The ABCs of ETFs
The first Exchange Traded Fund or ETF traded on the American Stock Exchange in 1993. Launched by State Street Global Advisors, the first ETF or S&P Depository Receipt (SPDR) was benchmarked to the S&P 500 Index. This SPDR fund, commonly referred to as “spider”, trades today under the symbol SPY and with over $380 billion in assets is the largest ETF in the market and typically reports the highest daily trading volume of all ETFs. From the first ETF in 1993 we now see a marketplace (US) with over 2,700 ETF offerings and $7.0 trillion in assets. An ETF is a standalone investment company which must be registered under the Securities Act of 1933 and is a separate legal entity from the company that manages it. The three largest managers or providers of ETFs are BlackRock (iShares), Vanguard and State Street (SPDRs).
I like to think of an ETF as a collection or basket of assets that is designed to replicate the performance of a segment of the market. Think of an ETF as a diversified portfolio that holds assets related to a specific market, industry sector, market capitalization, country or region, or a commodity without the cost and effort involved with buying each of the individual assets separately. SPY is a collection of 505 stocks that was constructed to provide investment results that are like the price and yield performance of the S&P 500 Index. Each stock represented within the index holds a similar weighting within SPY. I like ETFs because they offer ease of trade, transparency, low expenses, and excellent diversification. ETFs can be used in an all-ETF portfolio or to provide exposure to a subset of an asset class or alternative asset class. The most frequently asked question about ETFs is typically how are they different from mutual funds?
Trading – Investors buy and sell ETFs just like they would the shares in any public company on a stock exchange. ETFs trade like a stock as their prices fluctuate throughout the trading day. Purchases of ETFs are made in the number of shares desired. Mutual funds trade at their net asset value (NAV) which is set at the closing of the trading day and does not change throughout the day of purchase. Investors can place mutual fund orders throughout the day, but all orders received during the day will receive the same price (NAV). Active traders prefer ETFs as they can make intraday trades, use stop orders, options, and short sales, all of which cannot be done with mutual funds.
Transparency – Most ETFS are passive funds which are designed to hold a broad range of assets. Portfolio holdings of ETFs, which are static, are disclosed daily and provide greater transparency than the holdings of mutual funds. The performance of an ETF should track closely the index to which it is benchmarked. A mutual fund is an actively managed fund with day-to-day managers who buy and sell securities according to a plan which designates a specific purpose, style, or category. “Style drift” refers to the unscripted buying of securities for a mutual fund, which securities do not match the intended purpose, style, or fund category. Style drift typically occurs when mutual fund managers attempt to close the gap with a benchmark or get extra performance, in both cases exposing the investor to unforeseen risks.
Lower Cost – ETF expense ratios, which often range from just 0.05% to 0.50%, are much lower than the cost of most mutual funds which typically charge 0.75%, 1.0% or even 1.5%. Some mutual funds also have a sales load charge incurred at the time of purchase, time of sale, or a combination of both. ETFs are also more tax efficient than mutual funds and typically generate fewer taxable gain distributions. Most ETF investors will realize a taxable gain only when they decide to sell their ETF shares.