The stock market is a complex, unruly, overly colorful candy store. There are a dizzying number of investment opportunities and strategies that dictate them.
New investors starting their portfolios from scratch may feel faint when considering what their first holdings will be. Investors know they need to own more than one commodity. But they may not have the residual information, ability, or time to decide on all the stocks they want.
Fortunately, there’s an easy solution that both new and long-time investors are employing these days. It’s an innovative investment vehicle that offers structured diversity to investment portfolios—with relatively low management or effort. It’s called the exchange-traded fund (ETF).
A History of Exchange-Traded Funds
What’s an ETF? To better understand, let’s put on some bell bottoms and go back to the 1970s.
Indexed Mutual Funds
At the time, investment companies were looking into a concept that had been gathering steam in financial academic circles for a couple decades: index investing.
Index investing was envisioned as an alternative to picking individual stocks and trying to beat the major financial indexes—the Dow Jones Industrial Average and the S&P 500. Financial researchers theorized that a more solid, long-term strategy might be able to match those indexes’ performance, rather than scramble to find big paydays and beat them.
So, financial institutions began playing around with a new investment structure. In essence, they launched portfolios that investors could buy into—not just one stock, but several securities at once. These portfolios were overseen by financial managers. They were in charge of buying and selling the individual stocks (or bonds, treasury notes, whatever).
The investors didn’t have to do much of anything. They were encouraged to “buy and hold” these portfolios since they were designed to be long-term, steady profit generators. This concept is called “passive investing.”
In 1973, Wells Fargo started a portfolio that tracked all the stocks in the S&P 500. A couple other financial firms launched their own portfolios that held multiple stocks in some indexes as well. These were the first indexed mutual funds.
At first, indexed mutual funds were only offered to institutional investors like banks — individual investors weren’t allowed. That changed because of an investor named John Bogle.
Bogle was originally skeptical about the concepts of index investing and mutual funds. But after seeing the success of the Wells Fargo indexed fund, he changed his mind. He founded the Vanguard Company in 1974, and in 1976 created the first mutual fund to be made available to the general public. Despite initial skepticism in his fund, it eventually proved very successful. It’s still around today, known as the Vanguard 500 Index Fund.
How ETFs Began
Mutual funds became quite popular and still are. But with all their success and profitability, mutual funds had some limitations.
They were expensive to buy into. Many of them had minimum investment amounts. The process of investing in a mutual fund was a little tricky. You could order shares anytime you liked, but the transaction wouldn’t be executed until the stock market closed at 4pm Eastern on business days.
In 1990, the Toronto Stock Exchange created an investment vehicle called the Toronto 35 Index Participation Units (TIPs 35). This was, essentially, the first exchange-traded fund in the world. Three years later, State Street Global Investors launched an investment vehicle called the S&P 500 Trust ETF (SPY)—the first ETF ever listed in the United States.
Like Bogle’s first mutual fund, SPY tracks the entire S&P 500 index. When you buy a share in SPY, you get holdings in every company on the S&P 500. But unlike mutual funds, you obtain shares in ETFs just as you would stock shares. ETFs are listed on the stock exchange, right up there with all the public companies. This is considered one of the most convenient ETF advantages.
The ETF market expanded quickly. Major investment firms like Vanguard jumped on board and created their own ETFs. By 2010, almost 1,000 ETFs were on the market. As of March 2021, more than 1,450 ETFs are available in the United States.
Characteristics and Types of ETFs
Now that you know the answer to the question, “What’s an ETF?” we can look at some of the characteristics of ETFs. In many respects, ETFs are very similar to mutual funds. But they have certain distinguishing features and traits. Here are a few of the most pertinent.
Tradability
ETF shares are bought and sold like stock shares. If you visit an online brokerage site like Fidelity, you’ll see ETFs listed as if they were public companies. You can buy ETF shares during an open stock market session. You can buy them at current market value or set a limit order, just like you can with stocks.
