In last month’s Money Notes, we talked in depth about the importance of diversifying your assets. This month, we are focusing on one of the easiest tools investors can use to achieve this aim —exchange traded funds (ETFs).
Back in 1993, State Street Global Advisors launched their Standard & Poor’s Depositary Receipts (SPDRs) fund to track the S&P 500®. It was the first of many ETFs which, for more than a decade, remained relatively obscure vehicles in the vast investment landscape. After the 2008-2009 financial crisis, however, lower-cost, passive investment strategies designed to mirror a particular index began to gain greater traction.
Although index strategies were taking flight, many investors struggled with the relative inflexibility of traditional index mutual funds. Unlike stocks, mutual funds are priced daily rather than in real-time, and impose investment minimums and redemption fees – making them less than ideally suited for responding to volatile markets. ETFs on the other hand, were not saddled with any of these restrictions and quickly became the darling of both institutional and individual investors alike.
To date, investors have poured more than $3 trillion into ETFs (a market that’s expected to double by 2022), and now have over 1,700 specialized funds to choose from.1
The best of both worlds
The features and benefits of passive, index-linked ETFs are easy for investors to understand. Essentially, ETFs combine the low-cost index tracking benefits of index mutual funds with the convenience of being able to buy and sell them throughout the trading day like stocks. Because they’re designed to simply mirror an index, passive ETFs typically have markedly lower operating expenses than actively managed funds. Additionally, because they trade on an exchange (rather than requiring the issuing fund company to sell and redeem shares directly) their operating costs are usually lower as well.
ETFs are often favored by tax-conscious investors for their excellent tax efficiency. Since the stocks that are included in the indexes they track rarely change, passive ETFs tend to have comparatively low portfolio turnover and therefore smaller capital gains distributions than most similar mutual funds. And because of their proliferation, today there are ETFs corresponding to nearly every index, sector, asset class, country, and currency across the globe. Broad market diversification has never been easier or more accessible.
This ETF growth has also given rise to new ETF variations which incorporate elements of active management into the otherwise passive nature of the strategy. New leveraged and inverse ETFs employ derivatives to help amplify the performance of the index they track, or profit from its negative returns. Alternatively, “Smart Beta ETFs” and/or “Factor-based EFTs” use various rules-based methodologies to try and boost returns or hedge against downside risk by overweighting or underweighting certain stocks in an index – typically with a clear main objective such as limiting downside risk in a volatile market or generating higher income.
While these newer ETFs may forgo some of the cost and tax benefits, they offer individual investors access to sophisticated strategies that previously were only available to foundations, endowments, hedge funds, and other large institutional investors.
While ETFs provide a highly convenient means to more broadly diversify your portfolio (e.g., investing in the entire S&P 500 through a single fund), there are some important considerations you should be aware of before making any investment. Since ETF shares trade like stocks, whenever you buy or sell shares the transaction will be subject to a fee. For this reason, ETFs may not be ideal for investors who employ a monthly dollar-cost averaging strategy.
Additionally, because most ETFs are passive investments that are locked into a fixed allocation to track a particular index, during times of high volatility or a rapid market decline there’s no active manager involved who can seek to minimize fund losses by shifting assets into bonds or cash. Similarly, in highly volatile markets, ETF pricing can be difficult because some of the underlying securities may be trading so quickly or may not have orderly markets.
However, for investors with clear goals, the ability to make lump-sum investments, and a desire for broader diversification, ETFs can deliver instant access to entire markets and sectors around the globe. They afford you access to complex alternative assets, commodities, and currencies, along with the ease and flexibility to move in and out of markets swiftly. Interested in learning more about how we select and use ETFs to broadly diversify portfolios? Talk to your BLB&B advisor today.
1 ICI Factbook, 2017