ETFs, which stands for exchange traded funds, are a relatively recent innovation. The first commercially available ETF – the SPDR (Standard and Poor’s Depository Receipts) which tracks the S&P 500 – was launched in 1993 by State Street Global Advisors and the American Stock Exchange. Then in 2000, Barclays Global Investor’s iShares came to the market, dramatically accelerating the popularity of ETFs. By the end of 2007 there were 575 ETFs to choose from. In the past 3 years they have become the fastest growing packaged investments product. ETFs were originally marketed as a product for sophisticated institutional investors. Even today, State Street estimates 50% of the ETF marketplace is made up of institutions. But 40% is now advisor and wealth manger driven (and 10% comes from individual investors making purchasing decisions on their own).
ETFs can appeal to almost anyone. They can serve many masters at the same time. The original ETFs were all based on US equity indexes, be it the S&P 500 or 1500 or the Russell 3000. But the newest generation of ETFs have “enhanced” features which have positioned them to take advantage of new markets and to utilize new functions beyond passive exposure to US equities.
ETFs now offer access to domestic and international equities, fixed income, currencies and commodities, and new choices are constantly being added. For instance, investors can now purchase ETFs for oil, gold, and even timberland companies.
One common perspective found among both wealth advisors and providers of ETFs is that these aren’t “either/or” products. That is, a portfolio can deploy both ETFs as well as actively managed mutual funds. ETFs can be used alongside traditional investments in nearly countless way, in a core satellite approach, for access, or to gain leverage. Most of the funds flowing into ETFs come from individual stock positions rather than active mutual funds. And people are using them to monetize other positions when they are not sure about a market. Active traders are moving from individual stock positions to ETFs to diversify. Additionally, within the ETFs universe, individuals can mix and match between fundamental and traditional products just the way they would allocate their equity mutual fund exposure into various styles.
International real estate ETFs offer broad access in this hard to reach asset class in a single purchase. No one investment vehicle is perfect which is why we use several including ETFs. We like ETFs because they offer broad diversification, are tax efficient, and are low cost. Also, there is no style drift. You really know where you are. Every investment vehicle has its advantages and its disadvantages. For ETFs the list of potential concerns people should be aware of includes the transaction fee involved, which is comparable to buying a stock. Investors who may be dollar cost averaging and adding to their investments in very tiny amount, will find that a mutual fund is a more efficient way to go because of lower transaction fees.
More broadly, the bigger risk is that nearly one third of ETFs are new. They may include specialized niche products completely inappropriate for retail investors. Because of the recent proliferation in ETFs, everyone must now perform basic due diligence about the sponsor. People now need to dig deeper to the next level, asking: how is the ETF trading? What is the liquidity of the stocks? Who are the market makers? The capital providers? Everyone needs to use the same level of due diligence for ETFs they employ with active managers. For many individuals, these concerns are outweighed by the long list of advantaged of ETFs. Gross returns from an investment are brought down by the fees and taxes, making it challenging to reach your long term goals. ETFs get both of these right, paving the way for a wonderful investment experience.
Mutual Funds are a great way for one to accumulate wealth, diversity and have professional management. There are a few downside factors. Say someone has only $10,000 to invest. Many Mutual Funds require a $1,000, $5,000 or $10,000 minimum. This will reduce the number of asset classes one can invest in, unless one has $100,000 or so to invest. There are 158 asset classes and all studies show the “average” investor should be in 8-12 different asset classes. Second, if you want to buy or sell a mutual fund your order is not executed until 4 P.M. EST. Additionally, should there be a run on the market, and, investors sell the Mutual Fund you are in, then, as one of the remaining investors you get stuck with the capital gains at the end of the year.
With ETF’s you can buy them just like a stock. You can purchase just one (1) share. Each ETF share trades just like a stock. So, in theory, if you have only $1,000 to invest you could buy 10-15 different ETF’s thus diversifying completely. ETF’s trade by the second just like stocks. Your buy or sell order is executed immediately. Similar to individual stock ownership, should another holder sell the ETF you are in, that action does not affect your gain or loss. You determine when you sell and can control your tax situation.
Diversification. They allow an investor to buy exposure to an entire pool of securities.
Transparency. Since ETFs are typically designed to track an index – the components of which are clear – investors know exactly what they are buying.
Cost. The cost of owning an ETF is low, sometimes exceptionally low. For example, the fee for a municipal bond ETF is only 25 basis points versus 100 basis points for a comparable mutual fund.
Liquidity. ETFs are traded on exchanges, just like a stock, creating ease and flexibility of trading. Like any stock in a brokerage account, ETFs can be sold long or short, with stop loss orders, etc.
Tax Efficiency. Because they track an index, there is typically less turnover than in a mutual fund. Additionally, redeeming institutional investors can swap stocks with one another, further reducing capital gains.
