ETFs for dummies: what are they and why investors are flocking to them

When exchange-traded funds (ETFs) were introduced, they became a popular alternative to mutual funds because of their low costs. Although the two investments are very similar, their subtle differences create unique investment characteristics which serve different investment styles and objectives. A secular shift away from high-cost mutual funds towards low-cost ETFs has been occurring for years, with a record breaking inflow of $135 billion in the first quarter of 2017 alone. As the stock market continues to surge, ETFs are gaining in popularity. There are four main factors why investors are turning to ETFs in record numbers.

Investment strategy

The most critical factor is the investor’s investment strategy, which is the basis of determining whether an active or passive approach will be used to pursue investment goals. An active approach is best suited for investors who seek to generate returns in excess of the broad market. That usually requires utilizing a professional money manager who attempts employ research and analysis tools to buy and sell securities to maximize returns. A passive approach is better suited for investors who are satisfied with matching the returns of the broad market. Most ETFs are index-based, requiring minimal management to align the performance of a portfolio with an underlying index. However, there is a wide variety of ETFs available that offer exposure to many different index providers with varying index construction methodologies that are designed to outperform the broad-market indexes. 

Trading flexibility

Investors, who want greater control over the timing and price of their investments, might prefer ETFs, which are traded like stocks on the stock exchange. ETFs can be traded any time the exchanges are open, and transactions take place at market prices upon execution. ETFs with greater liquidity can be traded more quickly with market prices that are more closely aligned with the implied value of the ETFs underlying securities. With less liquid ETFs, the market price could vary more widely with less correlation to the actual value of the portfolio.

Mutual fund shares are highly liquid, but they only trade once a day after the close of the market. This is usually sufficient for investors who infrequently buy in and out of mutual funds as required by their investment strategy. 

Accessibility

Because ETFs trade on the stock exchanges, they provide much more accessibility than mutual funds. Any investor with a brokerage account can have access to any publicly traded ETF. For passive investors who want more choices in index funds, ETFs offer a greater variety of index strategies than mutual funds.

Costs

Investors are learning that fees do matter, which explains the surge in index funds and ETFs investing over the last decade. The ongoing costs of investments, which include expense ratios and taxes, can erode investment performance over time. Transaction costs, such as up-front sales loads or bid-ask spreads, take an immediate bite out of investable dollars. Investors have to consider several factors in determining the most cost effective options. On average, ETFs have smaller on-going costs than mutual funds and their transaction costs are minimal.

Easier to achieve optimum diversification

Successful investors know that the key to long-term performance is diversification. Due to their low cost and the wide ranging indexes and market sectors they cover, ETFs make it possible for investors to achieve broad diversification to be able to capture returns wherever they might occur. A broadly diversified portfolio of ETFs will also reduce portfolio volatility.

Investing in ETFs can get complicated

The good news is that, as an investment vehicle, ETFs are fairly easy to understand. The bad news is that identifying the right mix of ETFs from among the thousands that are available across multiple countries and currencies can be daunting. Add to that, the need to keep your portfolio properly balanced can be a chore as the price fluctuations of ETFs can skew your asset allocation resulting in increased risk exposure. Also, without a strategy to reinvest dividends, you can be capping your annualized returns. 

The point being, to achieve the maximum benefit from investing in a diversified portfolio of ETFs, investors would be better served by partnering with an investment professional who can bring essential knowledge and expertise to your investment strategy.

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