Exchange-traded funds, or ETFs, are some of the most popular investment products on the market today, despite having been with us for only about 20 years. ETFs have succeeded because they offer investors so many benefits - including easy diversification, flexible trading, tax efficiency, transparency, and the opportunity to invest in many markets and asset types that would otherwise be practically inaccessible for many investors .

A Brief History

ETFs trace back to an early attempt to create "Index Participation Shares" that mimicked the S&P 500 for the American Stock Exchange and Philly Stock Exchange back in 1989. While a lawsuit from the Chicago Merc scuttled this initial product, S&P Depository Receipts ("spiders") appeared four years later. Development was slow, with the introduction of MidCap SPDRs in 1995 and Barclays World Equity Benchmark Shares in 1996 (since renamed under the iShares brand).

Since its slow start, the field of ETFs has virtually exploded. There are now over a dozen ETF sponsors and over 1,400 ETFs and ETNs (exchange-traded notes) trading, with over $1.1 trillion in assets under management .

So, What is An ETF?

An ETF is basically an ownership stake in a pool of assets. When an investor buys an ETF share, he or she is buying a small percentage ownership of a large portfolio of stocks, bonds, or other assets. Said differently, ETFs allow a large number of investors to basically "share" in a larger, more diversified portfolio than they could assemble on their own.

As the value of the assets held by the ETF rise or fall, so too does the value of the ETF. If ever the price of the ETF varies meaningfully from the value of the assets held by the fund (called the net asset value or NAV), large institutional owners can buy or redeem shares with the fund's trustee (the independent financial company, often a bank, that holds the actual assets for safekeeping) to move the price back in line .

An ETF can be actively or passively managed. Passively-managed funds seek to reproduce the return of a stated index or benchmark and enter into trades only to maintain parity with that index/benchmark. Some passive ETFs are built around the ownership of hard assets (like gold) and will buy or sell the physical asset based on ETF share sales or redemptions. Actively-managed ETFs are similar to actively-managed mutual funds; the manager has discretion over the funds assets and is typically expected to maximize the growth of the fund's assets (within the mandates of the fund).

What Are The Advantages?

With over 1 trillion in assets under management, it is clear that ETFs serve a very real purpose for many investors.

ETFs are often celebrated for their ability to add "instant diversification" to a portfolio. This is a bit of a stretch, but it is true that ETFs give investors the ability to replicate the returns of entire sectors, markets, and asset types in one simple investment. Whereas it would be difficult and expensive for most investors to create a truly diversified bond portfolio, a few ETFs can accomplish the same diversification, and likewise for ETFs based upon foreign stocks, currencies, and commodities .

ETFs can also be cheaper for investors to own. With the notable exception of actively-managed ETFs, ETFs often trade much less often than mutual funds, and that lowers costs. Likewise, ETFs do not need to pay the salaries for active managers and investment staff, and the costs for marketing, accounting, and distribution are typically lower. Because ETFs don't trade as often (low turnover), they are often more tax-efficient for investors as well.

Investors can also take advantage of substantially more trading flexibility. With a mutual fund, an investor can only buy or sell shares at the fund's closing NAV for the day of the order; an ETF can be bought or sold at any time during market hours. ETFs also have a trading option that is simply unavailable with mutual funds - many of the large and liquid ETFs have options .

Disadvantages

No financial instrument is perfect, and ETFs are no exception.

Ironically, one of the advantages of ETFs is also a disadvantage - the ability to trade at any time during market hours. Whereas investors can buy or sell mutual funds directly from the managing company, often for no charge, investors must use a broker to buy or sell ETFs and brokers can charge commissions for each transaction. Likewise, the option to trade at any time can lead some investors to over-trade, frittering away money in commissions and taxes.

ETFs have also been implicated in creating or adding to market volatility. Commodity ETFs in particular have been singled out for contributing to bubbles and crashes as investors pile into (or out of) funds that hold actual physical commodities or futures contracts. Likewise, many ETFs have become popular with institutions and large traders as arbitrage instruments and sudden large movements in ETF prices can create havoc in the trading of individual stocks .

ETFs are also not necessarily cheaper than mutual funds. While the large, liquid ETFs often have lower fees and expenses (as a percentage of NAV) than similar mutual funds, the expense ratios for smaller ETFs and those ETFs where there is less competition can be quite high indeed.

Exchange-traded funds also have varying degrees of liquidity. While large and popular ETFs have low expenses, large daily volumes, and low bid-ask spreads, tiny funds can offer very low daily volume - making it more difficult for investors to build (or exit) a position and costing more in terms of bid/ask spread .

The Bottom Line

From their very limited beginnings, ETFs have become a major force in the U.S. investment industry. With ETFs, investors can now add exposure to almost any equity or bond sector, as well as foreign markets, currencies, and hard assets like commodities. While investors do need to mind details like the expense structure and the liquidity of the fund, they are often a quite cost-effective means of diversifying a portfolio and improving a portfolio's risk/return characteristics.

Disclosure: No positions at time of writing.

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