Exchange Traded Funds Gain Popularity

Exchange Traded Funds (ETF) have been around since the early 1990’s, but have seen a recent increase in popularity. Current estimates indicate that U.S. investors will have purchased $469 billion in ETFs this year. Quite a large sum, but still only a little over 3% of the $9.5 trillion currently invested in mutual funds. So why all the interest in ETFs and exactly what are they?

ETFs are similar to mutual funds in that they hold numerous unified companies focused in a specific industry or market. However, Exchange Traded Funds differ from mutual funds in a number of ways. The biggest difference is that ETF shares trade throughout the day on major stock exchanges. With traditional mutual funds, shares are purchased once at the end of the day net asset value.

ETFs are formed when a creation unit or block of shares (ranging from 25,000 to 200,000 shares) from different stocks, bonds, or other investments are aggregated together. The assets are meant to mirror a specific strategy, usually an index or benchmark. This pool of shares are then purchased by investors. Mutual fund formation is the exact inverse, in that investors pool money first, then stocks are purchased.

As the demand for ETFs grows, so do the offerings. Traditionally, ETFs were constructed to mirror a specific stock index, like the S&P 500 or the Russell 2000. Now you can buy ETFs that look to capture different bond strategies like High Yield, TIPs and Corporate Bonds. Additionally you can invest in ETFs that look to capture commodities and currency. ETFs can now be bought that try to capture two or three times the direction of a specific index, either in a positive or negative direction. The one downside to this expansion in options is that unsuccessful ETFs will often close. In the event of an ETF closure, you will have to find an alternative investment choice.

ETFs are designed for diversification. They are gaining in popularity because they can fill in asset allocation gaps and reduce concentration risk. Since they are traded all day long, ETFs also offer more flexibility in that they can be optioned and shorted. ETFs also have no minimums, so you can purchase a single share.

Because ETFs are based on indexes, management expenses are usually lower than those associated with many mutual funds. Annual expenses for ETFs generally range between 0.1% and 0.65%. In some cases, ETFs may prove to be more tax efficient, since their lower turnover rate for securities can generate lower capital gains.

A word of caution before you wade into ETFs. As with any investment, you need to understand what you are getting, so you should carefully review any ETFs holdings to be sure that they reflect the appropriate theme. Don’t rely on the description of the ETF alone. You’ll also need to remember that as with any purchase, there is a fee to trade ETFs. If you think ETFs might be a good addition to your portfolio, we encourage you to discuss the options with your advisor at FMA.