Exchanged Traded Funds (ETFs) have stormed the marketplace in the last 10 years, leaving mutual funds virtually in the dust.  So what is an ETF; how does it work; and what is all the excitement about?

Definition of ETF

An Exchange Traded Fund operates much like a mutual fund, providing the ability to buy (or sell) a basket of securities with one purchase.  This provides a higher level of diversification than owning a handful of individual securities; and simplifies the process of reaching that goal.  Each ETF has its own investment objective, just like a mutual fund, so you can find almost any ‘investment flavor’ you are looking for.

Advantages of an ETF vs Mutual Fund

An ETF provides distinct advantages over a mutual fund.  Let’s take a look:

• Tax Control: Mutual funds can generate year-end capital gain distributions to their shareholders when the portfolio manager harvests gains within the portfolio throughout the year.  These gains are hard to anticipate and add to the investor’s tax liability.  In addition, many of these gains can be short-term in nature, triggering higher tax liability for high net-worth clients.  ETFs do not generate year-end capital gain distributions.  The investor is only taxed on gains when they choose to sell their fund, not when the investment manager changes the portfolio.  This allows the investor better tax control.
• Liquidity: ETFs are traded on a stock market and can be bought and sold throughout the course of the business day.  Mutual funds on the other hand trade only once/day, and at end of day prices.  If the market is rising or falling significantly, ETFs provide greater liquidity to take advantage of market movements.
• Hedging: ETFs allow investors to issue stop loss orders, limit orders, or even to short a given fund.  This provides investors the ability to control risk and limit losses.
• Transparency: A mutual fund only discloses their holdings to investors a few times per year.  This makes it difficult to know exactly what you own and to see changes the manager has made to the portfolio.  ETFs on the other hand disclose their holdings every day, providing investors the transparency they need to make judgments about their holdings.
• Low Cost: ETFs almost always have a lower cost structure than mutual funds.  This is the cherry on top in helping to attract investors, both large and small, to take advantage of the other benefits listed above.

Passive and Active ETFs

ETFs historically were designed to mimic relatively static investment indices, such as the S&P 500, Russell 2000, and other well-known indices.  The holdings inside the original ETFs didn’t change much from year to year.  As their popularity has grown, many ETFs have incorporated more active strategies to their ETF Family.  These strategies, sometimes called Smart-Beta or Fundamental Investing, employ a rules-based system of managing portfolios.  These rules are considered the ‘algorithm’ that determines the construction of the portfolio.  Unlike a mutual fund manager who adheres to loosely defined investment disciplines, active ETF algorithms are clearly defined and more predictable, providing investors the certainty they are looking for when selecting an investment.

Proof is in the Pudding

The mainstream press has reported that mutual funds have seen asset outflows over the last several years.  This implies that investors are fleeing the market and hiding their assets under the mattress.  This couldn’t be further from the truth.  The untold story is that ETFs have seen record inflows of assets, far surpassing the outflows seen from mutual funds.  There are now over $3 trillion dollars invested in ETFs, which indicates that investors have figured out the distinct advantages these investment vehicles provide, relative to mutual funds. If you haven’t embraced ETFs in your portfolio, now is the time to rethink your strategy.