Exchange-Traded Funds (ETFs) have grown dynamically over the past decade, from less than $100 billion in 2000 to just under $800 billion in 2009 for the U.S. market alone. ETFs are a critically important feature of the investment landscape, and to help with your ETF research, here is a primer on the important things you need to know.
1. What is an ETF?
Exchange-traded funds are a type of pooled investment vehicle, meaning a single tradable entity containing multiple assets of one or more category such as stocks, bonds, commodities or currencies. ETFs were originally designed specifically to track a specific market benchmark, like the S&P 500 or the Barclays Aggregate US Bond index. In this way ETFs have much in common with the mutual fund variety known as index funds. Like index funds, ETFs are “passive” investment vehicles – their purpose is to closely replicate the performance of a market benchmark, not to outperform the benchmark (this is what actively-managed mutual funds attempt to do).
2. How do ETFs trade?
ETFs trade like regular shares of common stock, which is to say on a stock exchange with prices changing continually throughout the trading day in response to buy and sell orders. For example you can go to any popular financial news site, like Yahoo! or Wall Street Journal Online, type in the ticker symbol EPP (iShares MSCI Pacific ex-Japan Index ETF) and see its current share price ($37.85 as of 1.58pm on July 8), time of last trade, transaction volume, 52-week high/low, P/E ratio etc. – all the metrics you see for any ordinary share of stock.
This is convenient for ETF research and trading, and is quite different from the way mutual funds trade. Mutual funds typically price once at the end of each trading day, and investors buy and sell (“redeem” in mutual fund parlance) based on the Net Asset Value reflected in that price.
3. How do fees and expenses differ between ETFs and mutual funds?
Mutual funds often come in several varieties of share class, for example: front-end or back-end load, retirement, institutional and so forth. Each class reflects different types and levels of fees, including sales load, redemption, 12b-1 and other varieties (for a detailed examination of mutual fund fee structures please refer to David Buchanan’s excellent series “Understanding the various forms of mutual fund fees”).
ETFs typically contain just management fees (and occasionally other fund operating expenses). Because they are passively-managed vehicles ETFs will generally have lower management fees than actively managed mutual funds. In fact, according to a study produced by the ETF company iShares, ETF management fees are considerably lower on average than those for passively-managed index funds as well. For example (according to this study) the average management fee for active large cap blend mutual funds is 1.11%, and 0.42% for index funds in this style space. By comparison the management fee for the iShares S&P 500 Index fund (ticker IVV) is 0.09%, and for the Russell 1000 Index fund (ticker IWB) is 0.15%.
4. What asset classes can I gain access to through ETFs?
The number of asset classes covered by ETFs increases every day, and your ETF research will no doubt show you a range of both broadly-and narrowly-defined exposures. You can buy an ETF reflecting the market for US large cap value stocks (Russell 1000 Value index), or the Chilean stock market (MSCI Chile index), or the 7-10 year US Treasury bond market (Barclays 7-10 Year Treasury index), or specialized commodities positions from crude oil to gold. This makes ETFs a very handy instrument for portfolio construction, as it is possible to obtain very precise return, risk and correlation goals through selection of the appropriate assets. Moreover, because ETFs have a low tracking error relative to the benchmark, performance will be more directly related to asset class performance as opposed to fund manager decisions that are part and parcel of actively managed funds.
5. Are ETFs the same as ETNs?
ETNs are Exchange-Traded Notes, and they are not the same as ETFs. ETNs are a variety of a complex type of asset known as structured products. Structured products are essentially comprised of bonds issued by an AAA-rated financial institution containing one or more options or other derivative instruments like swaps. ETNs are often used to obtain exposure to even more exotic asset classes than ETFs, for example a commodity like copper or liquid natural gas, or a frontier stock market like Indonesia. It is a good idea to approach these instruments with caution, as they come with certain risks that are not features of ETFs.
As with any investment, you want to make sure you have conducted your ETF research thoroughly before wading into the ETF pool. A good rule of thumb is to focus your ETF research on ETF fund families that have been around for awhile and grown with the market, like iShares, PowerShares or SSGA’s SPDR fund family. Also remember that while ETFs can take you all over the world in terms of obtaining asset class exposure, they won’t shield you from the risk of investing in volatile markets. You can find fact sheets about each ETF offered by any of the fund families, including return and risk metrics, fund holdings and other important information.
Be on the lookout for more blog postings on ETFs in the coming weeks, as we will be discussing various aspects of these instruments and strategies for their use.
Note from Jemstep team: Jemstep will be releasing its ETF product in the very near future.
