Since the 2008-2009 financial crisis, there has been a steady migration away from active management towards more passive investing strategies. Mutual fund managers who seek to outperform a particular benchmark index by overweighting and underweighting individual stocks have given way to index funds which simply seek to mirror and track a specific index at a lower cost and with greater investment transparency.
It is a wholesale shift that comes as no surprise given the extent to which active managers struggle to beat their benchmark indexes. Over the past ten years, a staggering 82% of large-cap funds failed to match the returns of the S&P 500®.1 Yet index funds can, at times, seem a bit unwieldy and inflexible in their daily rather than real-time pricing as well as their investment minimums and redemption fees.
This fueled the emergence of exchange traded funds (ETFs) as a diversified, low-cost and more flexible alternative to mutual funds. And investors have eagerly embraced the new investment vehicles, resulting in exponential growth of the ETF marketplace. In 2015 alone, more than $370 billion flowed into ETFs. Globally, ETFs today comprise a $3 trillion market that is projected to more than double over the next five years.2
So what exactly are the benefits of ETFs and why might you want to consider them as investments for your portfolio?
How ETFs work
ETFs seek to combine the best features of index mutual funds (low-cost index tracking) with the stock-like convenience of an exchange where shares can be bought and sold throughout the trading day. Like passive index funds, ETF on average carry significantly lower annual operating expenses than actively managed mutual funds. And since ETF shares are traded on an exchange (eliminating the need for the fund company to directly sell or redeem shares) they often have lower operating costs than a comparable passive index mutual fund.
The prolific growth in ETFs also means there is a vast universe of indices, market sectors, asset classes, currencies, countries and market niches that you can easily invest in and gain broad diversification with a single investment. Tax-conscious investors tend to have a particular appreciation for the excellent tax efficiency of ETFs. As is the case with index funds, because they track an index which doesn’t frequently change, they tend to have relatively low portfolio turnover thus minimizing annual capital gains distributions.
Recent years have even seen the emergence of newer actively managed ETF strategies (such as leveraged ETFs that and inverse ETFs) which typically use derivatives to either amplify the movements of a particular index or take advantage of a downturn. While these newer ETFs forego many of the cost and tax benefits, they provide retail investors with easier access to approaches that were previously only available to hedge funds and institutional investors. Leveraged and inverse ETFs involve certain risks, including risk associated with the use of derivatives, imperfect benchmark correlation, leverage and market price variance. These risks may pose risks different from or greater than those associated with a direct investment in the securities underlying the funds' benchmarks, can increase volatility, and may dramatically decrease performance.
The one principal ETF drawback that should be noted is that since their shares trade like stocks, investors will incur transaction fees whenever they buy or sell shares. Therefore, ETFs are far more suited to lump-sum investments and by no means the ideal vehicle for investors who are pursuing a monthly dollar-cost averaging strategy. And of course, since they are crafted to closely track a particular index, when markets are declining ETFs don’t have the luxury of active manager who can quickly move into cash positions.
If you have a clear vision of your investment goals, however, ETFs can provide instant access to virtually any sector or market in the world. They enable you to add often complex assets such as commodities, gold, alternatives and emerging markets with ease, and allow you to move in and out of markets quickly – delivering the flexibility that empowers you to become the type of investor you always aspired to be.