Learn the ABCs of ETFs

Exchange-traded funds, or ETFs, are index funds that trade like stocks on major stock exchanges. They were introduced to U.S. markets in 1994 and now have a market value of $150 billion. Although that's still a relatively small number compared with the $7.5 trillion held in open-end mutual funds, ETFs are experiencing explosive growth and are now commonly found in the portfolios of institutional and retail investors alike.

ETFs differ fundamentally from mutual funds because they trade continuously during market hours and allow investors to lock in a price at any moment. Open-end mutual funds, on the other hand, are priced once a day using the closing prices of the stocks in the fund.

ETFs offer investors exposure to domestic indices such as the S&P and Dow Jones Industrial Average as well as to various international indices. The specific investment style of an index ETF can represent a specific sector or industry such as semiconductors, a broad market index such as the S&P 500 or a specific basket of stocks. In addition, various funds may focus on differing investment styles such as value or growth.

Virtues and Attractions

Aside from the liquidity benefits, a wide range of factors are behind the surge in ETF popularity:

  • Diversification: Like index mutual funds, ETFs provide diversified exposure to an index, industry, sector or group of stocks. However, unlike mutual funds, ETFs do so in a single investment vehicle that can often be hedged with options.
  • Tax advantages: Unlike mutual funds, ETFs have no hidden capital gains; taxes are owed only on gains that are actually realized.
  • Lower costs: According to Morningstar, the average expense fee for ETFs is 0.46%, and it can be as low as 0.09% for highly liquid ETFs such as the iShares S&P500 (IVV). The average index mutual fund expense ratio is nearly double that, at 0.88%.
  • Transparency: The holdings of index ETFs are available on a daily basis. Active mutual funds generally reveal their entire holdings just twice a year.
  • Demerits and Disadvantages

    Nevertheless, there are potential disadvantages in using ETFs compared with mutual funds, most notably the brokerage costs associated with purchasing and selling them, and the intrinsic inability of ETFs to beat their benchmark index.

    Though investors enjoy lower expense ratios, they must still pay a brokerage commission to purchase and sell shares for all index ETFs. This can significantly increase the cost of investing for those who trade frequently or who practice dollar-cost averaging with their purchases. So while index ETFs may have lower expense ratios, the total cost to the investor may not be lower.

    The goal of many investors is to beat a benchmark index such as the S&P 500 or the Dow Jones Industrial Average. They do this by investing in actively managed mutual funds. The goal of ETFs, however, is to track the benchmark index as closely as possible, thereby forgoing the opportunity to outperform it.

    (The ideal solution for investors looking to beat their chosen benchmarks would be actively managed ETFs. Because of structural difficulties, however, actively managed ETFs have yet to be introduced into the market. So for now, passively managed index ETFs will have to do.)

    The Bottom Line

    ETF investors need not fret too much about missing out when it comes to performance. According to the fund-tracking firm Morningstar, only 28% of active fund managers beat the S&P 500 over the last 10 years, and only 31% trumped the market over the last 15 years.

    That performance attribute, combined with the cost and liquidity benefits, makes a compelling case for ETFs.

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