Diverse Holdings
Like mutual funds, ETFs maintain holdings in a great number of companies and commodities. The number of different securities in an ETF can be as low as 10 or 20; a few of them have positions in several thousand. The iShares Core U.S. Aggregate Bond ETF (AGG), for example, has holdings in more than 8,000 securities.
Diverse Indexes
All the companies and commodities in any given ETF make up some sort of index—meaning, they have something in common. And that commonality could be almost anything. Some of the most common classifications in different types of ETFs include:
- Market cap (large, medium, small, micro, etc.)
- Business sector (healthcare, IT, communications, industrial, consumer, etc.)
- Specific industry (restaurants, aerospace, insurance, semiconductors, leisure and recreation, etc.)
- Commodity (oil, gas, metals, sugar, corn, livestock, soybeans, coffee, etc.)
- Region (country, continent, emerging markets, etc.)
- Market index (Dow Jones, S&P, Nasdaq, and financial services trackers)
Alternately, an ETF manager may choose companies with less formal, more intangible factors. For example, they may issue funds for “tech disruptors,” “5G innovators,” “genomic revolutionaries,” or some other unique category.
They can also combine more than one factor in an ETF—say, “Mid-Cap European Semiconductor Manufacturers.” The more specific the description, though, the riskier the ETF is (it’s less diverse). But even a few narrowly-focused types of ETFs have been very successful, especially tech-centric ones.
Passive Management
With very few exceptions, ETFs are passively managed. They simply track a certain index, which doesn’t require a lot of daily oversight. This is another key difference between ETFs and mutual funds. Forbes says only “about 2% of the funds in the $3.9 billion ETF industry are actively managed.”
Intraday Price Fluctuations
Since they’re traded like stocks, ETF prices go up and down several times during a given trading day. The value of a mutual fund is set only once a day after the market closes. That’s why mutual fund orders are only executed after business hours.
ETF Advantages
While mutual funds remain great investment vehicles, many retail investors believe ETF advantages make them a better choice. Here are some of the key reasons:
Easy Access
One of the biggest ETF advantages is simplicity. Any retail investor can buy ETF shares through their online brokerage account. The process is exactly like buying shares in a stock. Since most online brokerages have done away with commission fees on retail investor transactions, there’s usually no such fee on an ETF trade.
Diversification
Many investors use different types of ETFs to instantly diversify their portfolios in one shot. They immediately get shares, however fractional, in dozens of commodities. Diversification is considered a bedrock of stock market success, as it’s unwise to tie up all your investment capital in only a few commodities. Holding a single ETF fixes that; having multiple ETFs does even more so.
Lower Costs
ETFs are cheaper than mutual funds, with some very rare exceptions. There are a few reasons this is true.
ETFs are cheaper to run. That’s because most of them are passively managed since they only track index benchmarks and don’t change their company lineups that often. Operating costs in mutual funds and ETFs are expressed as expense ratios, which is the percentage of the fund’s assets that goes toward those operational costs. The average mutual fund, according to Fidelity.com, has an expense ratio of 1.40%. By contrast, the average ETF expense ratio in 2019 was 0.45%, according to Morningstar.
There are some operating costs in mutual funds that aren’t necessary for ETFs. The most notable ones are 12-b fees. These are annual costs associated with marketing that are written into the expense ratios in mutual funds. ETFs also don’t charge “load fees,” which are commissions charged to investors when they buy or sell shares in a mutual fund. (There are, however, “no-load” mutual funds that dispose of these fees.)
Tax Efficiency
One of the more unexpected ETF advantages involves taxes. Since they’re mostly passively managed, ETFs don’t generate a lot in capital gains. That means they have less exposure to taxes. Mutual fund managers, however, frequently have to sell shares in a certain commodity when they want to reallocate their funds. If those sales result in profit, then that profit must be paid back to the shareholders, and these payments are taxable.
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