ETFs and mutual funds have distinctly different structures, particularly around management and trading.
Mutual funds are actively managed, meaning that a portfolio manager selects what positions make it into the portfolio. While mutual funds may benchmark themselves to a particular index, the manager often tries to adjust the weight of certain positions to outperform that index.
Most ETFs, on the other hand, are passively managed. Instead of a portfolio manager selecting his or her “hot picks”, ETFs usually seek to carbon copy an index, such as the S&P 500 or Russell 1000.
Another key difference is trading. Mutual funds are “open ended”. This means that the portfolio manager creates new shares whenever an investor adds cash and eliminates shares whenever an investor makes a withdrawal.
ETFs, on the other hand, are “closed ended”. Instead of creating new shares for each purchase, an ETF is issued with a certain number of shares that trade among investors, similar to individual shares of a stock.
Why are ETFs so popular?
To figure out why ETFs are so popular, we’ll need to look beyond the basic structure to see how it impacts returns in three key areas: low fees, tax efficiency, and flexible trading.
ETFs generally have lower fees than mutual funds. Unlike actively managed mutual funds, most ETF portfolios passively follow indexes. Because of this, ETF portfolios are easier to maintain, resulting in lower management fees. Additionally, ETFs lack the loads, commissions and 12b-1 fees that some mutual funds charge investors on top of the annual expenses.
This doesn’t mean that ETFs have no trading costs. Investors pay a commission to their custodian or broker for each transaction. Another important cost is the bid-ask spread, or the difference between what the buyer pays and what the seller receives. For smaller, thinly traded ETFs, this bid-ask spread can become a sizable percentage of the purchase cost. However, even with these extra trading expenses, the overall cost of ETFs is often much lower than what you’d find in a comparable mutual fund.
Secondly, ETFs are often highly tax efficient. When an investor owns a mutual fund, all capital gains flow directly to the investor. This is because of the mutual fund structure. When cash is added to the portfolio, the manager will purchase new holdings, and when cash is withdrawn, the manager will sell holdings. Because of this, a mutual fund investor could pay taxes in a year that the fund is down. This underperformance may cause other investors to sell their shares and realize gains for all shareholders, even those who don’t sell—a double whammy!
ETFs, on the other hand, very rarely have capital gain distributions. This is because they usually don’t directly purchase or sell positions. Instead, they exchange baskets of securities in-kind with institutional authorized participants. Because there are no trades, there are no capital gains. ETF investors generally only pay capital gain taxes when they decide to sell, giving them the final say on their tax bill.
Third, ETFs have a flexible trading structure. Mutual funds trade only once at the end of the day, and everyone receives the same price. However, because ETFs trade like stocks, investors can buy or sell throughout the day, allowing them to take advantage of intra-day price changes. Additionally, sophisticated investors can purchase ETF shares on margin or even short them. These strategies are not available with mutual funds.
Should I purchase ETFs for my portfolio?
With all of these advantages, it’s no wonder that ETFs are so popular. They provide broad market exposure at a cheap price. For investors seeking long-term returns, the low expense ratios allow for more compounded growth over time. They are also a great tool for diversification, since they give exposure to potentially hundreds of underlying holdings.
However, there are a few situations where ETFs might not be the right structure. They may not provide exposure to certain areas of the market. For example, many countries don’t offer as many ETF options as the US. An investor interested in a particular international fund may need to purchase a mutual fund to gain the exposure they desire.
Also, not every ETF is the same. As mentioned above, some smaller ETFs have very low trading volume, making the purchase cost (the bid-ask spread) very large. Some also have low tracking error to their indexes and so don’t give the exposure that an investor desires. Finally, not all ETFs have low expense ratios. Some specialty ETFs, such as leveraged or inverse ETFs, may command annual fees of over 1%.
Still have questions?
Do you still have any questions about whether ETFs are right for you? Contact our office today to review your portfolio and learn more about your investment options.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.
Investment advice offered through Stratos Wealth Partners, Ltd., a registered investment advisor.