Exchange-traded funds made their debut in 1993 as a little-known, obscure financial security. Today, they’re an essential tool for both professional and retail investors, and they’re driving big changes in the field of investment management.
[Read: How to Reduce Your Investing Fees.]
So what is an ETF, exactly?
At their core, ETFs are funds — which can be comprised of stocks, bonds, commodities or other assets — that are designed to track a particular index. Like stocks, ETFs trade daily on stock exchanges, their prices fluctuating throughout the day.
And to say their popularity is on the rise is putting it mildly. Globally, ETFs saw assets under management (AUM) grow from about $200 billion in 2003 to more than $4 trillion in 2017.
More data on that later, but first, the basics:
How do ETFs work? ETFs are created by large money managers like the Vanguard Group, which bundle the underlying instruments of the fund together. After a series of regulatory steps, an ETF can be offered for sale to the public and can be purchased through a broker.
And importantly, they’re liquid: you can buy or sell them throughout the trading day, just like stocks.
There are ETFs available to suit almost any taste, style, asset class or industry. Many track an index, like the Standard & Poor’s 500 index, for example. If the value of the S&P 500 goes up, the value of the ETF goes up as well.
Some ETFs track indexes that follow commodities, currencies, and bonds. Others invest in precious metals like gold, while more esoteric offerings can even be designed to mimic the fluctuations of something intangible like market volatility.
There are also leveraged ETFs designed to multiply the daily returns of a particular index or asset class. Of course, that comes with increased risk.
“Leveraged ETFs can produce incredibly high returns,” says Kyle J. McCauley, managing partner at City Center Financial, LLC. “However, these ETFs are extremely volatile and can lose a lot of money very quickly.”
“Telltale signs you’re looking at a leveraged ETF are words like ‘Ultra,’ ‘3X,’ ‘2X,’ and ‘Enhanced,’ coupled with returns that are either significantly better, or significantly worse than the overall market,” McCauley says.
What are the similarities between ETFs and mutual funds? Mutual funds and ETFs are similar in some important ways. Like mutual funds, ETFs allow investors to instantly spread risk over a huge swath of investments — sometimes hundreds at a time — as opposed to buying a stock here, a bond there, and so on. Both give investors an easy way to become extremely well-diversified without spending the time and transactions costs to build a diversified portfolio.
Diversification is a beautiful thing in any portfolio, but it’s particularly important for retail investors because it lets them participate in a market’s upside with lower risk and volatility than a three- or five-stock portfolio.
What are the advantages of ETFs over mutual funds? Almost all of the differences between ETFs and mutual funds favor ETFs.
Many mutual funds don’t have the liquidity that ETFs do; only closed-end mutual funds trade throughout the day, and even they are managed and can be leveraged with debt. More traditional, open-end mutual funds are priced at the end of each day’s trading session, and when money flows out, shares must be sold.
As ETFs become more liquid, their bid-ask spread narrows, making them easier and more practical to trade in and out of.
[Read: Leverage Stakes Too High for Most Investors.]
One of the most impressive advantage of ETFs over their closest rivals, mutual funds, is that ETFs typically charge lower management fees. In 2016, the average expense ratio of index-following equity ETFs was 0.23 percent while equity mutual funds charged an average of 0.63 percent a year. That’s a huge difference, especially when you invest a meaningful amount of money over a long time.
These cost advantages are driven by how ETFs and mutual funds are run. Mutual fund managers are the primary custodians of their funds. They make daily buy and sell decisions that are executed by stock, bond or commodity traders. By contrast, ETFs are almost exclusively passive: Securities are bought in exact proportions to the index they track, then that fund is divided up into shares and sold. Management is only needed on a trivial basis, like when an index changes or when dividends must be distributed.
ETFs also provide tax advantages. Capital gains taxed on money made with an ETF do not have to be paid until the fund is redeemed. For investors concerned with long-term growth, this makes annual tax reporting a much easier process.
“Because ETFs represent an index, there’s very little buying and selling, unlike an active mutual fund that’s trying to beat the market,” says Mike Laubinger, vice president at Victoria Capital Management in Charleston, South Carolina.
“The ETF is ‘the market’ and is not replacing companies on news or outlook on a daily basis. Therefore ETFs will be more tax efficient,” Laubinger says.
But probably the most important advantage ETFs have over mutual funds — although lower fees and the aforementioned edges are all pretty impressive — is that passively managed funds absolutely smoke actively managed funds over time.
Consider this startling statistic: 92 percent of large-cap, 95 percent of mid-cap and 93 percent of small-cap fund managers underperformed their benchmark index over the 15-year period ending in December 2016.
That’s absolutely horrendous. Why not just buy the index itself and pay as little as possible for the right to do so?
The reliable underperformance of actively managed mutual funds has driven more investors to do just that. The financial crisis of 2008-2009 may also have encouraged the rush away from risk and into passive investing.
Between 2007 and 2016, outflows from actively managed mutual funds totaled $1.2 trillion. Meanwhile, inflows into index-tracking ETFs and mutual funds were $1.4 trillion over the same period. Today, ETFs account for roughly 30 percent of all U.S. trading by dollar value, up from about 2 percent in the year 2000.
What are the risks and trade-offs of ETFs? This is not to say that ETFs are a sure thing; no investment is. Being too closely tied to one sector or index means that a crisis can immediately impact your bottom line. Asset allocation spreads the risk but doesn’t eliminate it. The universal rule of “no risk, no reward” still applies.
Another thing to keep in mind with ETF investing is how well a particular fund achieves its goal — that is, how well it replicates the returns of an index. The difference between the index return and the fund’s return is called the tracking error.
“Use tracking error to narrow down investment options. Greater tracking error typically means greater risk or less management efficiency,” says Brian McDowell, wealth manager at Cascadia Wealth Management.
“All other factors equal, you want the ETF with less volatility and a narrower risk corridor,” McDowell says.
The major trade-off of ETFs happens to stem from its defining nature: Indexes are diversified, but may not carry the same explosive return potential of an individual stock. Investors who are a bit more accepting of risk might want to look into instruments that can provide more dramatic returns (excluding leveraged ETFs, which are rife with drama). ETFs are more suited for investors whose taste for risk is less strong.
[See: 7 Socially Responsible ETFs for Investors of All Stripes.]
At least one concern is settled. Some in the investment community once worried that ETFs might simply be a trend. Those fears may have held water when ETFs first emerged in 1993, but a quarter century and $4 trillion later, these once-exotic instruments are here to stay.
More from U.S. News
10 Smart-Beta ETFs That Will Help You Get Your Alpha
The Best Bitcoin Wallet of 2018
Artificial Intelligence Stocks: 10 Companies Betting on AI
What Is an ETF? A Beginner’s Guide originally appeared on usnews.com
