/ETFs: What you need to know

ETFs: What you need to know

From their role in a portfolio to how they work, here’s everything retail investors need to know about the ETF market.

Experts say exchange-traded funds have democratized investing. Others fear their rapid growth may help inflate a bubble in the US stock market.

One thing is sure, it has become impossible to ignore the ETF market.

The first exchange-traded fund was created in the late 1980s, but the market didn’t take off until the early 1990s when State Street Global Advisors launched the S&P 500 Trust ETF, which is still the most actively-traded ETF nowadays and also the largest in assets under management.

The market for ETFs has significantly grown since then, reaching $3.44 trillion in assets under management as of the end of 2017. The industry also had a record-breaking year in 2017 with $470 billion of inflows into ETFs.

ETFs are built to act like a mutual fund and represent a basket of securities, most often stocks but also bonds, commodities and increasingly more esoteric assets like loans. They trade like stocks, making it convenient and often cheaper for investors to own.

Trading of ETFs is open daily and can be done online through online brokerage firms or via financial advisors.

 

WHY ARE ETFs CHEAPER?

ETFs on average carry an expense ratio of 0.44% compared to 0.74% for the average traditional index mutual fund, according to Morningstar Investment Research.

One of the reasons for their lower cost is the fact that they’re index-based and often passively-managed strategies. They carry structures that are less expensive to administer and run. Another reason has to do with their operating structure, with no sub-brokerage arrangements and different distribution fees.

“Due to their low cost, tax efficiency and no required minimum purchase size (investors can buy as little as one share) exchange traded funds are slowly replacing mutual funds as the vehicle of choice to be the building blocks in building portfolios,” says Kevin Quigg, chief strategist at Exponential ETFs in Ann Arbor, Michigan.

Increasing competition in the ETF market place and a maturing industry have also pushed costs down.

 

WHAT ARE THE RISKS?

Not all ETFs are created equal and with the product proliferation of the past few years, investors should perform the adequate amount of due diligence. This is the case for example with the rise of smart-beta ETFs, which have an element of active management.

Investors also need to pay extra attention to the liquidity of the ETFs they pick. The secondary market is one of the main benefit of ETFs, however, the level of trading volume varies greatly among ETFs.

 

WHAT ROLE DO ETFs PLAY IN A PORTFOLIO?

Investors can use ETFs as a complement to traditional active managers that they have in the mutual fund space or as the core of their portfolio. The majority of ETFs are index-based but with a little expertise and thanks to transparency regarding the composition of a fund, some individual investors can also build their own diverse portfolios.

“As ETFs have continued to grow in both numbers and areas of the market they cover, investors can now build diverse portfolios consisting entirely of exchange traded funds,” Quigg adds. “More importantly, the number of strategies available to investors in equity, fixed income, and even alternatives (commodities, real estate, etc) has increased dramatically, giving ETF investors more choice than ever before when selecting a strategy to gain exposure to a specific area of the stock and bond markets.”

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