What seems to confuse most investors about Exchange-Traded Mutual Funds, or ETFs, is that they seem to be mutual funds – but aren’t. Investors like mutual funds because they spread risk by diversifying investments. However, most do not like the management and operating expenses associated with actively managed mutual funds. That is why index funds (designed to track the major indexes such as the S&P 500 or NASDAQ) have become so popular - they may not be actively managed but their returns are in-line with the benchmarks they were designed to mirror. Similarly, ETFs are not actively managed but they are designed to mirror other indexes and offer a number of significant advantages to investors.
One problem that many investors have with mutual or index funds is that they tend to just sit in a portfolio – for years. There is nothing wrong with long-term investments but they cannot be used to take advantage of short-term movements in the market. For instance, record oil prices were set in 2005 due to Hurricane Katrina. If an investor were to want to take advantage of the expected upturn in crude prices via mutual funds, they would have to wait until the end of the business day when the net asset value (NAV) is calculated. Then, on the next business day, the investor could then buy shares in a mutual fund with oil company holdings - and the value of that mutual fund would remain the same until its value was calculated again that evening. Basically, the price could fall again before the investor even was able to sell – and then there would be penalties and possibly sales commissions to pay.
Mutual funds are not investments tools for those looking to speculate on short term price movements. However, what if a number of tech companies made a recent round of earnings reports and the news was all good - even better than expected? It would seem that any index mirroring the NASDAQ would probably do quite well in the next day or two – right? With an ETF that tracked the NASDAQ, an investor could buy shares early on and then sell them later for a profit – because ETFs trade like stocks.
ETFs are not indexes but they were created to mirror them while trading like stocks. Investors must pay commissions for all trades just like for stocks but the ETFs are designed to be as diversified as the original indexes that they mirror. This provides the investor with a lot more flexibility along with the added benefit of reduced risk thanks to diversification.
One of the big selling points for ETFs is that they are much cheaper than actively managed mutual funds and less expensive than index funds. Most investors love ETFs and their low expense ratios because it means they have more money to actually invest. One of the big complaints about mutual funds is that management, operating fees, and even commissions are all taken out before any shares are even purchased. Although these same fees may lower turnover, they also reduce the amount of capital actually used to invest.
Index funds are less expensive than mutual funds because they are not actively managed so there are no management fees to worry about. But, ETFs have even lower expense ratios than index funds, as the average expense ratio for an ETF is between 0.1-0.7%. There are, however, commissions with every ETF trade but even these expenses can be minimized by finding brokerages with flat commissions in the $10-15 range.
Another of the major benefits of ETFs is their ability to help investors diversify their portfolio. Asset allocation is an important part of any investment strategy. No investor should put all of their “eggs in one basket” which is why most financial advisors recommend splitting portfolio assets between equities, bonds, cash, and real estate. Depending on the amount of risk an investor is willing to take; different proportions of money will be invested into each asset class. Younger investors tend to take more risks and may have a portfolio with 80% of assets devoted to equities and 20% to fixed-income bonds. As the investor progresses, more asset classes will be added to the portfolio and risks will be spread even further. ETFs allow investors the ability to quickly diversify their portfolio with minimal expense.
There are ETFs to cover every major index, asset class, and niche an investor can imagine. There are ETFs made up exclusively of specialty industries in the tech and energy sectors. Commodities such as gold and oil are also covered by ETFs. Investors can even add real estate investments to their portfolio buy purchasing a niche ETF in the REIT market. An entire portfolio of diversified investments can be created quickly and simply by using ETFs.