The Advantages of ETFs
Since they arrived in 1993, ETFs have steadily grown in popularity while rapidly expanding their ability to gather assets. ETFs, for those unfamiliar, are similar to mutual funds; however, ETFs trade in a similar fashion to stocks. A significant advantage of ETFs is that they trade like equities on an exchange. Index funds, on the other hand, have been available in U.S. markets ever since the 1970s. This kind of mutual fund seeks to track or match the index of its chosen sector. This is considered “passive” fund management and in most cases this provides higher ROI than actively managed mutual funds; however, this is a debate of its own. A fact is, index funds offer much lower management expenses than actively managed funds.
In the following, we briefly examine some of the advantages of ETFs compared to index funds.
More Variety and Choices
The number of index funds and ETFs are comparable; however, ETFs can track nearly 5-6 times the number of indices. In recent times, new ETFs have emerged tracking indices created for ETF instead of traditional index funds. (For more, see: Exchange-Traded Funds: Index Funds Vs. ETFs.)
One strong benefit of ETFs is the ability to invest in a several classes of assets in an extremely cost-effective manner. Certainly providers of index funds do their best to keep up with increasing consumer demand for such cost-effective access to different classes. The reality, however, is that ETFs remain more attractive to most investors because they retain greater flexibility overall than such offerings from index fund providers.
This greater range of variety and choices can lead to a broader as well as more effective diversification if intentionally ETFs are chosen which do not correlate positively. ETFs, therefore, are very convenient for investors looking to diversify their portfolios. There are plenty of ETFs available, and besides covering major indices, they cover different sectors of the equity markets, different asset classes (such as Fixed Income and Alternatives), specific sectors and industries, different currencies, particular market niches as well as several different strategies (such as long and/ or short ETFs). Of course, additionally, investors can further diversify internationally or globally by investing in regional as well as in international ETFs.
The Potential Cost Advantage
As explained by Van Steenwyk (2016), unlike traditional mutual funds, ETFs don’t require a team of analysts, a manager, and brokers working together to buy and sell investments within the fund. For this reason, ETFs almost always have far lower expense ratios. This is true when comparing ETFs to open-end index funds as well. This is because such open-end index funds must retain staff to process the continual redemption and purchases they require.
According to Tuchman (2013), another cost concern is the ongoing price war that ETF providers are currently engaged in. As of yet, a similar battle has not played out to investors benefit with index fund providers. When comparing ETFs to common index funds, S&P 500 rates the former’s expense ratio at a mere .05% compared to the latter’s .28%. The savings here are clearly a large draw to investors who will, in turn, use the percentage saved elsewhere in their portfolio improving its overall performance.
ETFs also provide great cost efficiency advantages to active traders. Because they are not tied to end-of-day prices, they can be traded throughout the day much like stocks for those looking to capitalize on hourly trends – for active short-term traders, however, it is important to choose highly liquid ETFs. Additionally, ETFs allow investors to employ speculative strategies in their trading (e.g., trading on margin or short selling.)
Even More Tax Efficient than Index Funds
For investors looking for the most tax-efficient funds to invest in, ETFs are extremely popular. Not only do they offer such investors a low turnover (which indexing also offers), they also uniquely enable such investors to trade in large volumes at once to qualify for unique redemptions. For example, trading large volumes of ETFs allows an investor to redeem those funds for the stocks the ETF tracks. Since this allows investors to defer tax obligation until their investment is sold, it significantly limits overall taxes owed. (For more, see: The Benefits of ETF Investing.)
The Bottom Line
It is the interest in ETFs from active traders as well as retail and institutional investors that keep fueling the rapid expansion of ETFs – the often so-called ongoing ETF boom. The diversity of different ETFs and its underlying strategies are mostly shaped by active and professional investors. However, no doubt, ETFs also hold a key spot in the portfolio of long-term private investors when the occasional opportunity arises to make diversified investments. This does not mean, however, that ETFs are completely superior to index funds as there are some unique disadvantages they present investors that traditional index funds do not. (For more, see: Exchange-Traded Funds: Index Funds Vs. ETFs.)