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What are Exchange Traded Funds?
There are a number of ways I could answer the question, “What are Exchange Traded Funds?“, but the most convenient is to say they are similar to mutual funds but with lower costs and greater convenience.
For individual investors Exchange Traded Funds (ETFs) are closed-end funds. This means they have lower administration costs than if they had to frequently create and redeem units like mutual funds. Costs savings don’t end there.
Traditionally, individual investors have been disadvantaged by investment spreads – the difference (sometimes large) between the quoted buy and sell price for an investment. ETFs have very small spreads. The expense ratio of ETF ownership – typically 0.1 to 1 percent is very low compared with a typical mutual fund.
Keeping expenses low is the easiest way to turn a mediocre investment performance into a worthwhile performance. Let’s say you and a friend invest $10,000 in a sector which, over 25 years delivers an average return of 8 percent annually.
Your friend invests through a mutual fund with fees at 3%. You invest using an ETF with fees at 0.2%.
At the end of the investment period, your investment will be worth $65,384. Your friend’s will only be worth $33,864.
Isn’t that enough incentive to chase low fee investments?
Most ETFs track an index, such as the S&P 500 or NASDAQ. You can buy an ETF if you think its associated index is going to rise. Inverse ETFs permit you to bet against an index. Alternatively, you can sell ETFs short, just as you would an individual stock. ETFs trade at roughly the same price as the value of the assets in the underlying index.
Since 2008 the SEC has allowed the creation of actively managed ETFs – the active management results, of course, in higher fees.
You can buy and sell ETFs at any time the stock market is open, unlike mutual funds which are only traded at the market close.
ETFs are becoming an increasingly popular investment because of low costs, liquidity and tax efficiency. They also offer individual investors the chance to diversify in ways that would previously have been beyond their reach.
There are now hundreds of ETFs from which investors may choose their preferred geographical region and their preferred investment vehicle from stock ETFs, bond ETFs, commodities, currencies, futures, etc.
If you have been thinking about investment in a mutual fund or diversifying your portfolio, exchange traded funds are worth looking at.