| 06 June 2006
They have been called the greatest innovation in the investment world in the last 50 years! Some might debate the point – but there is no disputing the fact that Exchange-Traded Funds (ETFs) are the fastest growing investment product. New ETFs are launched seemingly every day.
ETFs are very similar to index funds but they trade like stocks - thereby offering some of the best features of both. Like index funds, ETFs represent a passive investment designed to match the return of a particular market rather than an attempt to beat the market through superior security selection.
For example, the “Spider” (trading symbol SPY) which was the first and remains the largest ETF, tracks the S&P 500 Index by owning a representative sample of the largest U.S. stocks similar to the no-load Vanguard Index 500 Fund. Because neither devotes time and money to analyzing and selecting individual securities they are very inexpensive. Many index funds and ETFs have an expense ratio of 0.30% or less, compared to managed funds which are often between 1% and 2%. And because of the low turnover of the securities held within these vehicles, they are very tax-efficient. Because of these features, index funds and ETFs both offer excellent diversification, low cost and tax efficiency.
The main difference is that when you buy or sell an index fund you get the price (net asset value) posted at the end of the day, whereas an ETF can be traded during the day similar to a stock. This makes them popular with investors who might want to get out of an investment quickly or use them to hedge other positions they own. Individuals who want the benefits of index funds but also certain features of stocks – such as the ability to buy on margin or sell short – will find ETFs attractive.
The annual operating expenses of ETFs are similar to index funds but can sometimes be even lower. But there is no upfront cost to purchase a no-load index fund directly from the fund company, whereas there is a commission to buy an ETF from a broker. If purchased through a discount broker, though, the transaction cost can be as little as $8 per trade.
The choice between and index fund and an ETF would normally be based on how you plan to purchase shares. For instance, investors who like to dollar-cost average into a fund or perform frequent rebalancing might be better served with a traditional no-load index fund because there would be no transaction cost when each purchase is made. If you are planning to make a one-time buy-and-hold purchase, then an ETF might make more sense if its operating expenses are lower than the alternative index fund.
Not all ETFs are created equal. An investor should know the difference between competing products just as they should with managed mutual funds. For instance, while the largest ETFs issued by the top companies tend to track the relevant benchmark pretty closely, some have failed to achieve their objective.
There are many companies offering ETFs but two of the major players with exceptional products are Barclay’s Global Inventors with its iShares exchange-traded funds and Vanguard with its VIPERs. Each company offers an array of ETFs representing various sectors of the global markets.
I have used index funds for many years, but only recently have I begun to recommend ETFs to my clients. The specific use in client portfolios will depend upon the client’s particular needs. Exchange-traded funds will not be necessary for all investors – but with the inherent cost and tax advantages of index funds – and the flexibility of stocks – ETFs are a great innovation that has changed the investment landscape.
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