When compared with other long-time investment products, exchange-traded funds (ETFs) are relative youngsters—but they’ve seen a lot of living since their debut in 1993. The financial crisis of 2008-09 witnessed a steady migration from active managers trying to beat their benchmark indices toward more passive investing strategies seeking to mirror and track a specific index.
Investors saw them as flexible, less expensive, more tax efficient and, when caution and trust were topmost in everyone’s mind, transparent.
Here we are in the 2020s and the value of assets managed by ETFs globally is an eye-catching $7.74tr, with the SPDR S&P 500 as the largest ETF in the world by market capitalization at $327.31bn.1
All of this might have you wondering, if you aren’t familiar with them, what exactly is an ETF?
The ETF at a glance
An ETF combines the features of an index mutual fund and an individual stock. Like an index fund, an ETF owns a basket of securities based on market benchmark, such as the S&P 500. But ETFs differ from mutual funds in an important way: They can be traded throughout the day, just like individual stocks. Mutual funds are priced and traded only after the market closes each day.
Like mutual funds, ETFs let you conveniently and cost-effectively diversify your portfolio—many large brokerages offer trade-commission-free ETFs. Additionally, most ETFs are designed to help avoid realizing taxable capital gains, meaning they may help reduce the tax bite for investors who hold them in taxable accounts.
What are my costs and related risks?
ETFs are no different than any other investment: They come with costs and risks you should understand before you invest. Here are a few to consider:
- Commissions. While there are many commission-free ETFs, the charges for those that do can reduce your return every time you trade.
- Expense ratio. An ETF’s expense ratio is the money you pay to cover the fund’s operation—the higher the ratio, the lower your returns. Doing your homework is important: while ETFs generally have very low expense ratios, a similar mutual fund tracking the same index might charge less.
- Premiums and discounts. The price of an ETF can be different from the value of the assets in it. If the ETF is priced higher than its net asset value, it’s trading at a premium. If the ETF is priced lower, then it’s trading at a discount. Premiums and discounts aren’t much of an issue on ETFs that track major indices but can get as high as 3% or more on niche-oriented funds. In plain English, if you buy an ETF at a 2% premium and its price shifts to a 2% discount by the time you sell it, the net change of 4% will be how much you lose on your return.
- Temptation to trade. The good thing about ETFs is that you can buy and use them to track almost any corner of the market, from aluminum to nanotechnology companies, and jump in and out of them at will. The drawback is in precisely the ease of buying and selling: You may be tempted to overtrade, overthink…and then underperform.
Can a professional help me with the ABCs of ETFs?
Absolutely. A trusted advisor can not only help you to decide if ETFs are a good choice for your portfolio but assist you in choosing ones that best suit your time horizon, risk tolerance and all of your other investment requirements. Most of all, you’ll gain the guidance you need to avoid impulse buying and selling and stay the steady course on your goals.