Exchange Traded Funds (ETFs) are similar to mutual funds, but they trade on exchanges just like a stock. However, unlike most mutual funds that depend on the manager's stock-selection capabilities, ETFs are based on market indices such as the Dow Industrial Average ETF (DIA), the S&P Technology Sector ETF (XLK), or Russell 2000 Index ETF (IWM).
Compared to buying individual stocks, ETFs provide the advantage of instant and robust diversification in a single position. To match without the benefit of the fund's structure, would require an individual investor to own hundreds or thousands of different company stocks. Furthermore, ETF investors are never the victim of the abrupt price swings that single stocks experience, whether caused by earnings disappointments, management upheaval, or accounting scandals that all too regularly haunt self-managed investors.
An ETF will never go out of business because their consumer product is obsolete, never file a surprise bankruptcy, never get turned down by the FDA for drug approval, and never be involved in an irrationally conceived merger. In other words, because ETFs hold hundreds or thousands of the individual company stocks that populate the market indices, they eliminate the individual-company risk that traditional stock investors face. The purchase of a single ETF provides you with diversification across hundreds or even thousands of individual companies, so there's no need from the standpoint of diversification to hold more than one ETF in your portfolio.
Unlike mutual funds, which holdings are usually secretive until a quarterly report is required, Exchange Traded Funds (ETFs) have the advantage of being completely transparent, with the legal requirement to publish every investment owned by the ETF at all times. With index-based ETFs, “if you pick up a newspaper and see how the S&P performed, you will know how your portfolio did,” says Illinois State Board of Investment Chairman Marc Levine. “They provide perfect transparency.”
What are the pros and cons of ETFs?The biggest advantages of ETFs versus mutual funds or stocks include:
Nearly every type of investor will find ETFs more convenient and compelling than mutual funds.
On the other hand, some of the features which are advantages for most investors can be unattractive for a few. Fixed transaction costs, which are low for investors buying large dollar amounts of ETFs, become relatively high for investors purchasing small dollar amounts at a time. Therefore, any investor buying less than $1,000 worth of ETFs at a time should consider buying a transaction-free ETF (check with your broker as most are regularly adding cost-free ETFs). Likewise, flexibility is suitable for some investors, but investors with poor judgment and discipline might outthink themselves by making too many moves, and there are fewer restrictions to trading ETFs.
COST of ETFs vs MUTUAL FUNDS
Another advantage of ETFs over mutual funds is cost. According to Morningstar.com, a leading industry observer, the average ETF has a cost of 0.6% (60 basis points) while the average mutual fund carries a fee of about 1.45% – almost 2-1/2 times as much as ETFs. The following table, provided by Vanguard, shows a scenario of costs with trading individual stocks versus the cost of trading ETFs:
Mutual Funds Employ So-Called 'Experts'
Historically, the vast majority of non-professional investors turned to supposed experts – mutual funds and professional money managers – to handle the task of investing their hard-earned savings. These professional money managers combine your nest egg with thousands of other investor's funds and invest in the stocks that they believe have the best prospects to gain in the future. This approach makes mutual funds actively managed investments.
Like ETFs, mutual funds are easy to buy, easy to sell, and they usually offer adequate diversification. In the past, mutual funds were also the only investment offerings that are sponsored by corporate employers. In the 1980s and 1990s, the popularity of mutual funds surged, and the percentage of US households that owned mutual funds rose dramatically from 4.6% in 1980 to 45.7% in 2000. However, from 2005 to 2013, the mutual fund growth boom fizzled out and flatlined at about 45% of all US households owning mutual funds.
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The promise of experts managing investor's money has unfortunately not met the expectations. According to the latest 2016 release of Dalbar's Quantitative Analysis of Investor Behavior (QAIB), the average investor in a blend of equities and fixed-income mutual funds has garnered only a 2.6% net annualized rate of return for the 10-year period ending Dec. 31, 2016. Counterintuitively, over longer time frames, the results aren't any better. The 20-year annualized return comes in at 2.5%, while the 30-year annualized rate is just 1.9%. (Read more about the generational shift in the investment world – from mutual funds to ETFs…)
The Emergence of Exchange Traded Funds (ETFs)
The story of Exchange Traded Funds (ETFs) began with relatively humble beginnings when this new investment product, the S&P 500 ETF (SPY), was first announced in 1993. The product was familiar to investors in some ways because ETFs are similar to a mutual fund in that the purchase of a single share provides adequate diversification. That's because ETFs, by law, hold a minimum of 26 individual stock investments and the average index-based ETF holds hundreds or even thousands of individual-company, equity investments. But that's where the similarity ends because unlike mutual funds; Exchange Traded Funds have the advantage of trading like stocks; i.e., they can be purchased and sold at any time throughout the day when the market is open.
Global ETF assets under management (AUM), 2003-2017, Source: Morningstar.com. Click to enlarge.
For many investors, the real advantage comes because, unlike mutual funds where a fund manager determines the stocks held in the fund, 98% of ETFs passively follow a market index. As most investors know, there are many hundreds of market indices from which to choose. Indices range from everything from a broad index of America's premier large businesses, such as the S&P 500 ETF (SPY), to a cutting-edge, US biotechnology stock ETF (XBI), to an emerging-market Internet and e-commerce ETF (EMQQ), to a triple-leveraged Japanese government bond ETF (JGBT). If you can think of any business category, country, niche or style, it's likely there's an index for it and an ETF based on that index. Today there are about 4,000 different Exchange Traded Funds (ETFs) with nearly $5 trillion of assets under management worldwide.
Following the first Exchange Traded Fund's 1993 introduction with the S&P 500 ETF, (SPY), investment companies gradually added new variations to the ETF product lineup, and the products began to rapidly accumulate assets around the time of the 2007-2009 'Great Recession.' That's when investors saw how effective ETFs could be to provide instant diversification – or even the ability to earn profits when other investors were losing money – by using ETFs that profited from the market's volatile tumbles during that crisis. Because of this, Exchange Traded Funds (ETFs) have become the fastest-growing product in the history of the financial industry.
Exchange Traded Funds Experience Incredible Growth
Headed in the opposite direction from actively traded investments, the Exchange Traded Fund (ETF) industry experienced another bumper year in 2017 as net inflows grew by more than $1 trillion – more than double the $419-billion-inflow figure set in 2016, and the pace of gains is increasing. Total U.S. ETF assets under management now top $3.6 trillion, and insiders see plenty of room to grow. In fact, ETF assets under management (AUM) are forecast to reach $20 - $25 trillion by 2025, eclipsing the all-time high of assets in mutual funds, an investment vehicle that is now seeing rapidly slowing growth.
Exchange Traded Funds (ETFs) offer the advantage of trading like stocks and provide exposure to virtually every investible asset class, including every portion of the equity and bond markets, individual market sectors, different industries, commodities, precious metals, currencies, and international versions of all the above. Really, with ETFs, you can access virtually any market segment you can imagine. Over the last decade, tens of millions of investors have discovered the many advantages that Exchange Traded Funds (ETFs) have over individual stocks and mutual funds. As a result, the market for ETFs has exploded. In fact, according to Credit Suisse, 14 of the 15 most actively traded securities last year were ETFs.