1. Exchange-Traded Funds: Introduction
  2. Exchange-Traded Funds: Background
  3. Exchange-Traded Funds: Features
  4. Exchange-Traded Funds: Biggest ETFs and ETF Providers
  5. Exchange-Traded Funds: Active Vs. Passive Investing
  6. Exchange-Traded Funds: Index Funds Vs. ETFs
  7. Exchange-Traded Funds: Equity ETFs
  8. Exchange-Traded Funds: Fixed-Income and Asset-Allocation ETFs
  9. Exchange-Traded Funds: ETF Alternative Investments
  10. Exchange-Traded Funds: ETF Investment Strategies
  11. Exchange-Traded Funds: Best Practices for Trading ETFs
  12. Exchange-Traded Funds: Conclusion

The burgeoning popularity of ETFs can be attributed to several of their features that greatly benefit investors. Here are the top ten, ranked by our assessment of importance to the investor.

Intraday Trading

Since ETFs trade on stock exchanges, investors can buy and sell them during trading hours at market-determined prices. This feature gives investors instant liquidity and eliminates the need for them to wait until the end of the day to get filled on their orders, as is the case with mutual funds. This is of obvious benefit to investors particularly when markets are volatile. For example, assume the equity market is flat earlier in the day and ends the trading day 1% higher; the investor who buys an index ETF intraday rather than purchasing a mutual fund (whose price is determined at the close) would have purchased the ETF at a significantly lower price compared to the mutual fund.

Low Costs

ETFs typically have lower management fees and expenses than actively managed mutual funds, and often have lower management fees than index mutual funds. Since ETFs are exchange traded, the significant costs of record-keeping and the client relationship are handled by the broker, rather than the mutual fund company that handles these functions for its fund investors. In addition, ETFs enable investors to acquire a diversified portfolio for a single commission, as opposed to paying commissions for buying all the underlying securities in the portfolio.

Diversification

ETFs that track an index will incorporate all – or a representative sample of – the securities that make up the index, regardless of whether the securities included in the index number in the hundreds or thousands. This gives an investor a diversified portfolio that may have lower variability compared to individual securities. It is important to note that merely holding a number of ETFs does not ensure appropriate diversification, unless one also incorporates prudent asset allocation. For example, an investor who only holds equity ETFs may be adequately diversified as far as equities are concerned, but will still be fully exposed to market risk.

Transparency

There are two aspects of transparency as it pertains to ETFs – portfolio and price. Since index ETFs hold the same securities as the indexes that they track, investors know precisely what they are invested in. Even ETFs that do not track indexes publish their full portfolios on a daily basis, providing ongoing portfolio transparency. In contrast, actively managed mutual funds publish their portfolios only after a lengthy time lag, as transparency is actually likely to be detrimental to their business prospects (since investors can invest in the funds’ holdings on their own rather than through the mutual fund). In addition, ETFs track the market price of their underlying securities closely; if the price of an ETF deviates significantly from the underlying securities in its portfolios, arbitrageurs will step in and close the price gap rapidly. This price transparency ensures that the market price of ETFs is generally very close to its Net Asset Value (NAV), unlike a closed-end fund, for example, which can trade at a substantial premium or discount to its NAV. (Related: Advantages And Disadvantages Of ETFs)

Trading Flexibility

Since ETFs trade on an exchange, investors can buy and sell them like regular stocks, using different types of orders such as limit orders or stop orders to get optimal pricing for their trades. In contrast, mutual fund investors cannot use similar orders when they trade fund shares, and there is no scope for price improvement since all fund investors get the same closing NAV price on a given day. ETFs can also be sold short, just like a stock, and many ETFs have options on them, providing more trading flexibility to investors.

Access to Niche Markets and Asset Classes

The wide range of ETFs available makes it easy for retail investors to invest in markets and asset classes that were previously difficult to access, such as small emerging markets, currencies, commodities and alternative investments. The availability of inverse ETFs and leveraged ETFs also provides retail investors with more choices for hedging and speculation. Note that many of these ETFs carry the same risks as their underlying securities, and investors should be fully conversant with these risks before investing in them.

Increased Choices for Portfolio Construction

The plethora of investment themes and strategies that are available through ETFs gives investors increased choices for portfolio construction. Apart from the obvious benefit of using ETFs to create fully diversified portfolios, investors can use ETFs for relatively advanced strategies such as constructing market-neutral portfolios, hedging risk exposure or creating a net-short position to capitalize on a market downturn. ETFs enable such portfolios to be created in a very cost-effective and efficient manner.

Potential Tax Efficiency

ETFs have potentially greater tax efficiency than mutual funds due to their lower portfolio turnover, and also because they can do in-kind redemptions. As most ETFs track the performance of a specific benchmark or index, they generally have lower portfolio turnover than actively managed mutual funds, which translates into fewer capital gains or losses realized that may flow through to the ETF holders. ETFs also use in-kind redemptions to reduce unrealized gains, which keeps capital gains and losses low compared to mutual funds; many ETF investors therefore do not incur taxes on capital gains until they sell their ETF units.

Low Investment Threshold

ETFs make it possible for investors to construct diversified portfolios with a low investment threshold, a feature that is likely to appeal to young investors who may have limited capital to invest. This makes it possible to put one’s money to work as soon as possible, rather than waiting to amass a particular amount before investing.

Elimination of Manager Risk

Actively managed mutual funds usually have a significant degree of manager risk. A top-performing fund that has consistently outperformed its benchmark likely has a great fund manager. But what if the manager leaves the fund, or makes a series of poor calls that imperil the fund’s performance? Such manager risk is virtually eliminated in an ETF, as its objective is to track an index and not outperform it.


Exchange-Traded Funds: Biggest ETFs and ETF Providers
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