Exchange Traded Funds (ETFs): An Overview

Exchange Traded Funds are similar to mutual funds in that they are not an asset class themselves — but simply a vehicle for investing in different asset classes, separately or in combination. In a way, they are kind of an evolution of the mutual fund, one that introduces increased accessibility, ease of trading, and liquidity.

Like mutual funds, ETFs pool investors’ money and diversify by holding a “basket” of assets: sometimes narrowly focused on one sector or asset class, sometimes broadly diversified like many of the popular index funds. However, unlike a mutual fund, an ETF trades on an exchange, making it easy to buy and sell shares without an intermediary[1]. This results in lower operating costs, and tax benefits. At the turn of the century, there were only 90 ETFs with holdings of $70 billion. Today, world-wide, there are almost 7,000 ETF products, valued at $3 trillion.

ETFs have helped close the gap between institutional and individual investors, which is a good thing. The exchange traded securities are an easy way for investors to branch out into asset classes like real estate and commodities. For decades, the standard portfolio was split 60/40 between stocks and bonds. Institutional investors have for some time been breaking out of that two-dimensional mold, and now the individual investor can as well. Also, the low cost of ETFs and their growing popularity has helped push down costs for all mutual funds, active and passive.

When they were first introduced into the market, ETFs embraced the broadly-based, passive index approach espoused by Vanguard’s John Bogle. The first such fund, symbol: SPY, tracks the S&P 500, much like Bogle’s first index fund. It is by far the biggest ETF, with $166 billion in assets, and trails only Vanguard’s Total Stock Market Index Fund as the largest fund in the world. But, in an investing environment where above-average returns have been rare, and in which companies are competing for the attention and business of skeptical and wary investors, many ETFs have departed from their roots and become increasingly specialized. Broad funds now account for only 20% of the ETF market. Yet ETFs are still often marketed as passive investments.

The ease with which ETFs can be traded also comes with a dark side, tempting investors to make short-term bets in a bid to try to “time” the market. While Vanguard and other proponents of passive indexing actively discourage short-term trading, ETFs come with no such restrictions. To the contrary, they are sometimes marketed to so-called “day traders” — speculators who move quickly in and out of securities to exploit momentary price advantages. ETFs typically experience a high turnover with an average holding period of only six months. At the time of writing this book, the SPY ETF is the world’s most traded security, with an average daily trading volume four times that of Apple, the second-most traded security. On August 24, 2015 — Black Monday, when the market fell over 5%, its worst day in four years — ETFs (which typically make up 25% of total trading volume) accounted for 40%. The SEC is currently looking into the role ETFs played in that day’s market panic.

Buyer Beware

Exchange-traded funds are a valuable addition to the investor’s menu. As with any tool, they are only as smart as the person using it. Keep the following things in mind as you investigate your options in this area:

For the most part, use ETFs as a vehicle for broadly-based, index-like investing. Products with names like “total stock” or “total market” are more likely to stick to this approach.

As with index funds, in areas like foreign stocks and municipal bonds, actively managed funds which allow for judgment calls may be a better bet than an ETF, and in some cases can actually be cheaper as well.

ETFs can also be a problematic way to invest in certain commodities. Commodity ETFs usually hold so-called “futures contracts” which can leave them vulnerable to speculative ups and downs.

Take a buy-and-hold approach to ETFs, and resist the temptation to overreact to price fluctuations or to try to time the market.

[1] Parties called “Authorized Participants” ensure that ETFs trade near its fair market value.