Even though the U.S. exchange traded fund (ETF) was created 23 years ago, most financial advisors still consider this investment vehicle the new kid on the block. And many individual investors still have no idea what it is.
If you're just learning about how to invest in ETFs, it will help to know what they are. Almost all ETFs are products governed by the U.S. Securities and Exchange Commission (SEC) under the Investment Company Act of 1940. This act regulates open-end funds, closed-end funds and unit investment trusts (UITs). Most ETFs hold stocks or bonds and are structured either as open-end funds or UITs.
There are other exchange traded products that get lumped in with ETFs. They have many similarities, but they are not traditional ETFs. Some hold commodities or commodity futures, such as the SPDR Gold Shares (GLD). These are regulated by the U.S. Commodity Futures Trading Commission (CFTC).
Meanwhile, exchange traded notes (ETNs), like the iPath S&P GSCI Crude OIL TR ETN (OIL) are unsecured debt instruments issued by banks. ETNs and exchange traded commodities (ETCs) have different structures and are taxed differently than ETFs. This article will only deal with 40 Act ETFs.
ETFs have many structural similarities to mutual funds, which are also open-end funds governed by the 40 Act. They both hold portfolios of securities, typically stocks or bonds. They both issue and redeem shares in their portfolios. The shares are a proportion of the assets in the portfolio.
The two big differences are that the mutual fund gets a net asset value (NAV) each day after the market closes, whereas the ETF's price fluctuates intraday because it trades on an exchange when the market is open. The other difference is that the mutual fund sells and redeems its shares directly with its shareholders. Whereas the ETF sells its shares on the stock exchange, where investors trade their shares with each other.
The main benefits ETFs offer over mutual funds: ETFs have greater flexibility, lower fees, increased tax efficiency and greater transparency.
The largest sponsors of ETFs are BlackRock with $918.4 billion in assets under management (AUM), Vanguard with $568.6 billion AUM, State Street Global Advisors with $449.5 billion, of which $200.0 billion is just one fund, the SPDR S&P 500 ETF (SPY), Invesco PowerShares with $102.3 billion, and Charles Schwab with $52.5 billion (according to ETF.com as of Sept. 15).
"When people start investing with ETFs we recommend that they focus on five areas: exposure, cost, structure, liquidity and finally, price," said Brett Mossman, managing director and lead of BlackRock portfolio solutions. "With liquidity, some of the things to look at are: How many dollars are traded in the instrument? How often does the instrument trade? And could you trade in size without moving the price?"
When looking for ETFs, first you need to ask what kind of asset class you're looking for, said Alex Bryan, ETF analyst at Morningstar. Is it core U.S. stocks or bonds? Once you answer that, screen for ETFs in that group based on things like expense ratio, or how well-diversified the funds are, such as what percentage of the portfolio is in the top 10 holdings. A more diversified fund is a better composition of the market and a better starting place, said Bryan.
"Lower-cost funds give you a better chance of meeting you investment objectives because cost is the one thing you can control. The less you pay, the more you keep," said Bryan.
Cost is not just the explicit fee of the expense ratio, but also the tax cost and the bid/ask spread. How tax efficient is the fund? Also, what is the cost of liquidity? Does the fund trade efficiently?
"The strategy is the first step and the implementation is the second step," said Jim Rowley, senior investment analyst at Vanguard. "No matter what product you choose, the product is to supposed to track an index and that index's definition. So, when you think about how the manager implements it, how well does he replicate the index?"
"At the end of the day, getting the right exposure matters more than anything," said Mossman. "You can buy the cheapest product, but if it's not the right exposure you're not going to have a good experience."
For instance, Mossman says a lot of ETFs have "Emerging Markets" in their names. However, across these ETFs are different definitions of what they consider emerging markets. This can result in very different sector and country weightings. For instance, in the iShares MSCI Emerging Markets Index ETF (EEM), South Korea is the largest country. Meanwhile, South Korea isn't even included in the SPDR S&P Emerging Markets ETF (GMM). So, a seemingly similar name, emerging markets, can lead to a big difference in exposures.
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